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Plan B: Cut VAT back to 17.5 per cent

Dear Chancellor,

The advanced economies of the world are not yet out of recession. As you know, this recession is different from previous ones. It was caused by financial failures. These failures made people aware of the danger of too much borrowing and made the credit-rating agencies much more cautious than they were in the past, when they were unable to see the dangers brewing in the financial markets.

Banks are not the only institutions to come under scrutiny; governments have done, too, and the worry is that any sign of weakness in public finances will be punished with downgrades and higher interest rates.

I know you worry about the deficit but I think that you worry about it too much. Keynesianism of the kind that guided policy after the Second World War no longer works, but there are still lessons in it for us. Worrying too much about the deficit in a recession makes the recession worse. The problem with a recession is that it punishes a relatively small number of people and it punishes them a great deal. The unemployed, new school leavers and ethnic minorities bear the brunt of it. The cost of recession to them is not only lower income, but loss of self-esteem, loss of skill and damaged future career paths. Less concern about the deficit and more attention to the economy's ability to create jobs will reduce unemployment and improve well-being.

Let me emphasise that we do need a plan for deficit reduction. But it does not have to start so soon - when the economy is still in recession - go so deep and be so inflexible. Your approach to deficit reduction reminds me of Margaret Thatcher's approach to reducing inflation. She was right to be worried about it, and the reforms that she introduced were badly needed. But she squeezed the economy so much, in such a short period of time, that she caused a severe - and unnecessary - recession. It took almost ten years for unemployment to recover.

I fear that the way you are squeezing the economy now will have similar consequences. It will slow down the recovery and may even cause a double-dip recession.

Your plan for deficit reduction should start the spending cuts gradually and respond to the state of the economy. It should go deeper only when the recovery is more robust. A more flexible approach to the cuts is good both for economic growth and for the size of the deficit.

We know that taxes are harmful to job creation. I don't think reducing the top income tax rate from 50p to 40p in the pound will create many more jobs. But VAT and National Insurance contributions for low-skilled workers do hurt job creation. Cutting VAT back to 17.5 per cent, or reducing National Insurance contributions for those on low incomes, will revive job creation and reduce unemployment. Deficit reduction is best done with spending cuts when the economy is recovering, not with higher taxes in a downturn. There is enough time in the life of this parliament to achieve your deficit-reduction objective with a policy that is friendlier to job creation.

The markets are clearly telling us that you are too worried about the deficit. Looking at the G7, I don't see Britain in a worse position than other economies vis-à-vis Germany, the leading European economy. The spread of the yield on gilts over the German bund is only half of 1 per cent; in France, the spread is only slightly higher; and in Italy, which does have serious debt problems, it is 3.76 per cent. The financial markets are not worried about the British economy. They are not worried about the French economy, either, but France has higher debt than Britain and it isn't being punished for not squeezing its economy. We can afford to be a little more lax. The spread on the gilt might go up a little if you brought VAT back to 17.5 per cent. But a small rise in gilt interest rates is a small price to pay for more jobs.

Professor Christopher Pissarides holds the Norman Sosnow Chair in Economics at the London School of Economics. In 2010, he was awarded the Nobel Prize in Economics

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This article first appeared in the 17 October 2011 issue of the New Statesman, This is plan B