Sunday, November 23, 2008

15 Reasons Why a VAT Reduction May Backfire

A reader has sent this list of reasons why cutting VAT may not be the best way to boost the economy...

1. Deflationary for the next 12 months
2. Reduces business liquidity possibly by over £1bn
3. Little or no help to SME’s in the B2B sector
4. Helps lower income individuals/families proportionately less than higher ones
5. Gives businesses / retailers abilities to mark up price changes eg 70p chocolate bar is now 68.52p
6. Reduces the price of cigarettes probably first time in 20+ years
7. Reduces alcohol prices – possibly encouragement to binge drinking
8. Involves re-priceing by virtually all retailers at their busiest time of the year (supermarkets & garages can cope easily – others less so eg restaurants)
9. Reduces restaurant/ hairdressers etc tip income Lower paid impact again
10. Requires HMC&E to recalculate Flat rate VAT scheme rates & notify SME’s – initial confusion
11. Reversal to recover lost income requires possibly an increase of 33.3% in VAT rate
12. Reversal of rate increase will slow recovery
13. Optional increase in Income Tax personal allowance could have given 75% benefit immediately ie December/ January wheras VAT benefit spread over 12 months
14. Doesn’t reduce food prices – idea why not negative VAT rate!
15. Doesn’t significantly help housing market – critical

When I first heard about this yesterday evening, the following thoughts came to me...

* If I was running a shop, would I definitely pass on a 2.5 reduction in a VAT? Would I reduce a 99p product to 97p?
* For people at the lower end of the income scale, this will have marginal impact. A high proportion of their spending is on non VATable items or utility bills, where VAT is 5%
* Surely a fiscal stimulus works best when money is put directly into people's pockets and they can go out and spend it?
* What goes down, must surely then go up - and go up by more than the reduction in order to pay for the cost of borrowing that money. Is Robert Peston right when he predicts a new VAT rate of 22.5% within a couple of years?

These are the areas where the Conservatives should concentrate their attacks. I expect the government to obfuscate about how all these tax cuts will be paid for in the medium to long term. I doubt very much whether they have even thought about it. It's a real opportunity for the Tories to expose the government's sham of an economic policy.

So, can anyone expand this list of 15?

UPDATE: More from John Redwood.


@molesworth_1 said...

They will spin the VAT reduction on the back of the impending deflation in food & oil prices, claiming the credit for a cost-of-living reduction in the process.

Anonymous said...

This is a simply crazy policy. Prices are projected to fall in the economy anyway over the next few months (we have month-on-month deflation already, and it is projected to continue).

Yet even this is not going to stimulate enough demand to pull us out of recession. People need to have more money in their pockets (not just a 'feeling' they can buy more with what money they have):

- Most people will just save any savings, further reducing domestic demand and governmental revenue, exacerbated if they expect VAT to increase in a couple of years time.

- Has very little value for poor because (a) they spend the least anyway,(b) many of the products that they normally spend money on are VAT-exempt (c) this is even more the case in a recession when people stop buying luxury goods and just what they need (given that VAT-able goods are not intended to be these necessities...)

- When VAT increases in 2 years time, it is going to massively inflationary, which will lead to upward pressure on interest rates when we need it least

Welland Valley Broadband Group - Leicestershire said...

As the effect of a VAT reduction will be deflationary then the BOE will not need to reduce interest rates so much. A BOE interest rate cut costs the government nothing whereas a VAT reduction ...

Null said...

"6. Reduces the price of cigarettes probably first time in 20+ years
7. Reduces alcohol prices – possibly encouragement to binge drinking
9. Reduces restaurant/ hairdressers etc tip income Lower paid impact again"

Of course this will not happen because retailers will simply pocket the difference...

Tony said...

I did a post earlier on my blog asking a question about the Flat Rate scheme. Taking into account point 10, maybe your correspondent can take a look over on Waendel or send you the answer Iain? Thanks.

Mark Thompson said...

I think you have covered the points I have made on my blog but I have gone into more detail on some of them.

I certainly agree with you that a direct income tax rate change would be better and a quick back of the envelope calculation tells me that for the £12.5bn slated, instead of reducing VAT, they could have given an extra £46.30 per month to each taxpayer in the country. This would have benefitted everyone who pays tax equally and actually lifted some people out of paying tax altogether.

Mark Thompson said...

My link seems not to have worked.
Anyway it's here:

Steve Horgan said...

The general problem with fiscal stimulus, as with any measures that affect a system the size and complexity of the UK economy, is the lag between action and effect. It is known, for example, that interest rate changes take at least 3 months before they have any discernible effect, and up to 18 months to have their full effect on the economy. So, we are actually still living with the Bank of England's policy as it was over the last two years, and their recent handbrake turn is something for mid-2009, not today. It is similar with changes to taxation as they work through people's incomes and affect their confidence and economic decision-making. So, a key factor in choosing taxation changes to stave off or ameliorate recession is how quickly the change inserts itself into the decision cycle. Reducing VAT is a bad choice simply because it does not immediately connect with the consumer. Prices may come down, but not in any uniform and easily discernible way, and it will be some time before people feel that they have any more money in their pockets to spend, which is the point. Reducing VAT also does nothing to affect employee retention, which was the Conservative proposal.

What the government should have done is reduce the tax burden on small business, remember that a rise in Corporation Tax for small business is still planned though there are rumours that at least may be postponed. What they really should have done is reduce income tax, because that is an unequivocal rise in personal income that the consumer would immediately notice, and so the lag effect would be reduced.

Tax cuts should have been matched by savings of course, but, hey, this is a Labour government.

Anonymous said...

well i work for a retailer, and i can assure you that in all likelyhood, we won't be rushing to reduce prices to silly amounts like £2.92

it's very tough in retail at the moment. i'd be surprised if a sugnificant amount of retailers passed it on.

Anoneumouse said...

Will a reduction of VAT apply to the Mad Hatters Tea Party

John Pickworth said...

If you wanted to make £12,500,000,000 disappear, never to be seen again... this would the way to do it.

Saving a piffling 5p on a cup of coffee just isn't going to make anyone feel richer.

What might have been a wiser move would be to immediately halve everyone's Council Tax bills... even possibly giving a rebate for the current financial year. This could have been funded in part by borrowing but also by eventually finding savings at central and local government - sharing the pain in other words. Now that's the kind of money people would notice in their wallets.

Yak40 said...

16. Gives Labour an instant excuse to raise taxes in the future (not that they've ever really needed one).

Anonymous said...

Quite. Nothing I've heard so far puts a penny extra in my pocket. Any savings in my weekly shop would get eaten by my brother anyway. But seriously, as somebody on a fairly low income this PBR and talk of VAT cuts does nothing for me. No better off and no worse off really. Makes me wonder why I would bother working harder if I'm just going to end up getting taxed more.

Humanzee said...

Woo hoo! Britian's having a 2.5% off sale!
Quick grap your empty wallet and come window shopping, look at the fractionally smaller prices!

But wait, it isn't 2.5% off the price at the checkout.

If you have a product with a price before VAT of £100 and you add 17.5% VAT, you get £117.5.
With the new "low, low" rate of 15%, you save 2.5% of the VAT:
£100 + 15% = £115.

You're saving two and a half 117.5ths of the price, not two and a half 100ths.

It's an easy mistake to make (so easy every news program I've seen on the subject has made it) But if you thought £2.50 off every 100 was unlikely to stimulate a rush to the shops, 2.13 is even less likely to.

Lastly, but importantly, most 'before VAT' prices are deliberately calculated to give a round number as the post VAT price: £9.99 =£8.50+VAT

If this practice continues then price to the buyer will actually increase:
£9.99 = £8.69+VAT. Although this is good news for retailers with a fractionally higher profit margin, for other small businesses able to claim their VAT back, struggling in the recession, this means paying more, not less, because there will be less to claim back at the end of the year.

Unknown said...

It may well be true that a small reduction in the VAT rate will not automatically mean that any individual business will reduce prices. However, in an environment where most retailers are cutting prices anyway to increase their competitiveness, then this means that the treasury is sharing the pain of those reductions. Albeit with the potential to increase the risk of stimuating deflation.

Alternatively, for a business that decides not to reduce prices, then the impact on profits can be significant - a business operating with a 10% net margin will see profits rise by 25% as a result of the VAT cut.

More profit is generally good news for employees and shareholders.

I find it hard to believe that people here arguing that a small cut in VAT rate will have a negligible impact would be making the same arguments if the rate were being increased to 20%.