Abhay Venkitaraman
Illustration by Will Allen
The UK’s Value Added Tax (VAT), a tax on household consumption, spares many goods and services from the ‘standard’ 20% tax rate. Some, like food and children’s clothing, are subjected to reduced rates of VAT – whilst others, like education, are exempted from VAT altogether. This bleeds the government of £100bn every single year, burdens businesses with extra administration and compliance costs, and results in unfair tax treatment of goods and services. Is this arrangement justifiable, and how ought we to reform VAT to make it fit for purpose?
After 14 years of Conservative misrule, the degeneration of the public realm is clear for all to see. Prisons are full, waiting lists are through the roof, thousands of youth centres and libraries have closed, and the retrenchment of our welfare state has immiserated the most vulnerable. Something must give – and the British government will have to ramp up spending to relieve the multiplicity of funding pressures it currently faces. This begs the obvious question: how are we going to pay for it?
One area the Chancellor, Rachel Reeves, could start with is the UK’s Value Added Tax (VAT) regime. In particular, she should reduce the number of goods which are either exempted from or subjected to reduced rates of VAT. Not only could this raise tens of billions of Pounds worth of revenue, but it could also significantly reduce the administration and compliance costs businesses face and create a more equitable tax system.
How VAT works
VAT is a tax levied on the sales of goods and services sold in the UK, with the bulk being subject to a 20% standard rate. Every single participant in a product’s supply chain – whether it be suppliers, retailers, or consumers – pays VAT on the ‘value added’ (hence the name) at each stage of the production process. However, firms are reimbursed entirely for the VAT they pay on their inputs. This means the tax is only really paid by consumers, with firms being shielded from any monetary burden.
However, there are many exceptions to these rules. Many goods and services in the UK are subjected to a ‘reduced rate’ of VAT – meaning a rate of VAT lower than 20% -- sometimes even 0% (what is called ‘zero-rating’) -- is levied on them. This applies to most food and children’s clothing, alongside home energy, residential property, and other products.
However, firms selling these can still be reimbursed for the VAT they pay on their inputs.
Others, like education and training, are ‘exempted’ from VAT. This means consumers pay no VAT on these goods and services, but also that firms cannot claw back any of the VAT they pay on inputs used to produce them.
How the UK’s VAT regime differs from other countries
Whilst every country that has a VAT either exempts or subjects some goods to reduced rates, the UK is unique in terms of how many of these it provides. A relatively accurate measurement for this is the VAT revenue ratio (VRR). This measures the total amount of VAT revenue a government collects as a share of the revenue it would raise if it subjected all household consumption to VAT, with 1 being the highest possible number. In 2022, the UK’s VRR was 0.44 – significantly lower than the OECD average of 0.56.
These exemptions and reduced rates bleed the government dry. The Institute for Fiscal Studies has estimated they collectively cost the Exchequer £100 billion annually. For reference, were the government to raise that much additional revenue, it would be more than enough to allow all government departments’ day-to-day budgets to rise in line with GDP – the beginning of an end to austerity.
VAT reduced rates and exemptions create a host of deleterious effects
VAT exemptions and reduced rates also impose immense amounts of complexity on firms. Businesses must spend ample amounts of time and effort determining whether their goods and services are zero-rated or VAT-exempt. This burden is amplified by the fact that extensive, costly court cases are often fought over how their goods and services should be classified for tax purposes. A classic example of this occurred in 1991, when McVitie’s and the UK government fought a court case over the all-important question: should Jaffa Cakes be classified as cakes or chocolate biscuits? This had huge implications for McVitie’s – due to the design of the UK’s VAT system, cakes are zero-rated, but you must pay 20% VAT on chocolate biscuits, and it is alleged that as a result, the court ruling that Jaffa Cakes are chocolate biscuits could have cost the company £3 million. Following a lengthy legal battle where McVitie’s literally baked a giant Jaffa Cake to substantiate their case, the VAT tribunal ultimately ruled in their favour.
Moreover, VAT exemptions on goods and services – like education and training – result in firms having to pay the tax on inputs used to produce them. Importantly, because only certain products receive exemptions (whilst others don’t), this means the VAT regime ‘distorts’ businesses’ production choices, meaning it incentivises them to decide what to produce on tax rather than economic grounds. They are effectively discouraged from producing VAT-exempt goods and services even if those goods create more value for the firm and consumers. This results in a more inefficient distribution of resources and lower social welfare.
Some argue for reduced rates on distributional grounds. Levying VAT on essentials like food and children’s clothing would be regressive, they say, since low-income households spend a higher share of their income on these goods. This, in their view, justifies zero-rating them – as is currently the case in the UK.
This is widely off the mark. For one, wealthy households consume more of these essentials than poor ones in absolute terms. This means that in absolute terms, they benefit more from 0% VAT on food and children’s clothing than poorer ones do. It would be more distributionally progressive to subject these goods to 20% VAT, and to spend the resulting revenue on welfare programmes that benefit the poor. More broadly, what matters is not how distributionally progressive VAT is, but rather the progressivity of the overall tax system. Any regressivity stemming from VAT can be counterbalanced by other ‘progressive’ taxes – such as Income Tax and Capital Gains Tax.
Others hold the view that ‘meritorious’ goods and services, like books and cultural events, should be subjected to a reduced rate of VAT. This, it is argued, enables higher consumption of these, which is seen as benefiting society. Policymakers seem to be convinced by this logic in the UK, with both print books and e-books being zero-rated on this basis.
However, the subjectivity inherent to defining what a ‘meritorious’ good is means that this inevitably results in inequitable treatment of goods and services. For example, print newspapers are zero-rated, but digital newspapers are subject to 20% VAT. Is there any reasonable justification for this differentiation in tax treatment? Colouring books are another case study: they’re zero-rated, but only if they’re for children – colouring books deemed “suitable for adults” are subjected to 20% VAT.
This inequity extends to a wide range of other goods, leading to all manner of absurdities. A gingerbread man with chocolate eyes is zero-rated, but you have to pay 20% VAT if it has chocolate trousers. Strawberry milkshakes are zero-rated, but you have to pay 20% VAT on chocolate milkshakes. And the list goes on and on.
More broadly, reduced rates may not even result in lower prices for consumers. A report by the think tank Tax Policy Associates found the reduction of VAT on period products from 5% to 0%, the so-called ‘tampon tax abolition’, did not result in lower prices for consumers, with essentially all the windfall being pocketed by retailers. The think tank found the zero-rating of eBooks in 2020 created similar outcomes.
Policy Recommendations
Whilst the number of VAT exemptions and reduced rates should be significantly more limited than at present, there are some cases where they may be justified. There is a case for exempting financial services and public services from VAT – as these generally don’t offer services at a price and are therefore hard to value for tax purposes. Furthermore, there may be an efficiency case for reducing VAT on goods and services whose consumption heavily influences work incentives, as this might lead to higher levels of labour supply, and therefore economic growth. Many also highlight the potential benefits of exempting small businesses from VAT – given the disproportionate compliance and administrative costs they would face relative to their profits if they were subjected to the tax, although exempting them from VAT runs the risk of discouraging firms from expanding. And exports should also be VAT-exempt to prevent double taxation.
Overall, though, it must be emphasised that the share of goods and services subject to VAT exemptions and reduced rates in the UK is vastly excessive. The present regime deprives the government of desperately necessary tax revenue, imposes vast administrative and compliance costs on firms, and fosters horrific amounts of inequity. One can only hope that in the run up to this month’s Budget, Rachel Reeves makes the right choice: reforming VAT as one step of many to deliver the change our economic landscape desperately needs.
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