Why Labour should learn to love VAT

The tax is more progressive than its reputation suggests.

Photo by Wiktor Szymanowicz/Future Publishing via Getty Images

In an ideal world the Treasury would be done with tax-raising for this parliament. Last November’s Budget increased taxes by around £36bn a year, or just over 1 per cent of GDP, the second-largest tax hike of any single postwar fiscal statement. That was a necessary step to avoid further cuts to the UK’s already threadbare public services. The worry now, though, is that it will not be enough.

Britain’s economy, like many across Europe, appears to be losing momentum (contracting by 0.1 per cent in September and October). Surveys of business activity point to weak domestic and international demand, hiring freezes and tight investment plans. The return of Donald Trump to the White House this month may herald a new trade war. There is, then, a material risk that growth in the coming years undershoots forecasts and the public finances begin to deteriorate. In that case, taxes would have to rise again.

If Rachel Reeves is once again forced to look for revenue raisers, then she should turn to value-added tax (VAT). Economists have long argued that VAT is, in the jargon, an efficient tax, one that does relatively little to distort economic incentives. That is because, unlike many other taxes, it is charged across all sales (except for zero-rated categories such as food and children’s clothes) to both wholesalers and retailers but allows registered traders to deduct the charge levied on their inputs. As the name suggests, it is essentially a tax on the value added at each stage of production. A tax on a single commodity or on work changes the calculus of economic decision-making, a more broadly applied charge does not.

Economic efficiency might appeal to Treasury mandarins but the political case for relying on VAT, as opposed to other taxes, is more straightforward. One large tax rise is an easier sell than a smorgasbord of smaller changes, each of which tends to provoke its own opposition. Looking back at the coalition years of 2010 to 2015 it is both striking, and somewhat surprising, that the largest tax rise enacted by George Osborne – the 2.5 per cent rise in VAT – passed with little opposition while attempts to extend the charge to pasties provoked outrage and a U-turn.

The prospect of raising VAT tends to make Labour chancellors uneasy. The usual case made against is that it’s a regressive way to raise revenues compared with direct taxes such as income tax. That is, on a conventional measure, true. The poor do spend, rather than save, a larger portion of their income and so are hit harder by rises in taxes on consumption. That said, the zero rating applied to most food in the UK does help to cushion the impact. And some have argued that if one measures by expenditure rather than income, then VAT looks somewhat more progressive.

But all too often, concentrating on the progressivity or regressiveness of individual tax or spending measures in isolation means missing the woods for the trees. A one percentage point increase in VAT would raise around £9bn according to HMRC. If that money were used to fund public services and social security – which the poorest in society rely on the most – the overall package would be progressive. It is notable that VAT rates of 25 per cent are a core component of the progressive welfare systems found in Denmark, Sweden and Norway. It is equally notable that the US, almost uniquely in the rich world, lacks a national value added tax.

Taxing land or wealth more broadly may seem like a preferable alternative. The economics though are trickier and the politics more difficult still – there is a reason council tax remains an unsightly mess. Moving towards new forms of tax in this area is a sound principle, but one which will take time.

Labour bound its hands before the general election by pledging not to increase the rates of VAT, income tax or employee National Insurance contributions – the big three revenue raisers – and by further emphasising that it would not increase taxes on “working people”. While understandable, those manifesto commitments were always a hostage to fortune. The spirit, if not the letter, has already been broken with the increase in National Insurance contributions on employers. Much of the £25bn or so raised there will ultimately come from workers’ pay packets rather than firms.

Providing the public realm with the necessary levels of funding to improve the quality of services may mean breaking those tax pledges. If so, it will be time for Labour to learn to love VAT.