Tom Clougherty: Raising VAT looks like a self-inficted wound

In plain English, that means raising VAT from 17.5 to 20 per cent will destroy some 5bn of economic activity in the next tax year. The reason for this is simple: raising VAT will dent consumer confidence and discourage spending; fewer goods will be sold and lower profits will be recorded.

That's bad enough on its own to raise questions about the Government's plans. Does it really make sense to be willfully damaging the private sector economy, when the recovery is still so fragile?

We should not make the mistake of thinking we are already out of the woods: after all, a Eurozone crisis could easily trigger another financial crash. If Ireland, Portugal or – worst of all – Spain tank, the British economy will need all the help it can get.

Unfortunately, the OBR's prediction does not even tell the whole story. The economy is incredibly complex, and tax rises have all sorts of effects that take time to work their way through the system, setting off a variety of other reactions as they do so.

So raising VAT won't just reduce consumer spending and hit retail profits: it will also cause job losses, as sellers cut their overheads and producers reduce production. That will mean more people out of work and claiming benefits rather than paying taxes, and even less people going out and spending. The vicious circle is complete.

Independent economists have looked further into the future, and considered the impact that raising VAT will have over the next few years.

The British Retail Consortium, for example, has calculated that it will cost 30,000 jobs next year, and a total of 163,000 jobs by the end of 2014. David B Smith, a visiting professor at the University of Derby, has also run the VAT rise through his respected Beacon Economic Forecasting model, and found that the 20 per cent rate will increase the number of people claiming unemployment benefits by 236,000 over the next 10 years.

Worse still, Smith suggests raising VAT will worsen the budget deficit by 0.1 per cent in 2010-11, 0.6 per cent in 2011-12, and 0.4 per cent in 2012-13. That doesn't sound like much, I know, but when you are borrowing 17m per hour, and already spending 120m a day servicing the interest on your accumulated debt, every penny counts. We simply can't afford self-inflicted wounds like the VAT increase.

Sure, it might raise a few billion extra for the Treasury in the short term – but not without doing a whole lot of damage elsewhere.

To be blunt, the end does not justify the means.

We should also consider the impact that raising VAT to 20 per cent is going to have on inflation, which is already stubbornly high on the Government's preferred CPI measure (at 3.2 per cent), and higher still (at 4.7 per cent) on the Retail Price Index, which more closely reflects people's living costs. On Smith's model, inflation is 1.2 per cent higher in 2011 than it would otherwise have been, thanks to the VAT rise.

For pensioners and people dependent on their savings, this is a cruel blow. They have already seen their incomes hammered by low interest rates and high inflation, and now the Government is making things even worse.

Let's not forget that five per cent a year inflation will mean the value of your cash falling by more than 30 per cent over the next five years, which is no small beer.

Nor should we overlook the effect that inflation has on the poor and vulnerable, who are usually unable to demand higher wages to offset price increases, and therefore face watching their living standards collapse around them.

Of course, there is one positive thing we can say about raising VAT, and that is that it isn't nearly as damaging to the economy as raising some other taxes, like those on income or capital gains.

But given that the Government has already raised capital gains tax by 10 per cent, and has chosen to keep Labour's 50p income tax rate (even though the Institute of Fiscal Studies says it will lose them 800m a year), they don't get many brownie points for that.

On so many issues – from welfare reform to public spending – the coalition Government has made a good start.

But there is one thing they are sorely lacking, and that is a credible agenda to get the private sector economy growing strongly again.

After a decade of rising taxes and endless red tape, British businesses and entrepreneurs are crying out for change. Raising VAT to 20 per cent is a regrettable step in the wrong direction.

Tom Clougherty is executive Director of the Adam Smith Institute