Should VAT rise?

When government has been spending more than it has received it faces the obvious choice of spending less or increasing its revenue. There is much mumbling about tomorrow's budget containing an increase in the rate of VAT - perhaps by increasing the rate from 17.5% or by making VAT chargeable on items currently exempt such as food or by introducing variable rates to that some items are charged at a higher rate.

VAT is a curious tax because it operates in different ways in different situations.

Take a manufacturer of chairs. He buys raw materials costing £100 plus VAT. He is registered for VAT so he can reclaim the VAT he pays on those materials, they actually cost him £100. It costs him £70 to turn those materials into a chair. So it costs him £170 to make a chair. One might think he could sell the chair for £190 and make a profit of £20, but not so because he must charge VAT at 17.5%. If he sold at £190 that would comprise £161.70 plus VAT of £28.30 (£28.30 being 17.5% of £161.70). In order to cover his costs he must sell for at least £199.75. As the good Mr Wadsworth has pointed out, in this situation VAT is a cost to business rather than a sales tax.

On the other hand, take a lawyer. He charges £100 an hour plus VAT. His customer is billed £117.50 for every hour. A customer who is registered for VAT and incurs the charge in the course of his business can reclaim the VAT, so he actually pays £100 an hour. Mr Ordinary who wants advice about his neighbour's intrusive hedge (a quality my hedge no longer has) must pay £117.50 an hour and cannot reclaim the VAT. Different customers are paying different amounts for the same thing although the lawyer receives the same amount.

In practice work done for commercial clients often incurs a higher charging rate. One reason for this is that those who can claim back the VAT can be charged more yet still end up paying less than Mr Ordinary. For example, charging £115 an hour plus VAT costs the client £115 an hour because he gets the tax back. The real winner is the lawyer, a win he would not be able to secure if it weren't for VAT.

Then take the effect of VAT on those with fixed spending power. Mr Average has £100 a week to spend after council tax. He must buy food, electricity, gas, water, transport, clothes, furniture and appliances for his home and everything else he might want out of £100 a week. In his mind all potential expenditure is graded according to importance. If food goes up he might opt for cheaper baked beans but he must still eat, there is only so much he can do to reduce his food bill. So also with electricity gas and water, he might be able to reduce consumption but that can only be done to a certain extent. If the prices of these items go up because of additional VAT the suppliers might be able to absorb some of the additional cost (thereby reducing profit margins and tax receipts, as per the manufacturer of chairs) but they can only absorb so much. Mr Average will find his spending power eroded and it is inevitable that the items dropped from his list of desires will be items that are subject to VAT. The new telly waits until next year, the holiday at the Happy Camper Caravan Boutique is not taken, old trousers are mended not replaced.

There might be a slight increase in tax revenues (at the cost of Mr Average's standard of living falling) but only to the extent that he pays more in VAT out of his £100 than he would otherwise have done. It is not a one-way street, however, because he has to forgo things he would otherwise have bought and on which he would have paid VAT and on which the recipient of his cash would have paid tax. To take a simple illustration, say £70 out of his £100 was previously spent on VAT-able purchases (meaning, in effect, he spent £30 on non-VAT-able food). Out of that £70 of spending the VAT is £10.43, so he paid £10.43 in tax and £89.57 on goodies. Increase the range of foods on which VAT is charged and increase the rate so that £80 is spent on VAT-able items and the rate is 20% not 17.5% and he pays £13.33 in tax. He also has £13.33 less to spend. At the old VAT rate of 17.5% that sum of £13.33 would have generated £1.98 in VAT, so the revenue gains £2.90 (£13.33 - £10.43) but loses £1.98, a nett gain of 92p and it loses income or corporation taxes on the £13.33 he no longer spends at Mr Patel's Merry Mart.

Increasing VAT for Mr Average is hardly worthwhile and might actually lose tax revenue. Where an increase will be effective in raising revenue is in forcing people with some spare cash to divert some that would otherwise be saved in order to protect their standard of living. Mr Above-Average might have £120 a week to spend but be in the habit of saving £20. His spending habits are the same as Mr Average but, on the figures I have used above, he can afford to spend an extra £13.33 a week (or part thereof) to keep his standard of living roughly the same.

And then there is the black economy, that mysterious part of the turnover of builders, plumbers, electricians and the like who are always extremely busy but never disclose sufficient turnover to make them register for VAT. Saving £35 on a £200 job by using Dave Dodgy rather than Colin Clean turns into a saving of £40 if VAT rises to 20%, many a Colin might then find himself tempted to join Dave on the wrong side of the fence to retain business, thereby losing the Treasury all the VAT he previously generated.

As a generator of tax revenue VAT relies on chair manufacturers being able to sell their goods at a substantial profit, on consumers maintaining their spending and eating into reserves (or borrowing) and on businesses not keeping money off the books. The higher the VAT rate, the greater the price of a chair must be to break even, the more consumers must eat into reserves (or borrow) and the greater the temptation for businesses to hide their turnover (there are legitimate ways of doing this). It might result in a boost of revenue but the price is a high one because of the consequences to the Treasury and to the economy as a whole of these three factors.