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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13 Responses to “What role do we want VAT to pay in our tax system?”

  1. Duncan Weldon

    Thoughtful post from @jamestplunkett on the role of VAT in the tax system http://t.co/CyUn7tF

  2. Len Arthur

    Thoughtful post from @jamestplunkett on the role of VAT in the tax system http://t.co/CyUn7tF

  3. Duncan Stott

    RT @leftfootfwd: What role do we want VAT to pay in our tax system? http://t.co/sEzTDDM

  4. Michael

    What role do we want VAT to pay in our tax system? l Left Foot Forward – http://j.mp/qbg3hn

  5. Duncan Stott

    Very interesting.

    But just because other countries do their redistribution through spending, doesn’t mean that the taxation system can’t be progressive. Can’t we have it both ways?

  6. Stephen W

    To add to the point made by the article. As the IFS says, if you want your tax system to be progressive this does not mean that each individual tax has to be progressive, just that the system as a whole does.

    VAT can be a very economically efficient tax. We should allow it to do this, make VAT more unfiform and make income tax even more progressive to compensate.

  7. David Flisher

    At the least return VAT to 1970s levels, prior to the Thatcher hike, with the clear aim of ridding us of its regressive presence.

  8. Leon Wolfson

    “More uniform”? That means, what, VAT on food? Because I can guarantee that the poor won’t get ANY sort of compensation for that under this government, the amount they can afford to eat will just plummet.

    The reason I support a call for a VAT cut is it’s one of the few things which I can actually imagine this government *doing* to help the poorer people in society and getting the economy working again. Not because I think it’s a good idea overall.

  9. Mr. Sensible

    Interesting article.

    The thing in this particular case is that the VAT increase is not to increase spending, nor is it to cut the deficit as the Coalition claims; it is to pay for tax cuts elsewhere, such as Corporation Tax and freezing Council Tax, which I see as rather regressive.

  10. StephenHenderson

    I think people above make valid points. I would add..
    1. It is probably politically more difficult to garner support to increase spending than to progressively ameliorate taxation (in the UK at least).
    2. Apart from arguments over ‘progressiveness’ there is also the issue of the burden of VAT displacing business taxes onto consumers (often benefiting financial and low investment business most). As taxation of business become more and more fraught the HMRC strategy seesm to be to tax consumers more and more to compensate.
    3. Most importantly I question the whole analysis of the IFS that VAT is not regressive this relies on a highly dubious argument of ‘consumption smoothing’- basically the idea that rich people will eventually pay the VAT at some point during their lifetime???? To which I say ‘in the longrun we are all dead’ and no the rich will invest their money in property, spend it on non VAT payable things like school fees, student loans, and pass the cash to their children. So I think the IFS analysis is “fishy”.

  11. Gareth Jones

    http://tinyurl.com/3plnq9e What role do we want VAT to pay in our #tax system? #uk #eu #economy

  12. Mark Whitenstall

    Sorry, did anyone read that IFS study? VAT is regreesive, becasue the poor spend more as a proportion of income, and thus judging regressivity by proportion of expenditure on tax is a flawed model. The graph showing income proportions is much more accurate.

    Seriously, I expect better than this.

  13. James Plunkett

    Mark – yes, VAT is regressive when when judged on its own – but the overall regressivity of a VAT increase depends on how you spend the money it raises. If you spend the money in a progressive way (for example, on early years), you can (fairly easily) net out the regressive impacts of the tax itself and have an overall progressive impact. In general, spending does more redistribution than tax – so, overall, the left should worry more about how money is spent (and raised in a way that is efficient, sustainable and wins consensus) and less about the distributional impacts of tax moves.

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