It is rumoured that Labour will be proposing a 2.5% VAT cut tomorrow. This will no doubt lead to nice soundbites, but will it work to help the economy? Well, the general problem with fiscal stimulus, as with any measures that affect a system the size and complexity of the UK economy, is the lag between action and effect. It is known, for example, that interest rate changes take at least 3 months before they have any discernible effect, and up to 18 months to have their full effect on the economy. So, we are actually still living with the Bank of England's policy as it was over the last two years, and their recent handbrake turn is something for mid-2009, not today. It is similar with changes to taxation as they take time to work through people's incomes and affect their confidence and economic decision-making. So, a key factor in choosing taxation changes to stave off or ameliorate recession is how quickly the change inserts itself into the decision cycle. Reducing VAT is a bad choice simply because it does not immediately connect with the consumer. Prices may come down, but not in any uniform and easily discernible way, and it will be some time before people feel that they have any more money in their pockets to spend, which is the point. Reducing VAT also does nothing to affect employee retention, which was the Conservative proposal.
What the government should have done is reduce the tax burden on small business, remember that a rise in Corporation Tax for small business is still planned though there are rumours that at least may be postponed. What they really should have done is reduce income tax, because that is an unequivocal rise in personal income that the consumer would immediately notice, and so the lag effect would be reduced.
Tax cuts should have been matched by savings of course, but, hey, this is a Labour government.