April 22, 2009
VAT – What’s Not Being Said
Over at Liberal Conspiracy a much shorter version of the following piece can be found. Here I supply a longer, more detailed version for anybody wanting to really get stuck in.
In 1990, tens of thousands of angry Britons protested against the Poll Tax. Their objection was simple: it is wrong to levy a flat tax on all individuals regardless of income. That a worker barely scraping together £10,000 a year should pay the same contribution as a millionaire was so manifestly wrong that men and women took to the streets – and in some cases, rioted – to voice their discontent.
Yet the Thatcher government which proposed the Poll Tax also oversaw drastic increases in another tax, one which is arguably as regressive as the Poll Tax: the Value Added Tax (VAT).
Before getting into the politics, let’s cover the background. VAT is a simple concept: it is a tax on business transactions, charged at the point of sale in respect of goods and services, and in the UK is levelled as a percentage. At present, the “standard” rate of VAT in the UK is 15%. So if some item is priced by a retailer at £100 pre-VAT, the customer will pay £115 at the point of transaction.
VAT was adopted in the UK in 1973 as a condition of entry into the EEC, thus replacing Purchase Tax and Selective Employment Tax[1]. In 1979, the UK had three rates of VAT. A zero percent rate existed on specified items – including children’s clothing and food – which were deemed exempt for “clearly defined social reasons”[2]. In other words, these goods were so important to ordinary people’s well-being that it was deemed wrong for the state to increase the financial burden of citizens by increasing their price. The other two rates were set at a basic rate of 12.5% on “luxury” items, and a reduced rate of 8% charged on most other goods and services.
In 1979, when Thatcher came to power, Chancellor Geoffrey Howe increased both of these non-zero rates to a single rate of 15%. This was to partially offset the impact of large cuts to the Basic and Higher Rates of Income Tax, and was portrayed as a deliberate move aimed at shifting the burden of taxation from earnings to consumption[3]. In 1991, Conservative Chancellor Norman Lamont increased the rate to 17.5%.
VAT stayed at 17.5% under the rest of John Major’s premiership. However, in the 2001 budget Gordon Brown declared that a reduced rate of 5% VAT would be introduced for certain goods, including energy-saving products, women’s sanitary products, and some health products (like smoking-cessation patches)[4]. Furthermore, in December 2008 as a response to the worsening economic situation, the Government implemented a cut in the standard rate to 15%, in a bid to boost consumption.
OK, that’s the history lesson over. Now for the politics.
VAT is an extremely regressive tax. It affects the poor more than it affects the rich. This is for the simple reason that if you have less disposable income, a percentage tax levied at the point of sale will have a greater impact upon you.
Imagine two individuals, each heading off to buy a new washing machine. Let’s call the first individual Sarah, and suppose she has a disposable income of £100. Let’s call the other person Michele, and imagine she has a disposable income of £10,000. Now, for the sake of our example, let’s suppose that there is only one washing machine on the market, and that it costs £60 pre-VAT. If Sarah and Michele both buy a washing machine at the pre-VAT rate, Sarah is left with £40, Michele with £9,940. Now let’s add in a VAT rate of 17.5%: the total point-of-sale transaction cost will be £70.50. This will leave Sarah with £29.50 – £10.50 less than she would have had if VAT were 0%. Michele is left with £9,929.50 – again, £10.50 less than she would have had if VAT were 0%.
The important difference should, however, be clear: the loss of £10.50 is far more significant to Sarah – who is left with just £29.50 – than it is to Michele, who is left with £9,929.50. That’s why VAT is a regressive tax: its impact is greater upon the poor than it is upon the rich.
So it’s worth noting that VAT isn’t that dissimilar to the Poll Tax. The same rate is levied upon everyone, regardless of income – even though the resulting financial impact will be more keenly felt the poorer a person is. Indeed, the Tory’s successful implementation of higher VAT rates was perhaps precisely what gave Thatcher the impetus to introduce the Poll Tax. Britons had already accepted increases in a tax that regressively impacted upon the poorest in society, so why not give them more of the same? The added irony, of course, is that the failure of the Poll Tax led to the increased rate of VAT in 1991, intended to provide revenue for the “Community Charge Reduction Scheme” which aimed to assist local authorities suffering from the fall-out due to massive levels of defaulting on the Poll Tax[5].
So we have seen that VAT is a regressive tax, whose impacts are more keenly felt the poorer a person is. The Tories knew this when they increased VAT rates, deliberately employing VAT as an alternative to progressive rates of taxation such as scaled income tax with higher bands for higher earners. In plain English: the Tories thought the poor should see their tax burden go up, whilst the rich saw theirs go down.
Labour’s record on VAT thus looks – compared to its record on many other things – comparatively good. The decision to reinstate a reduced rate of 5% in 2001 was arguably an act of progressive taxation. The decision to cut the standard rate last December was also a progressive move – whatever Labour’s motives for the cut.
Yet this aspect of the VAT cut has hardly been publicised. The rightwing media has (generally) lambasted it as a “waste of money”[6]. David Cameron has gleefully added to this by citing comments from various European finance ministers and leaders criticising the VAT cut. Yet the leftwing media’s reply has broadly been to back the cut on grounds of being part of a wider economic stimulus – and here Brown has employed his “an extra £20 in each person’s pocket”[7] soundbite to good effect.
But what about the point that the VAT cut is desirable because it represents a reduction in a highly regressive tax regime that disproportionately affects the poor? Certainly the point has been made, for example over at Socialist Unity[8]. But if you stick terms like “VAT cut progressive” into Google News, it’s very hard to find discussion of the issue in “mainstream” news sources (though a piece from a Guardian blog produces food for thought[9]).
What I’m trying to say here is not that the VAT cut’s importance for progressive taxation hasn’t been discussed, just that it certainly hasn’t been at anything like the forefront of reaction by politicians or the media.
Which is a great shame. Firstly, because it represents an increasingly missed opportunity for all those who not only believe regressive taxation is morally objectionable, but who also believe the present situation – namely, a broad acceptance of VAT by people who would and did revolt against the Poll Tax – will only change if there is open public debate about the vices and virtues of different tax regimens.
Secondly, because Labour had a genuine opportunity to take action on behalf of the poor, and in turn to publicly profess a commitment to helping the most hard-up in society. Labour could have revealed the Tories as the party of the rich, for the rich. They could have presented themselves as something different.
Except that such a course of action would require the Labour government of the past 10 years to have been something different from its Tory predecessor, at least in any substantial sense. Given that this is the Premiership of the 10p Tax, the silence from Labour on the merits of a VAT cut being anything more than a consumer stimulus may in fact speak volumes.
[1] http://www.politics.co.uk/briefings-guides/issue-briefs/economy/taxation/vat/value-added-tax-$366603.htm
[2] Ibid
[3] Ibid
[4] http://www.hmrc.gov.uk/VAT/forms-rates/rates/goods-services.htm#1
[5] http://www.politics.co.uk/briefings-guides/issue-briefs/economy/taxation/vat/value-added-tax-$366603.htm
[6] http://www.dailymail.co.uk/news/article-1088818/VAT-cut-waste-millions-shops-pay-implement-changes.html
[7] http://www.publications.parliament.uk/pa/cm200809/cmhansrd/cm090311/debtext/90311-0003.htm
[8] http://www.socialistunity.com/?p=3112
[9] http://www.guardian.co.uk/politics/blog/2009/apr/08/who-gains-most-from-vat-cut-liberal-democrats
John said,
April 22, 2009 at 10:41 am
“VAT is an extremely regressive tax. It affects the poor more than it affects the rich”
Not according to the London School of Economics, it doesn’t.
No VAT on rent, food, kids’ clothes. Low VAT on heating, lighting. Taken together a far higher percentage of poor people’s spending than rich people.
Forget the washing machine in your example, the point is that Michele will buy a Plasma TV and a Car when she’s got the washing machine home, and Sarah won’t. Better to give Sarah some cash than cut VAT.
Duncan said,
April 22, 2009 at 11:15 am
Not according to the London School of Economics, it doesn’t.
Got a link for that John?
Paul said,
April 22, 2009 at 11:22 am
John,
Think carefully about what you are saying:
Poor people have to spend almost all their money on bare essentials: rent, food, clothes for their kids.
They don’t have much left over for “luxuries” (taken in a broad sense, not in the technical VAT sense). Yet what they do have left-over for more than the bare essentials suddenly gets taxed at 17.5% – the same rate that those who have to dedicate a far smaller proportion of their income to essentials incur.
Doesn’t that look wrong to you?
John said,
April 22, 2009 at 11:36 am
Paul, no it doesn’t look wrong to me. A person’s spending has to be taken in the round, and a person who spends far less on non-essentials will pay far less in VAT. The same principle applies with banding of income tax, it jumps very suddenly at particular points, but that doesn’t affect the amount “below the line”, so it isn’t unfair.
Person earning £15,000, spending £3000 a year on non-essentials, benefits by £64 from the VAT cut.
Person earning £50,000, spending £15000 a year on non-essentials (assume they save more and buy a better quality of essentials), benefits by £320 from the VAT cut.
Cut taxes at the lower end and they could both benefit by, say, £120. Much more progressive!
Duncan, I have to admit I have lost the LSE report but will see if I can track it down. You can reconstruct the general thrust of it from the expenditure and food survey though.
http://www.statistics.gov.uk/downloads/theme_social/Family_Spending_2007/FamilySpending2008_web.pdf
Comparing the poorest and the richest tenth, the poorest spend 14% of their income on food, and the richest spend 7%. The poorest spend 22% on housing, heating, and lighting, and the richest spend 7%. In contrast looking at VATable items the poorest spend 5% on restaurants and hotels, and the richest spend 9% (of a much higher sum).
Paul said,
April 22, 2009 at 11:42 am
John,
you raise good points, that need careful reply.
Unfortunately it’s budget day and I can’t offer you that reply right now, as work is about to go nuts. I’ll endeavour to reply to you later on.
Tom said,
April 22, 2009 at 2:50 pm
“The important difference should, however, be clear: the loss of £10.50 is far more significant to Sarah – who is left with just £29.50 – than it is to Michele, who is left with £9,929.50. That’s why VAT is a regressive tax: its impact is greater upon the poor than it is upon the rich.”
No, that’s where your argument fails. You’ve assumed that Michelle and Sarah buy just the one single thing – a washing machine. Sorry but that’s not realistic. Michelle, with her £9,929.50, can now go out and buy lots more things, lots with VAT on them. So the very fact that Michelle has more money means she buys more, meaning she ends up paying more on VAT than Sarah. And she will also pay a higher percentage of her earnings on VAT too, since she is more likely to buy things which have VAT on them, than things that don’t.
Paul said,
April 22, 2009 at 2:58 pm
“and a person who spends far less on non-essentials will pay far less in VAT”
True. But it doesn’t alter the fact that when they incur VAT, the VAT they incur will be at the same rate incurred by those who are far better off than they are. This means that the same rate of tax is incurred both by somebody with a large disposable income whose spending is not mostly swallowed-up by spending on essentials as somebody who has hardly any disposable income left, because they spent most of it on essentials.
You are right that the poor pay less VAT *overall* than the rich. My point is not about who pays the most in terms of absolute contributions. My point is that it is *unfair* to tax the poor at the same rate we tax the rich, for that small proportion of income which is left over from spending on essentials.
I fully take your point that if there was no VAT exemption on essentials, the situation would be appalling. But just because there is VAT exemption on essentials, it doesn’t change the fact that non-essentials are taxed at the same rate for rich and poor, even though that tax represents more of a burden on the poor.
Let me put it another way: you keep making the (true) point that poor people don’t spend much on non-essentials compared to those better off. Surely the correct conclusion to draw from this is not “VAT doesn’t matter”, but “Christ alive, not only do poor people have to spend most of their low incomes on essentials, what little they have left-over to spend on things for enjoyment, they get whalloped with a tax rate equal to that of those who have loads of money to spend on enjoyment!”
–
“The same principle applies with banding of income tax, it jumps very suddenly at particular points, but that doesn’t affect the amount “below the line”, so it isn’t unfair.”
I’m not really sure what this does to support your argument – are you trying to say that because poor people don’t buy luxury goods, they don’t get hit by VAT, so it’s analogous to them not being hit by a higher income tax band because they don’t qualift for taxation at that rate?
If so, I think I just need to repeat what I said above: it’s unfair that the little money the poor have left over for spending on non-essentials, those things which may bring their life a bit of pleasure, is taxed at the same rate as millionaires.
–
you are right to point out that a VAT cut will benefit the rich, cetaris paribus.
But this isn’t a zero-sum game; we shouldn’t be analysing this in terms of “it is only good to cut VAT if the poor gain money AND the rich lose money”.
for sure, cutting VAT will see the rich get better off, all things being equal. But it will also see the poor becoming better off. I can back that. And I can back it further by *supplementing* a VAT cut with an increase in income tax, to target those who are better off, and can best afford to contribute to society’s upkeep (which is fair). That is, *reverse* the process undertaken by the Tories as described in the original piece.
–
“Cut taxes at the lower end and they could both benefit by, say, £120. Much more progressive!”
Why don’t we do this *as well*? I’m all for cutting VAT and raising the threshold on low income earners. I don’t see why this has to be either/or.
–
“Comparing the poorest and the richest tenth, the poorest spend 14% of their income on food, and the richest spend 7%. The poorest spend 22% on housing, heating, and lighting, and the richest spend 7%. In contrast looking at VATable items the poorest spend 5% on restaurants and hotels, and the richest spend 9% (of a much higher sum).”
Again, see above argument as to why consumption patterns don’t settle the question.
Paul said,
April 22, 2009 at 3:02 pm
Tom,
See my last comment, above.
It’s not an argument about who pays the most in absolute contributions of VAT.
It’s about the impact that tax has on the poor, as a separate consideration from how much the rich may or may not pay in VAT.
I know that the rich will contribute more in VAT than the poor. But at the same time, the poor suffer in having to pay the same rate as the rich, on the few non-essential items they can afford. That to me is plainly wrong.
See above comment for what I would do about it.
Tom said,
April 22, 2009 at 3:39 pm
“You are right that the poor pay less VAT *overall* than the rich. My point is not about who pays the most in terms of absolute contributions. My point is that it is *unfair* to tax the poor at the same rate we tax the rich, for that small proportion of income which is left over from spending on essentials.”
Paul, the VAT rate may be the same for everyone, but not everyone pays the same percentage of their earnings on VAT. I think we agree the rich pay more in absolute terms, but they also pay more percentage wise too.
What I’m saying is that not only do the poorest people buy less (in number) luxury items, but they also spend less on luxury items as a percentage of their income than wealthier people do.
Take Jon’s example of the savings from the VAT cut above. He says that;
“Person earning £15,000, spending £3000 a year on non-essentials, benefits by £64 from the VAT cut.
Person earning £50,000, spending £15000 a year on non-essentials (assume they save more and buy a better quality of essentials), benefits by £320 from the VAT cut.”
I don’t know if those figures are correct, but they illustrate the point I’m trying to make, so relatively speaking they’re about right. As you can see, the VAT cut benefited the rich more than the poor in absolute terms (£320 vs £64), but it also shows that the rich benefit more in percent terms as well. £320 as a percentage of £50,000 is higher than £64 as a percentage of £15,000. In fact, you’ll see that £320 and £64 are in the ration 5:1, which is the same ratio as the amount they spend on non-essentials (£15,000:£3,000). So even though the income has gone up by 3.33, the amount spent on non-essentials (and therefore on VAT) has gone up by 5. So the amount paid in VAT is higher in percentage terms because the amount spent on non-essentials increases faster as income goes up than income actually goes up. Or in less confusing terms, if you double someone’s income, the amount they spend on non-essentials more than doubles (statistically speaking of course). Therefore, if double someone’s income, the amount they spend on VAT more than doubles. That is the very definition of a progressive tax.
John said,
April 22, 2009 at 3:43 pm
“Why don’t we do this *as well*? I’m all for cutting VAT and raising the threshold on low income earners. I don’t see why this has to be either/or”
Because we are projecting £175bn of public debt next year. We don’t have that much money left! “The language of priorities”, and all that.
“True. But it doesn’t alter the fact that when they incur VAT, the VAT they incur will be at the same rate incurred by those who are far better off than they are. This means that the same rate of tax is incurred both by somebody with a large disposable income whose spending is not mostly swallowed-up by spending on essentials as somebody who has hardly any disposable income left, because they spent most of it on essentials”
Yes, and let me use my income tax point again to see if it gets through. If income tax was 20% above £15k, and 40% above £40k, then someone earning £16k would bep paying “the same rate of tax” on the £1k over £15k they earned as the person earning £35k – but they would pay far less overall, both in absolute terms and as a percentage of their income. Anyone who described that as a regressive tax would be laughed out of the building.
My point is that you have described VAT as regressive, but now accept that it hits the rich more in absolute and percentage terms than the poor. I’d say that’s case closed on the question – VAT, particularly with exemptions for essentials, is a progressive tax – less progressive than a progressive income tax, but far far more progressive than poll tax, sales tax, flat rate income tax, fuel duty, alcohol and tobacco duties, TV license, council tax, etc. It’s probably our fourth most progressive tax after higher rate income tax, inheritance tax and capital gains tax (and maybe stamp duty).
Tom said,
April 22, 2009 at 4:01 pm
“Yes, and let me use my income tax point again to see if it gets through. If income tax was 20% above £15k, and 40% above £40k, then someone earning £16k would bep paying “the same rate of tax” on the £1k over £15k they earned as the person earning £35k – but they would pay far less overall, both in absolute terms and as a percentage of their income. Anyone who described that as a regressive tax would be laughed out of the building.”
I’ve always wondered why we have income tax bands, and not a “continuous” income tax system rather than the current “discrete” income tax system. I mean how hard could it be to come up with some function for income tax rate based on income, with the derivative of that function also increasing as income went up (maybe the second derivative too). That would be fully progressive.
Ste For Sure said,
April 22, 2009 at 9:32 pm
“I’ve always wondered why we have income tax bands, and not a “continuous” income tax system rather than the current “discrete” income tax system. I mean how hard could it be to come up with some function for income tax rate based on income, with the derivative of that function also increasing as income went up (maybe the second derivative too). That would be fully progressive.”
something i have wondered too. it just doesnt seem like it would be hard
Tories, VAT and Adam Smith « Bad Conscience said,
August 10, 2009 at 12:19 am
[...] either case, the Conservatives should be dissuaded from putting up VAT. I’ve written before about why VAT is an undesirable regressive tax. But such arguments are likely to have less [...]
Liberal Conspiracy » The Tories don’t know their Adam Smith said,
August 10, 2009 at 12:46 pm
[...] either case, the Conservatives should be dissuaded from putting up VAT. I’ve written before about why VAT is an undesirable regressive tax. But such arguments are likely to have less traction [...]
senusert said,
April 14, 2010 at 6:44 pm
VAT is a consumption tax, and is preferable to Income taxes (income = wages + rents + dividends + capital gains), as it doesn’t alter decisions regarding our current allocation of future consumption nearly as negetively as Income taxes do. Income taxes discourage saving, which, in the end, makes all of us worse off – the poor included (saving is one of the twin engines of economic growth).
More here: http://gregmankiw.blogspot.com/2006/06/consumption-vs-income-taxation.html
The regressivity (is that a word) of a flat tax can be altered by the Government by giving people lump-sum grants financed by the VAT.
It’s also worth noting that Sweden (loved by progressives) has a 25% VAT, yet a low Gini index.