Tourism and VAT - Exam Question Walkthrough for Edexcel A-Level Economics

Here is a suggested response to an Edexcel A-Level Economics style question assessing the arguments for and against cutting VAT for hospitality businesses impacted by the COVID-19 pandemic.

Extract 1: Tourism, Hospitality and VAT
There has been a long-running campaign by the tourism industry for the UK to introduce a rate on VAT below the standard rate of 20% on services supplied to tourists. Proponents have argued that this would allow hotels, restaurants and pubs to cut prices, boosting sales and employment in this sector, which in turn would generate growth in the wider economy.

VAT is charged on the supply of most goods and services. All businesses in the UK must register for VAT if their annual turnover is above a given threshold of £85,000

VAT is forecast to raise £128 billion in 2021/22. Only income tax and National Insurance contributions raise equivalent sums for the UK government.

Extract 2: The contribution of hospitality to the UK economy

In 2019 the hospitality sector contributed £59.3 billion to measured GDP of the UK economy, around 3.0% of GDP. In September 2020, there were 2.4 million jobs in the hospitality sector in the UK, representing 7% of total UK employment.

Economic output in the hospitality sector was down 90% in April 2020 compared to February 2020. Output recovered over the summer of 2020, boosted by the Eat Out to Help Out scheme in August, but was still below pre-pandemic levels. Output declined again from September as Covid-19 cases rose and restrictions were imposed.

From March 2020 to September 2020, the number of workers in the sector fell by 6% (147,000). However, the pandemic has not yet resulted in the expected increase in unemployment, partly due to the Coronavirus Job Retention Scheme.

Source: Adapted from House of Commons Library Research Report, Feb 2021

Q: Using the extracts and an appropriate analysis diagram, assess the view that the UK government should reduce value added tax for transport and hospitality businesses. (10 marks)

KAA Point 1:

One argument in favour of the government cutting VAT for these businesses is that it will reduce their costs and therefore help them achieve higher profits after the industry has struggled during the pandemic. Extract 2 says that output in UK hospitality fell 90 percent during the 1stlockdown and remains below pre-pandemic levels. My analysis diagram shows how a cut in VAT causes a pivotal outward shift in the supply curve which, ceteris paribus, then leads to a fall in prices and an expansion of demand. In theory this will lead to higher revenues for hospitality businesses and help to reduce losses made during the pandemic.

Evaluation Point 1:

However, the impact of a cut in VAT on sales, revenues and profits of hospitality businesses depends on the coefficient of price elasticity of demand. If demand has a low PED – for example -0.2 – then a 15% cut in VAT would have only a small impact on demand leaving hospitality businesses with excess capacity and perhaps less total revenue. Opening after the pandemic will increase their costs - for example by taking staff off furlough – so it is not guaranteed that a cut in VAT will be enough.

KAA Point 2:

A second argument in support of a cut in VAT fortransport and hospitality businesses is that the industry is labour-intensive, and a tax cut is needed to protect hundreds of thousands of jobs. The sector accounts for 7% of employment and pays 2.4 million people (Extract 2). Many are young people in their first job.Unless the industry is supported, they may suffer a loss in expected life-time income, and this will – in the longrun – cause a drain on government tax revenues. Lower VAT will allow hospitality businesses to spend more of their money on improving people’s human capital through extra training. This can boost the UK’s long-term competitiveness.

Evaluation Point 2:

A counter-argument is that VAT is a big source of taxrevenue (£128bn in 2022 according to Extract 2) and that cutting it for transport and hospitality businesseswould lead to an even-higher fiscal deficit and growing national debt. Critics of cutting VAT might argue that there are better medium-term alternatives to help businesses such as lowering national insurance contributions or reforming business rates which are a big fixed cost for many pubs and restaurants. Cutting VAT to simply boost corporate profits would be seen as a quick fix option which risks causing government failure.