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Consumption tax increases discourage consumerism; work tax increases discourage work. Shouldn't we welcome the shift to VAT?

VAT is not progressive, as claimed by UK Chancellor George Osborne in his defence of the tax rise. But it is a tax on something we should be doing less of. So shouldn't we welcome it?
Tony Curzon Price
Tony Curzon Price
4 January 2011

Is VAT a Tory tax? That was Evan Davis' excellent question to George Osborne on this morning's Today program. Davis' thesis is the usual one: VAT, essentially a flat tax on consumption, has no redistribution built into it. This is unlike income tax, where the more you earn, the greater proportion you pay in tax. You can spend £10,000 per year on final goods or £1m – you still only pay 20% VAT. Moreover, VAT has systematically risen under Tory governments while income tax has fallen. So there seems to be both motive and form – VAT is the Tory's tax because it is not very redistributive and history shows that they like to move towards it.

I think this is basically true. But when asked directly whether this was his motive for increasing VAT, Osborne quoted the Institute for Fiscal Studies as saying that VAT was in fact progressive. (Listen again – I think he actually claimed that it was more progressive than raising income tax.)

The basis for this claim, I think, is Mike Brewer's work at the IFS which he claims shows that 

... increasing the standard VAT rate in the current system is mildly progressive when examined on a lifetime basis. The intuition for this is that, over a lifetime, poorer households spend a higher proportion of their (lifetime) income on goods that are zero or reduced rated in the current VAT system, such as food, children’s clothes and domestic fuel and power, and hence a lower proportion of their lifetime income on items that are subject to the standard VAT rate.

It turns out that this claim is a bit of a stretch. A good detailed critique is available from Tax Research, over here. The IFS's own analysis of VAT shows that its impact by income band is as follows:

 

It is pretty clear from the graph that VAT is, in a rather straightforward sense, regressive. The lowest earning households are paying 19% of their income on the tax, while the richest are paying less than 10%. The reason is straight forward: the poorest spend more of their income; investments spending (savings) are not charged VAT; school fees and private health insurance are zero rated, etc. If you are consuming most of what you earn, you will pay a high proportion of your income on VAT.

Brewer's claim, used by Osborne to deny Davis' proposition, relies heavily on the assumptions made about the smoothing of consumption over a lifetime. Since many low earners are students and retirees, if these are borrowing or running down savings to consume, and spend much of their income on zero VAT rated goods, then the Brewer argument holds. Of course, many of the lowest earners do not have access to all the borrowing or savings that they might want, so one would like a bit more detail from Brewer and the IFS about the assumptions made about financial assets and access to capital markets.

Fine. VAT is almost certainly regressive, and certainly less progressive than income tax. So naturally, perhaps, Alan Johnson (also interviewed – much more fumblingly than Osborne –  this morning by Evan Davis), argued for a work tax (National Insurance Contributions) rise rather than a consumption tax rise (and asked for it to be phased in more slowly). NICs are paid as a percentage of earnings up to a maximum, and so more or less share the classic progressivity of income tax.

But there is something odd in Labour's attitude. Tax systems should do two things: they should encourage activities we want to promote and they should provide revenue for activities we want to commonly engage in, including redistribution. So VAT looks like a tax on consumerism, while NICs looks like a tax on work. So why shouldn't we want to use the tax system to discourage consumption (especially of goods that are not considered necessities, which in the UK are zero rated) and encourage work?

The trouble with the debate revolves around the argument for redistribution. If the argument for equality were made in a positive way, as suggested over here by Simon Griffiths, it would be possible to argue for VAT rises with distributional effects corrected by transfers. That would be much better than arguing for a tax on work which the left and the right would probably agree should be seen as a good in itself. In other words, Evan Davis is not quite right: VAT does not have to be a Tory tax; it is so only if it is used to reduce by stealth the progressivity of the overall tax and benefit system. VAT has some attractive characteristics that we shouldn't throw away.

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