Economics Q&A: Will the rise in VAT harm the UK’s economic performance?

On January 4th 2011, the standard rate of value added tax (VAT) jumped from 17.5% to 20%. For the first time, the UK VAT rate is now the same as the basic rate of income tax! Prime Minister David Cameron has stated publicly that the rise in VAT is likely to be permanent rather than temporary. The UK economy will thus have to adjust to this higher rate but what are some of the possible macroeconomic consequences?

Economic performance can be measured and assessed in several ways among them:

• The rate of growth of real GDP (focus here on the components of AD - C+I+G+(X-M))
• The rate of consumer price inflation (% annual change in consumer prices)
• Unemployment and employment rates
• The balance of trade in goods and services (our external trade performance)
• Supply-side indicators such as productivity growth investment and business profitability

A rise in VAT represents part of a policy of “fiscal tightening” by the coalition government. They have decided to use a mixture of government spending cuts and higher taxes to reduce the scale of the budget deficit. VAT is the most high profile of the tax rises although there have been several others including higher levels of excise duty and a tax on bank bonuses. VAT is a major source of revenue for the government. The rise in VAT is expected to net around £13bn extra per year into the government’s coffers - around 16% of total tax revenue comes from VAT, compared to 20% in most other EU countries.

When analyzing the effect of VAT on the macro economy there are plenty of aspects to consider:

1/ The effects on household demand, the distribution of income and the shadow economy

If higher VAT feeds through into higher prices in the shops, it will prompt a fall in real incomes especially at a time of wage freezes, higher fuel and energy costs, more expensive rail fares and food prices. People will have less discretionary income to spend on other goods and services leading to weaker consumption growth - consumption is the biggest single component of aggregate demand. Leisure industries seem to be particularly at risk.

Not all products are subject to VAT - banking, education and healthcare are exempt as are books, magazines, newspaper and most food (unless bought and eaten in a restaurant) rents and new houses. Water is exempt but electricity; oil and gas are subject to VAT - although at a reduced rate if for domestic use. And not all retailers will pass on the VAT especially in price-sensitive markets with a high price elasticity of demand.

There is a fierce political debate about whether the rise in VAT has a regressive effect on poor to middle-income families. Trade Unions and the Labour Party claim that VAT is a regressive tax meaning that the proportion of an individual’s income spent on VAT falls as one goes up the income scale. But others argue that the regressive nature of the tax is not as severe as this. If we focus on spending rather than income, over a lifetime, VAT will tend to be progressive (according to research from the IFS) because things that aren’t subject to the main rate of VAT are necessities that are consumed disproportionately by poorer households.

The rise in VAT is expected to boost the size of the shadow economy. VAT is widely evaded. It is currently estimated that about 14% of VAT is illegally unpaid or by-passed for example VAT is not charged on imports of less than 3100 which is why so many CDs and DVDs are imported into the UK from the Channel islands! If the shadow economy grows, recorded GDP will suffer but paradoxically total consumer spending using cash may rise stimulating demand in many localities.

2/ The effects on the UK retail sector which employs 3 million people and accounts for 25% of GDP

Consumer spending is expected to grow less quickly than GDP in each of the next three years. Falling real income and a possible double dip in the housing market are two key factors here. The consensus forecast for the economy is that real GDP will grow by 2% in 2011 but consumption will only be 1.3% higher and an increase of just 1.5% expected in 2012. If household demand is fragile, many retailers will feel the pinch and thousands of jobs are at risk.

3/ The impact on inflation and inflation expectations.

Inflation has been above the 2% target for most of the last three years and the spike in VAT will cause a further lift in CPI inflation in the first half of 2011 before the effects fall out of the calculation at the start of 2012. The latest VAT increase should add 2.1 per cent to the prices of most items and perhaps drive inflation to 4% or higher. The Bank of England understands that most of the rise in inflation will reverse in a year’s time - but with other inflationary pressures mounting, higher VAT might just bring about an end to the period of ultra-low interest rates which has provided a support to the economy during the recession.

4/ The overall impact on economic growth at a crucial stage of the economic cycle

The increase from 17.5 per cent will reduce gross domestic product by 0.3 per cent, or £4.6 billion, in 2011/12, according to the independent Office for Budget Responsibility. A broader study of the government spending cuts and rising VAT from the Chartered Institute of Personnel and Development has found that the fiscal squeeze will result in more than 1.6 million job losses across the public and private sectors by 2016.

5/ Medium term benefits of reducing the fiscal deficit.

One argument is that strong action now to cut the deficit will bring macroeconomic dividends in the future because it will limit and eventually reduce the size of the national debt mountain and cut the need for further tax hikes in the future. Would alternatives for higher taxation such as a rise in national insurance contributions have a worse effect?

Chancellor George Osborne has repeatedly claimed that the main alternative - a rise in national insurance contributions - would have a more damaging effect on the jobs market and the economy - he has called this a “tax on jobs.” He has called the rise in VAT “a structural tax change to deal with a structural budget deficit.’

Osborne is hoping that a stronger recovery in UK exports of goods and services and a pick up in business capital spending will help to offset slower consumer spending and encourage people to save a little more to pay off some of their existing debts. But this anticipated re-balancing of the economy depends on the strength of the world economy and also a possible depreciation of sterling against the US dollar and the Euro - none of which is certain.

Keynesian economists tend to believe that there is no strong case to be made for cutting government spending and raising taxes at this time, the economic recovery is simply too fragile.

The UK is not alone within Europe in increasing VAT. Portugal, Poland, Latvia and Slovakia, have tabled increases in sales taxes for the start of 2011 – most to more than 20 per cent. And although the 20% rate is likely to remain in the UK for some time, there is still scope for extending it to a wider range of goods and services.

Overall the rise in VAT is likely to cause higher inflation, reduced GDP growth and some job losses in 2011 and into 2012 - so some deterioration in three microeconomic indicators at the expense of improved government finances. But in the long term a 20% VAT rate is unlikely to have any noticeable effect on UK competitiveness and growth. The long-term trend GDP is driven by supply side factors such as technological progress, working age population growth, improved work and enterprise incentives and the scale and quality of capital investment spending).