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Tuesday, January 04, 2011

VAT and all that

A lot of stuff has been written today about the VAT rise, including many soothsayers who are convinced that it will all end badly. As ever with these matters we should take these things with a pinch of salt, remembering that they are making predictions not stating facts. In the case of economists I apply another rule: they are very good at predicting the past.

Here is one example of the sort of nonsense that the opposition have come up with, this time from August, when the Welsh Government put out a press release predicting that the Welsh health service expects to lose more than £20m next year because of the Government's increase in VAT.

Putting aside the fact that the NHS can claim back its VAT, this claim contrasted massively with a previous answer to a written question in which the same Government stated that Labour's 2.5% cut in VAT would only save £4.5m over the whole of the planned period of the reduced rate of VAT (1 December 2008 to 31 December 2009). Some mistake surely!

It is also worth noting Labour's crocodile tears on this issue in the light of the admission by Alistair Darling that he had wanted to raise VAT hinself so as to bring down Britain’s budget deficit.

The former chancellor told BBC’s Andrew Marr Show: “It’s no secret. I said at the time and, since Peter (Mandelson) has actually spelt out in gory detail, I’m not going to deny what was patently true.”

Asked whether his proposal to increase VAT was a “battle” he wished he had won, Mr Darling replied: “Yeah, obviously.”

He continued: “The advantage of VAT is that it brings a lot of money, it would have allowed you to do a lot to take down the deficit but also given you money to spend on things that actually matter.

“It would have ameliorated some of the worst effects of reductions.”

Finally, Labour also have to answer the question as to why, if they are opposed to the rise in VAT, they did not vote for the Nationalist amendment in the House of Commons, which would have scrapped it and why they did not manage to get all their MPs into the House of Commons for the final three line whip on this issue.

Just so that people do not think I am dismissing this issue out of hand, I can certainly concur that this was a very difficult decision and that it will impact on people's cost of living as well as on the economic recovery. Whether it has the impact Labour is predicting is another matter.

The fact is that VAT is not as regressive as it is being portrayed. Its biggest impact is on luxury goods as it does not apply to food or children's clothes, whilst it remains at 5% for fuel bills. The proportion of income one spends on these goods is therefore important.

The Institute of Fiscal Studies even suggests that VAT is a mildly progressive tax:

We believe that increasing the standard VAT rate in the current system is mildly progressive when examined on a lifetime basis. The intuition for this is that, over a lifetime, poorer households spend a higher proportion of their (lifetime) income on goods that are zero or reduced rated in the current VAT system, such as food, children's clothes and domestic fuel and power, and hence a lower proportion of their lifetime income on items that are subject to the standard VAT rate.

The common perception that VAT is regressive largely comes from noting that households with low current income often spend a lot – and therefore see a big cash rise in their living costs – relative to their income. But as explained in the previous answers, this is a weakness of looking at a snapshot of income: as the ONS notes, "referring to income distribution to identify the incidence of indirect taxes on households with low income can be misleading". In general, over a lifetime people's expenditure must match their income (the main difference being inheritances), so if someone is spending (and therefore losing) a lot relative to their income at the moment – either borrowing or drawing on past savings – they must be spending (and therefore losing) little relative to their incomes at other times. Looking over the lifetime as a whole, what matters is whether the lifetime-rich or the lifetime-poor see a larger share of their lifetime resources taken in VAT, and on that basis VAT is progressive because necessities (consumed disproportionately by the lifetime-poor) are typically subject to zero or reduced rates of VAT

As ever then things are not as black and white as they are portrayed.
George Osborne is wrong to go around touting the VAT rise as progressive. VAT, like council tax and the BBC licence fee, is not a progressive tax.

That said, I agree with the rest of your post. It should be added that the general view of economists is that the UK economy should grow at just over 2% in 2011, even allowing for the tax rise. I would guess that economic activity would be slightly greater without it, but it is not going to lead to the double-dip recession so long prophesied by Labour.
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