I have often pointed out that although there is a legal fiction that only end-consumers pay VAT (and a surrounding myth that somehow VAT doesn't damage the economy), in economic terms, VAT is a tax on gross margins (i.e. there is no deduction for non-VAT-able inputs, primarily wages and finance costs). Thus VAT is far more damaging than corporation tax, firstly because VAT raises four times as much from only half the economy - the other half is either exempt or zero-rated; and secondly because corporation tax allows a deduction for (nearly) all expenses, so if you aren't making a real profit, you don't pay corporation tax, but VAT is still payable even if the business is making a net loss.
It seems there are still far too many people who prefer the legal fiction than the economic reality - particularly annoying are people who run businesses that make VAT-able supplies to other businesses and believe that because their customers can "reclaim" the VAT they they are charged, somehow that VAT doesn't affect them.
Simple maths proves that this is twaddle. Let's assume you are a VAT-able sole-trader (with no input VAT) who provides services to the value of £115,000 to another VAT-able business. Your VAT bill is 13.04% of your gross margin, which in this case is the same as your profit, and you pay £15,000 VAT and then income tax/corporation tax on £100,000. Your customer pays you £115,000 and sells [whatever his end product is] for £230,000. His gross margin is also £115,000, so he also pays £15,000 'gross margin tax'. The idea that the end-consumer 'pays' £30,000 which the various businesses in the chain meekly collect on the state's behalf is laughable (even though this is how it is always presented).
If there were any honesty in the system, we could replace VAT with a 13.04% gross margin tax applied to the business who currently pay VAT and in cash-flow terms, absolutely nothing would change. (Sure there'd have to be some tweaking for zero-rated businesses, that's a different topic).
So far so bad. Having failed to convince many people of that VAT is The Worst Tax (with Employer's NI a close second, of course) and ought to be a priority in any tax-cutting programme, some bright spark then points out that "Businesses won't pass on the VAT cut".
Well of course they won't (or not in the short term at least), but that just illustrates my first point that VAT is a tax on gross margins!
Consider this: if we reduced corporation tax, would we expect businesses to "pass on" the corporation tax cut? Not particularly, as businesses would neither voluntarily "pass on" a reduction in a tax on net margins nor a tax on gross margins. In the medium term however, market forces would ensure that businesses pass on the VAT cut, because scrapping it would approximately double the net profits of hitherto VAT-able businesses. This would attract new entrants to the market, and the increased competition would ultimately push prices down. So not only would goods and services be cheaper overall, there'd be more businesses, more people in work, fewer businesses being sent to the wall by the tax system etc etc.
What's not to like?
PS - Another common objection is that we'd have to leave the EU first (as all Member States have to charge VAT of at least 15%). To me that looks like an argument in favour, not against...
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6 comments:
When VAT was introduced in the 70s did prices go up, or did retailers swallow the tax and keep prices the same? I don't know, I was a toddler at the time.
But if the former, surely that indicates there was a market price for X, which allowed the retailer to make a profit. The tax was then added, increasing the price. Surely that means the consumer was paying extra for the same item, thereby paying the tax?
If I sell an item for £115 I have to give £15 to the govt. My profit has to come from the £100 remaining. In the absence of VAT I could sell the item for £100 and still make the same profit. Ergo the consumer is overcharged by £15 which he would not have to pay if VAT did not exist.
Does the fact that small VAT exempt businesses can undercut their larger rivals because they do not have to charge VAT show that the end consumer is paying the tax?
S, the 1970s isn't a fair comparison, as prior to VAT we had various sales taxes at different rates on different types of items.
In the short term, if VAT went up again, most businesses would try to 'pass on' the increase, but as consumers only have a limited amount of spending power, volumes would go down, so some businesses would go out of business.
As your third para, if they scrapped VAT, prices would not go down by the full £15 (as I tried to explain), it all depends on the particular price elasticities of supply and demand for each particular unit of goods or services.
But on the whole, gross turnover of all hitherto VAT-able businesses would go up by something approaching 15%* - maybe volumes would go up by 20% and prices down by 5%, or volumes would go up by 25% and prices down by 10%, that is all guesswork. Whatever the result will be, it is highly unlikely that all businesses drop their prices by 15% overnight and volumes stay the same.
* There would also be a spillover into stuff that's currently not VAT-able, so perhaps people would buy the same volume of haircuts, petrol, cinema tickets etc, and spend the extra disposable income on education, food, housing. That is yet more guesswork.
As to your third para, that is yet another complication, and neither of us know the extent to which this actually happens.
If there were any honesty in the system, we could replace VAT with a 13.04% gross margin tax applied to the business who currently pay VAT and in cash-flow terms, absolutely nothing would change. (Sure there'd have to be some tweaking for zero-rated businesses, that's a different topic).
Er, what happened to incentive for businesses to continue trading? To replace VAT withsomething equally as high is hardly an improvement.
JH, I didn't say it would be prima facie "better", I said it would be "more honest".
If the government came clean about the true incidence of VAT, people would be queuing up to scrap it, which, as it happens, can only be achieved after we've left the EU.
Mark,
Well said. Though presumably only companies selling price elastic goods would pass on immediate cuts in VAT (increases in their margin) since they would gain immediately from shifting a higher volume of goods?
Those selling price inelastic goods would be the slower ones to change only once new entrants force them to do so?
V, yes, precisely what would happen depends on elasticities, marginal vs average costs, barriers to entry and so on, but whatever the result it would be "very good" all round.
When you say "price inelastic" do you mean PE of demand or of supply? If you mean the former (e.g. petrol) it is highly likely that VAT cut will be passed on fairly quickly (see how closely pump prices track world oil price), which is an argument FOR rather than AGAINST fuel duties (higher fuel duties stabilise the pump price, albeit at a high level).
If you mean the latter, then it is unikely that the cut will be 'passed on' (see e.g. also arguments for Land Value Tax).
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