BRITAIN'S CHANCELLOR of the exchequer Alistair Darling hopes the country can spend its way out of recession. In his pre-budget report yesterday, he announced a temporary indirect tax cut by lowering the standard VAT rate to 15 per cent from 17.5 per cent from next month.
His aim in this mini-budget is to stimulate demand by encouraging consumers to shop and thereby reverse the economy's slide into a deepening recession. This fiscal stimulus - via lower taxes - represents a calculated gamble. Given the weak state of the British economy, however, the risk is worth taking.
The tax cuts to boost consumption will be financed by increased public borrowing. Mr Darling expects that when economic growth resumes in a couple of years, large budget deficits will be quickly reduced and budget balance restored. In an economy that is undergoing something of a deflationary spiral, with prices falling, consumers have changed their spending habits. Shoppers are slower to spend today as they anticipate lower prices tomorrow. But a 2.5 percentage point reduction in the VAT rate may not change their psychology. So far the pre-Christmas sales on Britain's high streets, with price discounts of 20 to 25 per cent on offer, have failed to persuade shoppers to open wallets.
Certainly, yesterday's move represents an adverse development for the Irish economy. In Border areas the continued weakness of sterling has made British goods much more competitive. To visitors from the Republic, a 15 per cent VAT rate makes cross border shopping increasingly attractive with the prices of some goods (groceries, alcohol and clothes) up to 30 per cent cheaper. A much lower UK VAT rate opens a huge indirect tax differential between Britain and Ireland. It has happened just as the Government is raising VAT by half a percentage point (to 21.5 per cent). And with sterling likely to weaken further as a result of yesterday's fiscal package, that disadvantage seems set to increase.
The mini-budget response by the British government, as indeed by many other governments, highlights the very different policy response adopted by the Irish government in tackling the challenge of economic recession. Where other countries have favoured tax cuts as a means of stimulating demand, the Government has raised taxes in a bid to control a soaring budget deficit - but without much obvious sign of success. No economy has experienced such a rapid reversal of fortune as the Irish economy over the last year as the property bubble burst and property related tax revenue collapsed dramatically. That has left the Government struggling to contain a sharp deterioration in the public finances. Next year, a planned general government deficit of 6.5 per cent of GDP, which is twice the borrowing limit set for euro zone economies, seems likely to be exceeded. Ireland finds itself paying more to international lenders to finance a soaring budget deficit and this risk premium partly reflects the rapid deterioration in the public finances. The Government has left itself with less scope to provide a fiscal stimulus of the kind provided by its British counterpart.