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Fight recession: put cash into people's pockets

Growth will come through income redistribution not paying billions to bankers says Prem Sikka

Western economies are heading for a deep recession and governments everywhere are using vast amounts of money to rescue financial institutions. The US government has so far committed around $8.5 trillion (£6 trillion). The UK has committed about £500 billion. The bailout queue is now joined by auto manufacturers and others are waiting in the wings.

There is a desperate need to wean western economies off the toxicity of finance capitalism and rebuild them through investment in science, technology and manufacturing. Governments also need to address social inequalities in the distribution of income and wealth.

The teetering economies need a desperate infusion of cash. Governments need to stimulate demand through investment in public works and an increase in people's spending power. Yet the UK government's response has been timid as it does not wish to upset big corporations and economic elites. The government has offered help to some homeowners through a scheme that defers mortgage payments. The plan may help 9,000 homeowners. Though this will be welcomed by many, it does nothing for those living in rented property, or those whose homes have already been repossessed.

The government could have chosen a number of reforms to put cash into people's pockets. It could have simply sent a cheque for £500 to each household, at a total cost of around £15 billion and left each household to decide how it spent that cash. This is a small fraction of the money being showered on bankers. It could have abolished VAT on domestic fuel and thus reduce gas and electricity costs. This would have helped to reduce average households costs by about £60 and help three million people suffering from fuel poverty.

Instead the centrepiece of the government's £12.5 billion stimulus is a temporary 2.5% cut in Value Added Tax (VAT). This is unlikely to be effective. Woolworths, MFI and car showrooms have been offering massive discounts, but this has not helped to lift gloom from the high street. It is difficult to see how a 2.5% discount will entice hard pressed households to spend. At best, it will suck in more imports from China.

The government's strategy presupposes that most people already have cash, or can borrow money to make purchases. Such an assumption is not supported by social statistics. The UK economic growth has been fuelled by a personal debt mountain of around £1,410 billion, bigger than the gross domestic product. The average household debt, excluding mortgages, is £9,633 and credit is now scarce and expensive. Most UK citizens cannot tap into any sizeable reservoir of savings. It is estimated that 36% of people have less than £500 in savings to use in an emergency. The average savings are estimated to be £2,474. This position is likely to worsen as the savings ratio (proportion of take-home pay that is saved) has continued to decline. In early 2008, it was estimated to be minus 1.1%, compared to plus 11.7% in 1992.

A major reason for debt and inability to spend is inequalities in the distribution of income. The most recent government statistics show that in 2006/07, original income, before taxes and benefits, of the top fifth of households in the UK was 15 times greater than that for the bottom fifth (£72,900 per household per year compared with £4,900). After redistribution through taxes and benefits, the ratio between the top and bottom fifths is reduced to four-to-one (average final income of £52,400 compared with £14,400). This is further compounded by inequities in the tax burden. The poorest 20% of people lose nearly 40% of their total income in direct and indirect taxes, compared with a national average of 35.3%. The figure is 34.8% for the richest 20%. The spending power of the middle class and the low-paid has been sapped.

Most retired citizens do not have a pot of gold either. The UK state pension for a single person is 17% of average earnings, compared to 57% for the EU, and barely allows pensioners to subsist. Some may have been lucky enough to supplement this with income from occupational and private pension schemes. The government statistics show that during 2005-2006, 62% of pensioner couples had less than £10,000 in pension income. Half of single pensioners had income from pensions of less than £6,000. Last year, 25,300 pensioners died from cold.

These statistics do not support the assumption that normal people have enough spending power to stimulate the economy. Government needs to put cash into people's pockets and particularly help those on low incomes. Tax cuts for the less well-off provide a greater stimulus to the economy because they spend it on everyday things and as a result the multiplier effect is much greater than tax cuts for the rich.

The government could have boosted the spending power of the people by increased personal allowances for the current tax year. A 10% increase in personal allowances backdated to 6 April 2008 would have cost the Treasury £3.8 billion for 2008-09 and immediately put £120 into people's pockets. A commitment to raise personal allowances by 10% from April 2009 would have cost the Treasury £4.65 billion for 2009-10 and £4.7 billion for 2010-11. A 10% increase in the state pension would cost an extra £3 billion a year; and a 25% increase would cost around £9 billion. A doubling of the £250 winter fuel allowance would have cost around £2 billion. The government could have abolished prescription and dental charges at a cost of £1 billion. Currently, 80% of the people in the 18-60 age bracket pay the full costs of their prescription. Abolishing fees for undergraduate degrees would put another £2 billion into people's pockets.

There is plenty of scope for the government to provide cash to the low-paid and the middle classes. The cost of this should be borne by the relatively well-off. Here are some suggestions.

The proposed marginal rate of tax of 45% and the related claw back of personal allowances, after 2011, on those earning over £150,000 has an element of progressiveness, but it is too little and too late. Currently, no National Insurance Contribution (NIC) is paid on income in excess of £770 per week. From 2009-2010, this artificial ceiling will rise to £844 per week. The artificial ceiling makes NIC regressive. By abolishing the upper limit and levying NIC on the entire income, the government could raise an additional £8.5 billion.

The relatively well-off are able to claim more tax relief on pension contributions. Over 50% of the annual £21 billion tax relief on pension contributions goes to just 3% of higher rate tax payers. By restricting the relief to the basic rate of income tax (20%) rather than granting it at 40%, the government could have released £5 billion to help hard pressed people. The government allows numerous exemptions and then taxes capital gains at only 18%. If instead these were taxed at the basic rate of income tax, that would raise another £1 billion.

We all know that oil prices have plummeted but gas and electricity prices have rocketed. The government should address this by a windfall tax on energy companies. This should be supplemented by a massive clampdown on the tax avoidance industry. The UK loses around £100 billion of tax revenues each year as corporations and their wealthy controllers avoid taxes, often through schemes which simply shuffle profits and income and have no economic substance. It was estimated that, in 2006, 54 billionaires living in Britain paid £14.7 million in tax on their combined fortune of £126 billion - an average rate of a little over 0.1%.

Additional funds can also be raised by taxing the financial instruments that have played a key role in the current financial crisis. The face value of derivatives, which are often just clever bets though some businesses like to describe them as insurance, is estimated to be a round $1,140 trillion. The UK levies tax on insurance and gambling and there is no reason to exempt derivatives. Even a modest 1% tax on derivatives could raise $11 trillion and the UK would receive a sizeable share of that.

This all shows there is plenty of scope for stimulating the economy by boosting the cash flow of each household. It also enables the government to make public investment, rebalance the tax burdens and reduce poverty.