What role do we want VAT to pay in our tax system?

James Plunkett, secretary to the Resolution Foundation's Commission on Living Standards, writes of the need for a debate on the role of VAT in the tax system.

James Plunkett is the secretary to the Resolution Foundation’s Commission on Living Standards

There’s been a fair bit of discussion recently about the proper role and appropriate level of VAT. Much of this is to do with the potential use of a temporary VAT cut to stimulate demand.

The Federation of Small Businesses (FSB) today, for example, calls for temporary, targeted cuts to VAT in key sectors to get the economy back on track. Last week, a pamphlet by young Labour thinkers made a different argument – for a cut in VAT as a means to ‘unsqueeze the middle’.

No doubt these arguments will continue for some time, with critics claiming a VAT cut unaffordable and advocates pointing out the immediate relief it could bring to hard-pressed households.

But whatever your views on these short-term questions, there’s a different, longer term debate to be had about the role we want VAT to play in our tax system.

In that debate, it’s important we don’t overlook the international evidence. It tells us, first, that consumption taxes in the UK aren’t particularly high in comparison to other countries.

In fact, the UK headline rate of VAT has long been below the average rate of sales tax in the OECD. Even after this year’s rise to 20 per cent, 13 other OECD countries have headline rates of consumption tax that are the same as the UK or higher.

That includes the countries with the most progressive tax-benefit systems in the world, from Belgium to Denmark, Sweden and Norway. And Britain also comes out around average when you look at the tax revenue raised through consumption tax as a proportion of GDP.

Overall, we raise a relatively large proportion of revenue through income taxes and a relatively small proportion through consumption tax.

Perhaps more important, though, is the second lesson from the evidence: the distributional importance of VAT can be overstated. This isn’t to deny that VAT is regressive when considered on its own (a question that’s been looked at in detail by the IFS) or that a rise in VAT hits particularly hard when inflation is already high and living standards are being squeezed.

Instead, it’s to say that, when you step back and look at the big picture, the importance of tax in general (as opposed to spending) is often overplayed as a tool of redistribution. Put simply, the thing that marks out very redistributive tax-benefit systems from less redistributive ones tends to be the amount of tax they raise – and how they spend it – rather than who they raise that tax from.

Figure 1 below, from Lane Kenworthy’s excellent blog, makes this point clearly. It shows that, in advanced economies it is spending that does the major work in reducing inequality, not tax. Again, it is striking that many countries with very progressive tax-benefit systems do very little of their redistribution through tax.

In fact, when considered in isolation, the tax systems of Finland and Sweden are less progressive than the UK’s; instead, those economies remain more progressive overall because:

(a). They raise a lot of money; and

(b). They spend it in highly progressive ways.

And when it comes to raising a lot of money, few taxes are more effective and efficient than VAT.

Figure 1:

Inequality-reduction-via-taxes-and-government-transfers
Of course, none of this undermines the fact that this year’s rise in VAT is hitting the household budgets of people on low-to-middle incomes. Nor does it undermine the view that that a temporary cut to VAT would relieve those pressures.

And, of course, calls to cut VAT as a stimulus measure rely on a different argument entirely. But whatever your views on these short-term questions, there’s a longer-term debate to be had on VAT. Those who would advocate greater efforts to lower inequality should be cautious before turning to lower consumption tax as a means to a more redistributive tax-benefit system.

Passing a judgment on that depends on how we spend the money that’s raised.

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