Why is VAT seen as the natural option?

In George Osborne's first budget next week, most commentators are expecting him to put VAT up to 20% or thereabouts. It will bring in a decent chunk of extra revenue to help deal with the deficit.

Why is it though that VAT is perceived as a natural, easy option for putting up by politicians?

If you measure how VAT affects people by relating it to their income then it is regressive, i.e. it affects the poorer disproportionately. There are some who argue it should be measured by consumption (by which measure it is less regressive) but opinion is at the very least divided on which is the right way to measure it. Items such as some foods, children's clothes and other essentials are exempt from the tax and I would be surprised if Osborne significantly changes this but I still think putting up VAT is quite unfair. There are plenty of things that are not exempt.

One form of tax that is not regressive is income tax because it is based on the ability to pay. So for example if Osborne instead decided to put up income tax by 2% next week, at least then those paying the extra tax would be those earning above the earnings threshold and would only be proportionate to how far up that scale they go.

Of course income tax is the most visible of taxes. A VAT rise may not even be noticed by lots of people because it is many small adjustments to the various things they purchase rather than being able to compare one month's salary slip with another and seeing a very definite and comparatively chunky drop.

But just because something is politically easier should not make it the only game in town. I hope these options are being discussed at a high level and not dismissed out of hand.

The current government is almost certain to be unpopular in a year or two's time due to all the things it is going to have to do that will affect people's services and pockets. Given that, it might as well implement measures that spread the pain more fairly around.

1992 "Tax bombshell" scars go deep for Labour and Conservatives

As Stephen Glenn pointed out yesterday, both Labour and the Conservatives are apparently thinking about raising VAT to 20% after the election in order to help try to reduce the budget deficit. There was a quote in The Times saying:

Though Labour and the Tories have denied having any current plans to increase VAT, neither will rule it out and The Times understands a rise in the tax is being considered by both parties.

The problem with VAT rises is that they do not spread the pain evenly. They disproportionately affect people on lower incomes because it effectively increases the amount of tax they pay overall as a proportion of their income far more than on more wealthy people. However the tax is not as visible as income tax. People do not see it directly taken out of their salary and hence if it goes up, they will not be able to compare last month's pay slip with this month's and see the extra amount the government is taking. They don't feel it as keenly even though it still affects them. That is why governments raise these indirect taxes, because it is politically less painful to do so.

But to understand why income tax rises are considered to be so politically poisonous we have to go back to the 1992 general election campaign. During that campaign, the Conservatives ran this poster campaign based on their calculations of what the Labour manifesto and the promised income tax rises would mean for the average family:

The poster was widely credited with having had a big impact on the result. Some, including Tony Blair even think that it was Labour's tax promises and the very effective way that the Tories highlighted them that directly led to them losing that election. The scars of that loss run very deep within the Labour Party and it was these that led to Blair's iron conviction to do everything he possibly could to avoid raising income tax rates. The line has been softened slightly under Brown with the pledge to introduce a 50% rate of tax for those earning over £100,000 but this only affects a very small number of people. The idea of raising income tax rates for many is still considered politically suicidal by most senior politicians in the two largest parties.

So the result of this toxic legacy is that instead of going for the fairest and most transparent tax rises which would be solely based on ability to pay, they are instead thinking about the best way to sneak them in through the back door.

Nobody likes tax rises. Indeed I wish we were not in a position where we were having to contemplate them but hardly anybody thinks we can get through the next few years without them in some form. So given that, the least any prospective government can do is to pledge to introduce them in the most equitable and transparent way possible.

H/T to Conservative Home for the image used above

VAT's not the way to do it

So it looks like the government is going to announce a temporary cut in the rate of VAT from 17.5% to 15%.

My initial thoughts on this are:

1. For the cost to the economy, this is not going to make a significant difference to people's daily lives. It will cost £12.5bn per year apparently (for as long as it is left in place). However let's say you are going to go out and purchase a massive plasma TV that would previously have cost £999. Well under the new proposals it will now cost you £977.74 (a 2.13% overall reduction). Will that really make that much of a difference?
2. What are the odds that retailers will take the opportunity to not pass the full reduction onto customers? In the above example it would be very easy for the retailer to reduce the price to £979. It looks virtually the same at the reduced price but is slightly higher. I cannot imagine many people insisting to see the manager and demanding the full 2.12765957% reduction (assuming they even know what the previous price for the item was).
   
3. VAT does not apply to things like (most) food, children's clothese, books etc. so quite a lot of the things that people purchase on a daily basis will be unaffected by the change. This effectively means that the change will benefit the richer more as they are more likely to have more disposable income to spend on discretionary goods that are affected by VAT. This is starting to have echoes to me of the 10p debacle that ultimately made the poorer worse off.
   
4. I run a small business, as do lots of people in this country. At the moment our systems all use 17.5% as the basis for VAT calculation. It will not be a huge effort to change this, but it will take some and it is possible mistakes will be made. Now multiply this by all the millions of businesses that will be affected by the change and you can see there will be an administrative burden. To an extent, that's just the way it is for businesses, there is always red tape. However this is a "temporary" change, i.e. they are just fiddling and it is likely to go back up in a year or two's time. That's yet more changes later on and yet more administrative work.
5. Relating to our business, this change is not likely to make much is any difference to our revenues as a business. Virtually all the VAT we pay is offset by the VAT we charge our customers.
6. Robert Peston thinks that in order to pay for this VAT cut, the rate will eventually have to go up to 22.5%, the only question is when will this happen. However if/when that does eventually happen, that will mean a pretty large hike in the amount charged for goods which include VAT. Surely this will damage the economy. Oh, and it is also worth noting that aside from this (temporary) measure, VAT has never come down in the long term s it is a pretty safe bet that once it reaches 22.5% it will stay at that rate (or higher) for the long term.
   

Overall, I cannot see this change having that much of an impact. Given that the £120 basic tax rate hike from earlier in the year (a cobbled together fudge to mitigate the effect of the abolition of the 10p tax rate) that gave each taxpayer an extra £10 a month cost £2.7bn, a quick back of the envelope calculation tells me that instead of reducing VAT, they could have given an extra £46.30 per month to each taxpayer in the country. This would have benefitted everyone who pays tax equally and actually lifted some people out of paying tax altogether. There are doubtless even more equitable ways to do this to focus on the poorest most.

I think if this change goes through in the form I have seen reported so far then it will be a very expensive and possibly counter productive damp squib.