First, a quick explanation of what VAT actually is. Value Added Tax is known in economic language as an ad-valorem indirect tax. Ad valorem means that it is a percentage that is added to the value of the good, so the amount of tax paid rises depending on the price of the good. It is an indirect tax because it is not paid directly by consumers to the government but it is collected by businesses (who operate as unpaid tax collectors). It is now charged at 20% on all products except those that are "zero-rated" which includes necessities like most food and children's clothing. Household energy bills are subject to a 5% VAT rate, which isn't being touched.
The reason why the coalition raised VAT is quite simple. There is a £160bn deficit and raising VAT by 2.5% raises something like £13bn. That said, here are the issues with it.
|Figure 1: VAT is regressive.|
BUT others argue that this is a misleading graph, as VAT is better measured on how much extra people will actually pay. The graph opposite makes a lot of assumptions, in particular on what the poorest actually buy, when in fact it is those on higher incomes or those who are at a stage in life when they have to make certain purchases (e.g. moving house) who actually pay more in VAT.
2) It is easy to avoid - it is reckoned that VAT fraud costs the UK government about £2 billion a year, but the rise in VAT will motivate people to pay their plumber in cash this time whereas before they wouldn't have. There are predictions that VAT fraud will thus go up to £3-4 billion as a result of this change, so the government won't collect as much as they think
BUT - Legal income tax avoidance adds up to about £35 billion at the moment, making VAT pale into insignifiance. Also, this misses out the fact that the simplest way to avoid VAT is not to buy items that are not zero-rated. Ed Miliband helped out with this by saying that "they will be taxing you higher when you go out and get a cup of coffee. And when you pick up a DVD for the kids to watch at home." Both of those purchases are what you would definitely call 'discretionary'. If Miliband was saying that you were being taxed more for a pint of milk or a loaf of bread then he would have a point. But he isn't, so he doesn't.
3) There are other alternatives - money can be raised using carbon taxes or a tax on financial transactions. Some argue that bank bonuses should be taxed more and the higher rate of income tax should be put up. There is also an argument for a "land tax" of 1% on the value of land owned (much of it by hereditary landowners), which could raise about £50bn. There is also the fact raised by those on the right that the same effect on the deficit could be achieved by cutting 2% more off government spending. There are those on the left who will suggest that the deficit is not so much of a problem that anything needs being done about it. The point is, there are alternatives.
BUT - if you want to raise money to cut the deficit in a way that can easily be implemented and be almost guaranteed for it to work, VAT is probably the most effective solution.
4) Both the Conservatives and the Lib Dems promised not to raise it during the election campaign - yes, this did happen, although the Conservatives said they "had no plans to" rather than promising not to.
BUT - The problem is that you campaign in poetry and govern in prose and there were a lot of promises made in that election campaign that were irresponsible, and now they have the responsibility of government they have to just do what they feel is right. It would be irresponsible to not do something simply because they said they wouldn't in the election campaign. Also, as the Conservatives quickly pointed out, Ed Miliband was in the Cabinet only a year ago that tried to raise VAT - a plan nixed by Gordon Brown for purely political rather than economic reasons.
This is the first major tax rise by this government and it makes economic sense. The opportunity cost of not doing it was to cut more spending, so to raise any tax should be seen as a good thing by the "fight any cuts" lobby. Is it the right tax? Well, there are alternatives, and I would hope they are being considered. But this VAT rise seems the right policy for right now.