BEAT WATCH: A UK Present: A Carrot And A Stick

LONDON --Doesn't it spoil the surprise when you know what your present is going to be. Supposedly all of the U.K. knows Chancellor Alistair Darling will, in his Pre-Budget Report to the House of Commons, propose a temporary Value-added Tax cut.

The move has been much trailed, and is expected to be a temporary cut of 2.5%, moving rates down to 15% from 17.5%.

The move is a combination of a carrot and a stick. The carrot is the cut, but the stick is the warning that taxes will have to rise in the medium term, this will "act on consumer psychology in much the same way as a reversible price cut," said Monument Securities.

Demand would be stimulated in the short term as consumers would also appreciate the temporary nature of the tax cut.

"Without it, consumers might be left merely shrugging their shoulders at a once-off price fall."

Such a VAT cut would be a "bold, headline-grabbing measure," said Jonathan Loynes at Capital Economics, but it is unlikely to stop household spending dropping off, along with overall U.K. economic activity.

There are a number of reasons why the move might not work, said Loynes.

First, will it be big enough? On a High Street where the likes of Marks & Spencer PLC (MKS.LN) is cutting by 20%, it may seem insignificant.

Also to offset fiscal policy tightening, the tax cuts would need to be about 1% of Gross Domestic Production or GBP15 billion; the VAT cut is worth GBP12.5 billion.

Second, how much will be passed on by the retailers? "There must be doubts over whether smaller retailers will do so," added Loynes, just on the practicalities of changing prices for a short period.

Third, will households choose to spend all the money freed up? Beleagured consumers eyeing rising unemployment and falling house prices may decide to look to an "even rainier day."

And finally, the cut will increase the chances of negative inflation in 2009. This possible move will cut CPI inflation by near 1%, "perhaps pushing it as low as -1.5% next autumn." Which will probably encourage people to keep their hands out of their pockets if they think prices will keep falling.

A VAT cut won't avoid the need for more interest rate cuts and is unlikely to prevent a severe U.K. recession, added Loynes.

However, in the immediate-term, there's the risk "that markets are disappointed should the Chancellor prove too cautious," warned Dresdner Kleinwort.

-By Chris Purcell, Dow Jones Newswires; +44-20-7842-9444; chris.purcell@dowjones.com

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