Thursday 5 January 2012

VAT & Inflation Fun

1. The traditional view is that "VAT is a good tax because - unlike corporation tax - VAT does not affect the heroic producer, who just adds it to the price and the greedy consumer who is trying to destroy all that lovely output either pays it or consumes less. If he consumes less, that is good, because that way there is more money for investment, despite the fact that once we have discovered the path of True Righteousness and foregone all consumption, there'd be no point investing, because the only point of investing is to be able to produce and sell even more in future. And of course, VAT appeals to our authoritarian and protectionist instincts because it acts a bit like import duties."*

2. The big fat lie (which I underlined to make it easy to spot) allows the Powers That Be to explain away why CPI inflation was so high this year, at about 5%. They say it is because we were comparing prices inclusive of 20% with prices inclusive of 17.5% VAT, so half of that nominal 5% is just the impact of the VAT increase. This allows The Powers That Be (e.g. The Bank of England) to make outrageous claims like this in their November 2011 Inflation Report:

Inflation is likely to fall back sharply through 2012 as the contributions of VAT, energy and import prices decline, and downward pressure from slack in the labour market persists. But how far and how fast inflation will fall are uncertain. Under the assumption that Bank Rate moves in line with market interest rates and the size of the asset purchase programme remains at £275 billion, inflation is judged more likely to be below than above the 2% target at the forecast horizon.

3. For a start, that can't possibly be true because only about half the items in the CPI shopping basket** are liable to VAT at the full rate, which means that at most a quarter of CPI inflation can be thus explained away. Further, and more interestingly, it seems highly unlikely that higher VAT can all be merrily passed on in higher prices. Luckily, we have had four successive years with different VAT rates to enable us to do comparisons.

2008 - 17.5% (OK, strictly speaking, the rate went down to 15% on 1 December 2008)
2009 - 15%
2010 - 17.5%
2011 - 20%

4. My previous workings, based on the gross profits of Tesco for the four years concerned suggested that the producer bears/benefits from 60% of any VAT increases/reductions. We'd expect to see this if supply is less price-elastic than demand, which makes sense. If you are set up with your supply chain, you cannot increase or reduce amount supplied very quickly, but a customer can change his buying patterns from one day to the next, easily decide to postpone a decision to buy something etc.

5. There's another way of trying to guesstimate how VAT is split between consumer and producer, and that is to look at changes in Consumer Price Index inflation. Half the items in the index are liable to VAT at the full rate and the other half aren't (i.e. exempt, zero-rated or reduced rate 5%), so if it were true that VAT is always passed on to the consumer in full, a 2.5% change in the main rate would lead to a 1.25% change in prices from one month to the next. Happily, the ONS publish CPI figures inclusive and exclusive of VAT.

In December 2008 the main rate of VAT went down from 17.5% to 15%. According to the ONS**, CPI inclusive of VAT went down from 109.9 to 109.5; and CPI excl. VAT went up from 110.3 to 111.3. So consumers gained 0.4% and producers gained 0.9% (total gain 1.3%) and the split was 29% for the consumer and 71% for the producer.

In January 2010 the main rate went back up to 17.5%. CPI inclusive of VAT actually went down from 112.6 to 112.4; and CPI exclusive of VAT went down from 114.4 to 112.5. So consumers gained 0.2% and producers lost 1.7% (total loss 1.5%) and the split was more than 100% for the producer.

In January 2011 the main rate went up to 20%. CPI inclusive of VAT went up from 116.8 to 116.9 and CPI exclusive of VAT went down from 116.7 to 115.2. So consumers lost 0.1% and producers lost 1.3% (total loss 1.4%) and the split was 7% for the consumer and 93% for the producer.

The fact that the total gain/losses were 1.3%, 1.5% and 1.4% each time the main rate changed by 2.5% is very reassuring of course, because this is in line with what we'd expect, being approx. half of 2.5% in each case.

6. The alternative approach would be to compare CPI inflation for VAT-able supplies with CPI inflation for non-VAT-able supplies over the two years from November 2009 to November 2011, a period in which the main rate of VAT went up from 15% to 20% (from Table 1, link as below).

CPI for VAT-able supplies went up from 103.1 to 113.2 = 9.8% inflation.
CPI for non-VAT-able supplies went up from 129.9 to 141.9 = 9.3% inflation.

If producers passed on VAT in full, then CPI inflation for VAT-able supplies would have been 4.3% higher (120/115 - 1) than for non-VAT-able. It was only 0.5% higher, which suggests that producers bear nearly nine-tenths of VAT increases.

7. Therefore on average the producer swallows at least two-thirds of a VAT increase. So in 2012, VAT-inclusive prices would have gone up by no more than 0.8%. VAT-inclusive prices only make up half the shopping basket anyway, so the element of recent CPI inflation which can be explained away by the VAT increase is actually no more than 0.4%.

8. So I'll bet you all a dollar to a dime that the annual CPI inflation figures for the first few months of 2012 are only about 0.4% lower than the CPI inflation figures for the last few months of 2011, i.e. 5.0% for October and 4.8% for November (the figure for December is not out yet AFAIAA). The Bank of England's "forecast horizon" of 2% CPI is a long, long way away.
* This is all complete nonsense of course. If nothing else, by and large, the VAT is primarily suffered by the producer (see evidence above). This, and reduced quantity demanded, pushes some producers out of business, which restricts supply (and causes unemployment etc) and so the equilibrium price paid by the consumer goes up slightly.

i. The absolute best source of funding for investment is re-invested profits, because there is a direct correlation between businesses which do stuff which people want and businesses which have more spare money to invest. So there is no need for outside investors to try and guess what type of business to invest in (they are historically quite bad at this).

ii. . The clue is in the name: Value Added Tax is a tax on value added, i.e. it is a tax on gross profits, so it's like corporation tax but much worse, because at least with corporation tax, you can deduct wages from the tax base, and corporation tax does not push marginal businesses into a loss making position but VAT does.

iii. So VAT reduces gross profits and hence net profits and so there is less left over to re-invest. By and large, timing differences aside, corporation tax is not a tax on re-invested profits (the business gets a full deduction for re-invested profits), it is a tax on money left over which is not needed for re-investment and which can be paid out as dividends. So it's not the best tax in the world, but it is far from the worst.

iv. Corporation tax applies at the same rate to all businesses, whilst VAT only applies to wealth creating businesses and not to monopoly source income.

v. VAT is largely borne by the producer, even though nominally it is borne by the consumer. The reverse - that corporation tax is borne by the consumer - is probably also true, but to a lesser degree. It is also more difficult to measure, because corporation tax is a much smaller tax - it only raises a third as much as VAT - and rate changes are usually less dramatic.
** Go to here and download "Data tables (Excel): Detailed CPI and RPI Briefing Tables". I've taken the figures from Table 2.


Richard Allan said...

I think you might be missing the point of the CPI target slightly. It's to ensure that companies can bargain for consistent wage increases and not have the price they receive for their output fall, eating into their profits. If VAT rises then as you've pointed out, the price the companies receive won't go up even if the price paid by consumers does. Thus allowing the VAT increase to raise CPI gives the impression that the picture for companies is rosier than it is.

Steven_L said...

The devaluation has a lot to answer for. When I was in Prague in May it was notable how much more expensive the clothes shops were for identical items post devaluation of the £.

Producers/retailers seem to have made some headway on that now, and prices are becoming more even with the continent.

The Italian guy I spent new years eve with tells me everyone in Italy wants to get their (tax evaded) money out of Italy and buy sterling. Was bemoaning the 'declare cash over 10k' rule and asking me how to go about laundering it.

(To which I replied I really had no idea, obviously).

Mark Wadsworth said...

RA, the CPI forecasts are all hokum and propaganda, obviously. But VAT increases don't increase the CPI, that's the point of this post.

SL, re devaluation, yes of course, that's as can't be helped. And work, we have to go on regular money laundering courses and for the life of me, I still don't know how to do it.

Anonymous said...

The pound has devalued since 2005, but over the long term the current value is about right. If you're comparing with CZK, not sure how much the Czechs import from the Eurozone, but remember that the EUR also started off being undervalued, and rightly rose in its first few years. In any case, the CZK has also been devaluing against the euro since it started.

Anonymous said...

...corporation tax ... it is a tax on money left over which is not needed for re-investment and which can be paid out as dividends.

Just a little question on the CT-system. Retained profits are also taxed, right? Are there provisions to get this back if using last years profits for investments, so as to make CT neutral for timing investments?


Lola said...

I had a bit of a go at John Redwood about this the other day. Well about 'inflation' actually, which is relevant. See here:

There is rather a long discussion but I am sure you all know how to do Ctrl F and type in 'Lola' to find my remarks.

Of course, I may have been completely wrong....

Lola said...

Steven-L. Your Italian friend asked you how to launder money?

Dear oh dear. What is the Mafia coming to?

James Higham said...

When you stop and think about that 20% - it's an astounding figure on top of purchase price.

Mark Wadsworth said...

Kj: "Are there provisions to get this back if using last years profits for investments, so as to make CT neutral for timing investments?"

In a roundabout way, and in the medium term, yes. But even if you can't, then you'll get relief against future CT for this year's investment.

L, agreed to your comments at JR. He also banged on about "VAT dropping out of the picture".

JH, it's a bloody outrage is what it is. Take 20% of our incomes in income tax, fair enough, but as much again when you spend money?

ontheotherhand said...

JH - "when you stop and think about that 20% - it's an astounding figure on top of purchase price."

I agree and that's the point - nobody stops to think about it so governments love it. In the US sales tax is added at the till and you really notice how much your local state is taking from you, so it educates which way you vote. The result is that some states are 0% sales tax and I think the highest is NY around 7%?

Mark Wadsworth said...

OTOH, yes, but the USA is a very large and isolated country, so their optimum tax mix (from the point of view of revenue raising) is to have very high corporation tax (about 40%) and very low sales taxes.

The reverse applies to small countries and tax havens, which have low or zero corporation tax and very high sales taxes.

mombers said...

"VAT does not affect the heroic producer, who just adds it to the price"
Just like employer NICs don't affect employees... No doubt if employer NICs were abolished, none of this extra money would ever feed into higher wages, and if it were doubled, it would have no effect on wages. Well done on the politicians who pulled the wool over our eyes on this one! Basic rate income tax is 20%, but basic rate marginal tax is a whopping 40.2% when you add in both sides of NI. Higher rate marginal is 49% and additional rate is 57.8%. Of course income tax is what it says on the tin if you're lucky enough to be over 65, when despite consuming most of the NI budget, you don't have to pay anymore.

Mark Wadsworth said...

M, 40.2%? You iz having a larf!

Bung in VAT and Tax Credit withdrawal, higher rate tax etc. and the overall average is over 50%.

mombers said...

MW, tax credit withdrawal is at 41% IIRC, so that the marginal tax rate becomes:
Employer pays £113.80
That includes 13.8% employer NIC so we're down to £100
Less 20% income tax = £80
Less 12% employee NIC = £68
Less 41% tax credit withdrawal = £27
So employer has £113.80 to pay you, you get £27. Marginal rate of 76.2%. Jaysus! And the real kicker: 9% student loan = net £18 off £113.80, a shocking 84.1% marginal rate. No wonder so many people make the rational choice that you have a better standard of living on benefits in many cases.

Mark Wadsworth said...

M, the calculations are more complex than that, which is why you can use the DWP's Tax Benefit Model Tables. To summarise:

Single earner, no kids - 79% clawed back on first £18,500 per annum.

Single earner, two kids - 77% clawed back on first £38,800 per annum.

Couple, two kids - 82% clawed back on first £40,500 per annum.

Links and explanation here.

Anonymous said...

I wouldn't call student loans tax tho.


Mark Wadsworth said...

Kj, it is, in practice, a tax.

Until ten years ago, when you qualified, Student Loans were just repayable at a flat monthly amount over five years with no back-chat. That's not a tax, but making it a % of income makes it so much like a tax as to effectively be a tax.

Anonymous said...

Losing it a bit, that "Tax" is based on a subsidy/loan.

Are all loan repayments also a tax? Since these student loans are kept at an unreasonably low interest they are still an effective subsidy.

Mark Wadsworth said...

Anon, 17.09, the whole student loan thing, as majorly revamped last year (this was the Tories f-ing over the Lib-Dems), is a complete mess, best to chuck it in the bin and start again.

I didn't say that the loans themselves were a tax, I said that if the loan repayments are a fixed % of income, they have the same disincentive effect as a tax.

You can apply the same logic to child maintenance payments. If Dad has to fork out a flat £100 a week, well so be it, that motivates him to earn more. If Dad is sentenced to paying a fifth of his income, that is disincentive to earning more. So the former version is far better.

Bayard said...

"If Dad has to fork out a flat £100 a week, well so be it, that motivates him to earn more. If Dad is sentenced to paying a fifth of his income, that is disincentive to earning more. So the former version is far better."

Not really. Dad has to fork out every month until the brat is 18 or whatever, so the more he earns the more he pays out in toto in the latter system. With the student loan repayment, the more you pay out every month, the quicker you pay the loan off, and the total amount paid out remains the same under both systems.

Mark Wadsworth said...

B, in the long run yes, and that is how a rational person might look at it, but in the short term no.

Further, under Lib-COn rules, if you earn less than £21,000 you pay nothing at all, and whatever is left outstanding after thirty (?) years is written off.

So if you are on £21,000 a year and are offered a job paying £30,000, it's worth taking, but it's not worth taking a job for £25,000.

Bayard said...

Which just goes to show that there is no system so bad that the pols can't make it worse.

mombers said...

The real problem with the student loan arrangement is the best and brightest have a real incentive to bugger off overseas and skip paying the loan altogether. Try getting an overseas country to disclose the tax records of all young Britons!

Mark Wadsworth said...

B, the main reason that the Tories shoved this through was to discredit the Lib Dems, it is deliberately awful.

M, yes, that's another shit cherry on top of the shit cake.

Bayard said...

Mark, it shows where their true priorities lie.