August 10, 2009

Tories, VAT and Adam Smith

Posted in Economics, History, Politics, Society, Tax Justice at 9:00 am by Paul Sagar

This article was first published at Liberal Conspiracy

On Sunday morning the Telegraph brazenly declared that “The Conservatives are studying plans to increase VAT to 20 per cent if they win power at the next election as part of an ‘emergency’ package to pull Britain out of the red”. But within hours this was being denied. Reuters reported a Tory spokeswoman saying: “There are absolutely no plans for such a rise and there’s never been any discussion about it.”

What to make of it all? It could be that the Tories do want to put VAT up to 20%…but want to keep this possible vote-loser quiet ahead of an election. Alternatively, the Tories themselves may be divided: some want a VAT rise, some don’t.

In 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 with those on the political right.

So instead I suggest pointing the Tories back to the founder of modern economics: Adam Smith. For his Wealth of Nations has some very interesting things to say about the “indirect” taxes of which VAT is a modern manifestation.

The present VAT system of adding a percentage tax to transactions for goods and services is one Smith would have recognised, as he wrote at length about “taxes on consumable commodities”. He would also have recognised, and applauded, the exemption of certain goods from VAT on the grounds that they are necessities. Smith divided all consumable commodities into those that “are either necessaries or luxuries” – and he was clear that the first ought not to be taxed.

But his reasoning was not born of a simple altruism towards the poor:

“Any rise in the average prices of necessaries, unless it is compensated by a proportionable rise in the wages of labour, must necessarily diminish more or less the ability of the poor to bring up numerous families, and consequently to supply the demand for useful labour”
…
“Taxes upon necessaries, by raising the wages of labour, necessarily tend to raise the price of all manufacturers, and consequently to diminish the extent of their sale and consumption”
…
“The middling and superior ranks of people, if they understood their own interest, ought always to oppose all taxes upon the necessaries of life”

Smith thought increasing taxes on “necessities” would be counterproductive. Not just for the poor, who are hit with higher effective prices, but for the better-off, who suffer from the economic stagnation higher indirect taxes on necessities produces.

Yet this alone only takes us so far. After all (a Tory in favour of a VAT-increase might reply) necessities are already exempted from modern VAT. Thus the rise to 20% would not incur Smith’s disdain, because only “luxuries” would be affected.

Yet that seems not in fact to be the case. Here we come to a fascinating passage from the Wealth of Nations that all in favour of increased rates of VAT should take note of:

“By necessaries I understand, not only the commodities which are indispensably necessary for the support of life, but whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without. A linen shirt, for example, is, strictly speaking, not a necessary of life. The Greeks and Romans lived, I suppose, very comfortably, though they had no linen. But in present times…a creditable day-labourer would be ashamed to appear in public without a linen shirt, the want of which would be supposed to denote that disgraceful degree of poverty, which it is presumed, no body can well fall into without extreme bad conduct.”

Smith’s reasoning is simple: for human beings embedded in the context of society, the idea of a “necessary” good extends beyond mere food and shelter. There are some things people must have, without which their lives go intolerably worse. And those things should not be taxed.

The present VAT regime exempts most food and drink, children’s clothes and other things deemed necessities. Yet many things are not exempt nor receiving the 5% reduced rate: adult clothing is a fitting example, given our context. Here we should take note of Smith: whilst having presentable clothing is not “necessary” in the narrow terms of being essential to prevent death, having such a thing will be deemed “necessary” by anyone who wants to be accepted by the standards of modern society, and who desires to avoid the shame and marginalisation that will result from not reaching those standards.

Raising the VAT rate to 20% would increase the cost of many goods which are necessities to poorer people and middle income households struggling with recession in the wider, socialised context that Smith was pointing to.

Regardless of what Tory policy-makers think about the (de)merits of regressive taxation in terms of equality of the popular tax burden, they should carefully consider Smith’s contention: that increasing taxes on the necessities of life will be counterproductive and damage the interests of everybody, wherever they happen to stand on the income scale.

All quotes from: Wealth of Nations, Volume II, Book V – “Taxes upon consumable Commodities”

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