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.
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* 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.
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** Go to here and download "Data tables (Excel): Detailed CPI and RPI Briefing Tables". I've taken the figures from Table 2.