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Wednesday, 5 January 2011

VAT - economically right whatever the politics says

VAT is one of those issues on which many of the arguments involve a suspension of economic logic in favour of political expediency. On the day the Coalition government has put it up to 20%, it is worth reviewing and evaluating those arguments so that it is possible at least to see through the political mist that has descended over real assessment of whether raising it was the right thing to do.

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.
1) It is a regressive tax - this is the classic argument, that since it is a flat-rate tax, those on a lower income pay proportionately more than those on a higher income. In simple terms, it hits the poorest hardest. This is shown by the graph on the right, produced by the Institute of Fiscal Studies.

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.


  1. Or they could just take vodafone and others to court. At the end of the day it's a tax on consumption which will reduce the amount people will spend and is likely to lead to job losses and higher unemployment meaning less tax revenue and more job seekers allowance must be paid and so the cycle continues.

  2. Before I answer the second bit - are you referring to Vodafone's tax avoidance? They have taken them to court, and got a settlement.

    Anyway. Yes, it is a tax on consumption. It will be interesting to see what happens in terms of the revenue raised from it. A 2.5% rise in prices is not enormous so it may not make a huge amount of difference, depending on the elasticity of demand for the products it affects. You use the word "will" but I prefer the word "may". What you say may happen makes economic sense but whether it will remains to be seen.

    What is certain is that we have to look at different ways to rid ourselves of this deficit and VAT was one of them. The prospect of £13bn in extra tax revenue stopped £13bn in cuts so is it such a bad thing?

    I suppose we could have raised national insurance, which is a tax on employing people, but that would also have cost jobs.

    It's not easy being in government

  3. They where taken to court and where close to a large settlement until the exchequer stopped the case.

    It may not be easy being in government but it is easy to help out your friends in big business cutting cooperation tax to rediculously low levels and not chasing up tax avoidance. There admittedly must be some hard descisions made but when Cameron talks of the hike being long term and of scrapping the 50p rate of tax you get the idea of where his priorities lie.

    I would laso like to point out national insurance is less regressive.

  4. 1) Labour cut corporation tax to 28%, the coalition to 27%, apparently to encourage small businesses to grow. Corporation tax is paid on the profits of limited companies. Ironically it would be one way to cut the bonuses paid out as it should encourage companies to retain their profits as capital instead of paying it out.

    Remember also that profits can be used for investment in order to grow the company, create jobs and new, better and cheaper products and services.

    So whilst lowering corporation tax looks like "helping out your friends in big business" it is not as simple as that

    2) As for the 50p rate of tax...what Cameron actually said is that he wanted to see whether it actually raises more tax. The Laffer curve (comparing tax revenue with the higher tax rate suggests the highest tax revenue would be received when the higher tax rate is around 43%). Since you are interested in progressiveness, every piece of research on what happened in the 80s when the higher rate of income tax was cut from 83% to 40% showed that those on a higher income paid more tax after the change than before AND paid a higher proportion of their income in tax than the lower paid, so it actually increased progressiveness. So I repeat, Cameron DOES want to scrap the 50p rate of tax. After all, didn't Labour promise not to raise the top rate of income tax? But he will only scrap it if it is not raising more tax revenue, for which we will have to wait to find out. If it is then it makes sense to keep it if he is serious about cutting the deficit.

    3) National insurance is less regressive. It is also a tax on employment. Those who pay it are employees, yes, and it is set up to be progressive. But also employers, who pay more the more employees they have, so you put up national insurance if you want to incentivise employers not to hire people. Do you want less jobs or more?