EEF blog

We've been calling for a rebalancing of the economy since the publication of our report 'Manufacturing: Our Future' almost 12 months ago and now it has the official backing of the Prime Minister who gave a welcome commitment to chart a different direction today. he echoed many of our sentiments that business as usual and a return to the same will not be enough to rebuild our economy and a new approach is needed. Business will now look to the forthcoming emergency budget as the first litmus test of this commitment

Our Chief Executive, Terry Scuoler, attended the event and echoed the  Prime  Minister's sentiments:

"The Uk's economy is now at a crossroads and we have to realise we didn't get here by accident. Manufacturers will be heartened to hear such a strong commitment from the Prime Minister that the government is planning to chart a different direction from now on. The next step is to put in place a policy framework across government at national and regional level that will build this momentum and deliver the crucial rebalancing we need.

"Reducing the deficit is clearly paramount. But, in addressing this we have to place equal emphasis on growing our way out of the current situation. In particular, government departments must balance the efforts to cut costs with a focus on pulling together to promote growth."

At EEF we are looking forward to working closely with government to promote a dynamic manufacturing sector at the heart of a rebalanced economy. There is no time to lose.

So the long slog of fiscal consolidation begins today.

And the new government has got off to a good start by delivering the £6.24bn in savings through cuts in the cost of government itself.

Because it's a big spending the deparment, the Department for Business was never going to be immune from the tough decisions.

Where EEF have concerns, however, is the uncertainty around investments in energy security: where commercial contracts are involved, the government need to fairly quickly provide some certainty for the companies concerned.

As our Chief Executive, Terry Scouler, said today,

“The task of repairing the public finances is a significant one and we don't have to look too far to see what happens when governments don't act quickly to address deficits.

“Given the tough decisions it faces the government is right to make an early start and proceed with a focus on reducing the cost of government and ensuring value for money.  The Efficiency and Reform Group should formalise the process of bringing transparency to what should be an ongoing process of improving public sector productivity.

“However, the decision to freeze funding for frontline investments from the previous government’s Strategic Investment Fund could have significant consequences on investments already underway. Where commercial interests are involved these must be resolved as quickly as possible.”

Inflation statistics released today showed that the CPI inflation measure has risen to 3.7%, well above the target of 2% and, above the consensus forecast of 3.5%. However earlier this month the Bank of England announced that not only would interest rates be put on hold this month but also for the foreseeable future to accommodate the new government’s fiscal contraction.

Given that the Bank of England’s specific remit is to keep inflation at around 2%, this announcement might seem a little surprising. CPI is currently the highest it has been since November 2008 when interest rates were at a rather more robust 3%. What is more, the Bank of England’s own statistics suggest that 72% of people expect prices to rise in the next 12 months.

Consumer expectations of inflation are something that the Bank should be concerned about. Over the last five years changes in the RPI (which is the measure of inflation most commonly used for wage setting) have closely followed consumer expectations. If inflation remains above target for a significant period of time the Bank’s credibility could be undermined, leading consumers to expect frequent price rises and ultimately leading to a requirement for much greater interest rate hikes.

Year on year changes in RPI, CPI and total weekly pay; and the percentage of people expecting price rises in the next 12 months
 

If inflation did continue to rise this would discourage investors away from the UK and lead to further falls in the value of the pound. Continued exchange rate volatility could also undermine chances of an export-led recovery as manufacturers and other exporters struggle to recognise price signals and market opportunities.

For the time being, however, the Bank is right to keep interest rates on hold. Primarily this is because the effects of fiscal consolidation are likely to dampen inflationary pressures in the economy. A combination of fiscal and monetary tightening would be likely to significantly limit economic growth.

In addition to this the Monetary Policy Committee consider many pressures on UK inflation (oil price rises, the VAT increase, and the depreciation of sterling) to be temporary. This could be masking a significant amount of spare capacity in the economy which, according to the MPC, will continue to pull down on inflation and may even bring it below target in the next year.

The MPC would be advised to remain vigilant, however. Core inflation has been growing steadily even in the recession; consumers continue to expect higher prices; and wages are on the up. As Mervyn King himself noted “the pace and extent of the prospective fall in inflation are highly uncertain”. If inflation doesn’t start to fall back soon, the bank may have to consider putting up interest rates – rather than risk its credibility – regardless of the fiscal situation.

In March, EEF called for VAT to rise to 20% as part of tax reforms designed to rebalance the economy.

Today, the BBC released a poll showed that 24 of the 28 independent economists that help guide HM Treasury forecasts believed VAT is likely to rise as part of the package to cut the deficit. The IFS - which exposed the massive holes in the parties' pre-election budget plans - also expects VAT to go up.

And a closer look at the coalition agreement between the Conservatives and the Liberal Democrats suggests the new government has left the door open to a VAT rise.

But why a VAT rise?

To help rebalance our economy, we need to look at where the balance of the tax burden lies. Currently, the VAT rate in the UK is below the EU average, and typically, VAT rises are less damaging than other taxes - a slightly higher tax rate on spending will help shift our economy away from debt-fuelled consumption, while higher taxes on investment or profits simply punishes productive companies trying to grow and invest in the UK.

This shift in tax receipts will have reinforced the economic trend towards debt-fuelled consumption: households need to supplement higher taxes with borrowing to finance relatively lightly taxed consumption.

EEF's recommendation of a 20% VAT rate from 1 January 2012 would accomplish two goals.

Firstly, it would provide a boost to spending before the VAT rise, helping to reinforce the recovery through 2011.

It would also raise almost £12 bn a year.

That revenue could - and should - be used to rethink and realign priorities for public sector spending cuts. In particular, the government could offset some of the economically damaging cuts to capital budgets built into the last government's plans and ignored during the election.

The coalition government can either find ways to repair the public finances by cutting into economic muscle, or do it in ways that boost growth at the same time.

We think a VAT rise is not only needed to raise revenue, but is also economically rational to help rebalance the economy.