Sunday, 23 November 2008

Hoist by their own petard

On the basis of other newspaper articles, comments thereon, other 'blogs, email exchanges and so on, I get the impression that the mooted reduction in the standard rate of VAT in tomorrow's PBR is not going down particularly well. The main objections seem to be:

1. VAT is a tax on consumption. We should be cutting taxes on production, not on consumption.

2. A 2.5% VAT cut would reduce the price of goods or services for which the consumer currently pays £100 by only £2.22. That is of neglible benefit to the consumer and isn't enough to 'get Britain spending again'.

3. It will suck in imports.


Reducing the standard rate of VAT to the lowest rate allowed by the EU would be one of the few good things that this government has ever done, but to appreciate why, you must first shake off thirty years of lies and brainwashing (perpetuated by the self-same people who are now not getting any plaudits ... ) and realise that VAT is not 'a consumption tax borne by the consumer that does not affect producers', it is a turnover tax on VAT-registered businesses! ( With no deduction for other expenses, so it is payable even if the tax pushes a business from making small profits into making losses - *see footnote)

Standard rate VAT applies to services as well as goods. The UK is a largely service based economy (of course it is, we have enough cars and fridges and TV sets and stuff). With services there is no distinction between consumption and production - you sit in the barber's chair, he cuts your hair. Does anybody believe that we can invent a tax that magically discourages you from sitting in a barber's chair (consuming) while simultaneously encouraging the barber to cut hair (producing)?

Even if you buy new physical goods that were manufactured overseas, more than half of the retail price goes to the retailer, his landlord, the shop workers, the distributor, the lorry driver, the warehouseman - all UK based.

Further, let's look at the numbers. Total UK corporation tax receipts were expected to be £50 billion or so this year, of which £10 billion is North Sea oil tax and half of the rest was supposed to be from UK banks. In other words, the rest of UK plc paid £20 billion corporation tax.

Total VAT receipts, on the other hand, were expected to be £80 billlion. Remembering that banks don't pay VAT on their turnover or profits, that means the non-bank part of UK plc paid four time as much in VAT as it did in corporation tax. So VAT is the tax that hits most businesses hardest, not corporation tax.

So it is irrelevant whether businesses 'pass on' the VAT reduction by reducing prices by two percent (and seeing as VAT is a turnover tax, there is no strong reason to assume that they will). The point is, instead of handing over 14.89% of their gross turnover to HM Revenue & Customs, they will only have to hand over 13.04%. That extra 1.85% of turnover will be used to keep up with the rent, the bank interest, paying wages and so on, and hopefully staying in business. What people are really worried about is their employer going out of business and them losing their jobs, not whether the price of what they spent their net wages on goes down a per cent or two.

But ... you will only understand this post if you understand subtle but important economic concepts like the difference between the legal and economic incidence of a tax. I, for once, wish the Nulab government the best of British luck on this one.


* As I said recently, in reply to somebody who'd fallen for nonsense that 'VAT is a tax on gross margins'...

Here are three explanations [showing that VAT is a turnover tax]:

a) HMRC collects 17.5% of the end turnover of the whole chain. Yes, if there is no vertical integration, each part of the chain just pays 17.5% on its markup, but what about a vertically integrated producer, that owns the forests, the mines, the factories, the lorries and the retail outlets? It’s the same amount of VAT either way, ergo it is a turnover tax.

b) The cheque to HMRC is 17.5% of turnover minus input VAT. So a company with £117,500 gross turnover hands over (say) £10,000 to HMRC and £7,500 to the supplier. Or any two other numbers that add up to £17,500.

c) Let’s imagine we scrapped this nonsense of VAT registered businesses charging other VAT registered businesses VAT, with the supplier paying the tax and the customer deducting it from its own liability. Instead, we could just exempt such business-to-business supplies, and have the retailer charging the full 17.5% to the non-VAT registered end-user (as they do in some countries). The total tax paid would be the same. So it’s a turnover tax on the retailer. The suppliers may think that they are VAT exempt but this is nonsense (go back to example of fully vertically integrated supplier).


Mrs Smallprint said...

A good post, I hope Gordon reads it!

Is there any reason that you know of under EU rules why we shouldn't raise the VAT threshold substantially?

AntiCitizenOne said...

The way I see it is that VAT is really a tax on income. The value add, is your staffs productivity-time.

In the end it discourages people from exchanging their time, and thus harms the division of labour and money velocity and thus the wider economy.

Bill Quango MP said...

It is a good idea to reduce VAT for all the reasons you raise. Plenty of business leaders today have said "yes it will be a great boost".

2.5% extra in the till .. kerrching
i/m not passing any of mine on. mostly because its already been bought at 17.5%.
Shoppers can still have the 20% we were planning on giving them anyway.

Mark Wadsworth said...

Mrs SP, the UK threshold is very high. We have to go to the EU and grovel every year.

AC1, exactly. It's not a tax on 'consumption', it's a tax on incomes and production etc.

BQ, thanks for anecdotal evidence. That's what counts.

Mrs Smallprint said...

I thought that might be the case (I did have a look at a rather boring directive earlier). So no scope there then unless we save billions by getting out of the EU so we can set our own policies again. Thanks for looking.

Mrs S.

Politically Numb said...


I follow your theoretical argument until here:

So it is irrelevant whether businesses 'pass on' the VAT reduction by reducing prices by two percent (and seeing as VAT is a turnover tax, there is no strong reason to assume that they will)

Surely in reality this is ultimately relevant because it decides where the 2.5% cash goes - to the consumer or the business.

From my experience (would be interested in any short term figures on this) businesses have been passing on the VAT cut to consumers.

This is why in my mind it's a "2.5% sale!" (yawn).

Even if it were being retained by business, 1.84% is useful for marginal businesses, but throwing money down the toilet for the rest. It also completely ignores the whole B2B sector.

Mark Wadsworth said...

PN, 'a business' is not some inanimate thing, it is people - entrepreneurs, employees and investors. Whether 'businesses pass on' the VAT cut to people, or retain them, thus benefitting a slightly different group of people, but seeing as all the categories overlap, it comes to the same thing.

In a recession, the biggest worry is that businesses fail. Cutting corporation tax is pointless because it won't help businesses who are making losses. Remember that most businesses have wafer thin profit margins, let's say 5% of turnover. That 1.8% of turnover is thus a heck of a boost to profits.

And although the B2B sector may think it doesn't pay VAT, it makes supplies (ultimately) to retailers or service providers, so if retailers or hairdressers go bankrupt, the B2B sector suffers as well.

Politically Numb said...

Let's say that in the first place the money's staying with the consumer, because the businesses aren't ripping them off the 2.5% (my experience).

Your assumption is that the consumer must spend that money with businesses.

But if there's no confidence (like now, because this 2.5% VAT sale is a joke), people don't spend that money. They either save it, or more likely just get into less debt than they have been.

The marginal businesses go under, taking consumers jobs with them. I believe this is called a recession?

It therefore matters how the saving is dispersed.

PLUS - Even if you were right ;) Brown (anyone seen Darling?) announced it as a confidence booster to consumers, so he still gets nil points!