My enemy's enemy is my friend

OK chaps, set your mobiles to 'silent', sharpen your pencils, it's time for my Monday night economics lecture. What sparked this off was Allister Heath, editor of London free-sheet CityAM, who has consistently come out as a cheerleader for higher VAT, culminating in this petulant outburst last Friday:

...only 70 per cent of the structural deficit will be met with spending cuts; the remainder will come from tax hikes. Some will be more destructive than others: a windfall tax on banks is the last thing the City needs right now. Value added tax will increase from 17.5 per cent (once the temporary cut to 15 per cent expires) to at least 20 per cent. But at least Vat is less damaging to the economy’s efficiency than direct tax...

Why on earth, you might think, would a businessman be crying out for higher VAT? Taking the UK economy as a whole, VAT is the most damaging, as well as the stealthiest tax (it raises three times as much as Council Tax with nary a wimper from the voter). Well, let's remind ourselves of a few things:

1. 'Economic efficiency' would be best achieved in the absence of any taxes or regulations whatsoever. To the extent we have to have taxes (and we do, I'm afraid), economic efficiency is affected least where they affect business decisions least, such as shutting down an otherwise profitable business. (Business Rates is an outrider here - it encourages profitable businesses at the expense of less profitable businesses, thereby encouraging economic efficiency, or worst case depressing capital land values, a point completely lost on young Allister).

2. What businesses fear most is the competition, and what businesses like best is barriers to entry, which ensure super-returns to incumbents. From the point of view of customers, artificial restrictions on supply, for example restricting the number of people who are allowed to operate as taxi-drivers in a town, has much the same effect as turnover taxes (aka sales taxes, aka gross profit taxes, aka Value Added Tax, the clue is in the name). Only with barriers to entry, it is incumbents who benefit from the higher prices, not the taxman.

3. As mentioned, Allister Heath is editor of one of three London free newspapers, CityAM. Then there's the London Lite, and the third slot was vacated by the londonpaper three weeks ago and taken over by The Evening Standard, which is free as of today. I shall exclude The Metro, as it is distributed in many other towns and cities in the UK.

4. We know that the three free London newspapers are competing for a limited advertising budget and have high fixed daily costs. As the third slot is marginal, we can deduce that the potential total advertising revenues to be earned are fairly close to the cost of writing, printing and distributing the three newspapers. Let's assume in round figures, London businesses are prepared to pay £350,000 a day for advertising in these newspapers, and it costs £100,000 to write, print and distributed a few hundred thousand copies of each free-sheet. So there'd be just enough money to fund three teams of staff, three sets of printers, delivery drivers, people on the street handing them out etc, while leaving the publishers with daily profits of around £17,000 each.

5. I doubt whether any of the three newspapers has the political clout to do like the taxi-drivers and have whomever is in charge enact a law or by-law restricting the number of free newspapers to two. This would be an ideal outcome for the two survivors, of course - they could share that £350,000 two ways, £175,000 each, spend £100,000 on production and make £75,000 profit each, with no fear of competition from new entrants.

6. But let's assume they can't do that (or else they would have done). So what's the other variable - remembering that restrictions on supply act much like a turnover tax? Well, it's turnover tax (called "Value Added Tax" in the UK). Publishing newspapers is "zero-rated", but that is a red herring - that has to do with input VAT. As a free newspaper earns no money from the cover price, there is no output VAT due on that, but selling advertising space, however, in a newspaper is VAT-able at standard rates.

7. So let's re-work that £350,000 figure. The official rate of VAT is 15%, which means that for £350,000 gross turnover, net income is £304,000 (20/23 x £350,000). Which is still just enough to keep three newspapers alive, with daily fixed costs of £100,000 each, but only just. Each publisher is desperately hoping that one of the other two goes bust. Each of the two survivors would then have net income of £152,000 and expenses of £100,000, giving them a profit of £52,000 per day - three times what they are making now, but it is an expensive war of attrition.

8. Now, what might sound the final death-knell for the weakest of the three? How about a VAT hike from 15% to 20%, as Allister recommends? That would reduce the potential total income of the three newspapers to £292,000, meaning that the three newspapers would be racking up losses of £8,000 per day; the weakest of the three would go bust all the quicker, and the two survivors would then be able to share the £292,000 net advertising revenues between themselves, making a daily profit of £46,000 each, which is a lot better than three newspapers having to split a total daily profit of £4,000 three ways, as they do with VAT at 15%.

9. No doubt somebody will claim that VAT does not affect business-to-business supplies. In the limiting case of zero-rated advertisers (homebuilders, food retailers) that is true; for zero-rated businesses (like banks, insurance companies) the VAT that the newspaper charges on advertising is a real cost; and for advertisers running a VAT-able business selling e.g. cars of watches or clothes to end-consumers, a VAT hike reduces their gross income and profits, and hence must reduce their advertising budget as well. There's no point arguing the precise impact, the principle is important here.