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VAT rise hits UK economic growth

New figures announced by the Office for National Statistics (ONS) today show that GDP growth has slowed to 0.2% in the second quarter of 2011. What the figures do not show is economists’ belief that January’s VAT rise is partly to blame and this may affect future tax policy.

The ONS cited five factors to account for the UK’s weak economic growth between April and June: the royal wedding and the extra bank holiday provided for it, the aftermath of the Japanese tsunami, the first phase of Olympics ticket sales and the warm weather in April.

Leading economists agree that these factors are important; however they also believe that January’s VAT rise to 20% is continuing to stunt UK growth.

“Effectively there’s a squeeze on real incomes and VAT is impacting on that,” said Andrew Smith, chief economist at KPMG.

Smith points out that a VAT increase means spending is initially brought forward before the rise and it slumps immediately after that. These factors would have worn off by the second quarter, but the VAT rise is continuing to squeeze domestic demand.

“A VAT cut now would help relieve the income squeeze,” Smith said. “But the big thing is high inflation. The main factors driving inflation are oil, energy and food prices and the VAT rise didn’t help either.”

Andy Goodwin, senior economist at Oxford Economics, agrees that the VAT rise is impacting on growth.

“The ONS have ignored it because it’s been sitting in the background since January,” said Goodwin. “The main factors are the bank holiday and the tsunami. But it’s put up prices for consumers and demand is weak.”

This is a view shared by one tax director.

“Undoubtedly people are just not spending money,” he said. “The man on the street would certainly think twice before making purchases.”

The economists’ analysis is bad news for the retail sector, though evidence that the VAT rise is hitting growth could be good news for those seeking to change the direction of tax policy.

Last month, Shadow Chancellor Ed Balls called for a temporary VAT reduction back to 17.5% to jump-start the UK economy. The Federation of Small Businesses has also called for targeted VAT cuts to boost the tourism and construction industries.

Goodwin believes that a temporary VAT cut would have a small effect, but it would not be enough to rescue the economy alone.

“There’s a good reason why the government put VAT up in the first place,” Goodwin said. “Our rate is lower than those of our rivals on the continent and most people are comfortable with the increase. The main bone of contention is the timing. The government was unlucky in that the VAT rise coincided with rising commodity prices, which put pressure on consumers.”

Stuart Adam, senior research economist at the Institute of Fiscal Studies, would not speculate on whether the VAT rise has had a direct impact on growth in the last quarter, but confirmed that in the long run, higher VAT is likely to reduce the level of GDP, though not the long-run growth rate of GDP, because it reduces work incentives.

“But you have to bear in mind that the VAT revenue finances public spending which could potentially increase GDP, for example if it leads to a better educated population or better transport infrastructure,” Adam said. “Without the VAT rise, either spending would have to be lower, or the revenue would have to come from some other tax, which might reduce GDP just as much as VAT does.”

Adam’s analysis is likely to give some comfort to the government, which is unwilling to reverse its VAT policy. However the latest growth figures, which have been affected by the VAT increase, will add to the mounting opposition to higher VAT rates in the UK. Companies, consumers and industry associations looking to see a cut will find their case has added weight.

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