The Laffer Rainbow: Value Added Tax

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The Laffer Rainbow applies just as much to the Worst Tax Of All, VAT which is forecast to raise £63 billion in the current tax year, or about twice as much as corporation tax (HMRC, Table 1.2, Excel). Mathematically, it is a tax on turnover, or on gross profits before salaries and interest (depending which way you argue it) and is only payable by normal, productive businesses. Very small businesses are exempt, and anything to do with land is either exempt (banking and residential letting) or zero-rated (farming and residential construction).

The rate was reduced from 17.5% to 15% this year, but is expected to go up again to 17.5% or even 20% next year, so I have used 17.5% as the normal rate. If the rate were cut to 0%, VAT receipts would fall to £nil, of course, but other taxes would rise...

On a static basis, business profits would increase by £63 billion, so there'd be an extra £20 billion corporation tax (or possible more, if businesses which are currently loss-making move into profits), illustrated by the red area.

On a dynamic basis (the green area), more new businesses would open to take advantage of the higher profits to be earned, so prices would be competed down ("some of the cut would be passed on to the consumer" is how they like to say it), but if people still have £470 billion to spend and businesses can keep £470 billion rather than just £400 billion, we'd expect business activity and employment to increase by 15% or thereabouts. So the blue area would increase corporation tax or income tax receipts by half as much again as the red area, call it another £10 billion.

Finally, the blue area. Even if employment in the previously VAT-able sector was only ten million and only went up by 10% or so, that'd be another million jobs, assuming that a lot of these workers were formerly claiming benefits (costing the taxpayer £5,000 a year each) or superfluous public sector employees (costing the taxpayer £25,000 a year each), that'd reduce government expenditure by £15 billion.

Tot up those three areas, and we see that getting rid of VAT entirely would only reduce the amount that the Exchequer has to play with by £18 billion, or only about a quarter of the amount that VAT raises in the first place.

UPDATE: (re JH's comment) in case that's not clear, this is the main reason why VAT ought to be scrapped - the productive economy ends up (say) £60 billion better off and 'the state' has (say) £20 billion less to spend. What's not to like?

UPDATE: (re Adam C's comment) the other reasons are, it is hugely complicated to administer; open to all sorts of fraud and error; sublimely stealthy and dishonest; it distorts economic activity away from productive stuff and towards banking & land speculation; and acts as a barrier to entry (it burdens large or profitable businesses far less than smaller or marginal ones).