Today sees a rise in the standard rate of VAT from 17.5% to 20%. Now, as I've mentioned before, I'm not an expert in economics, I'm a beginning economics student, so my thoughts on this subject may be ill-informed or based on misunderstandings. But I'll share them with you anyway. Do feel free to point out in the comments if there's anything you think I've got wrong.
3 questions spring to my mind about this VAT increase. Is it necessary? Is it fair? And what effect will it have on the economy?
As for whether it's necessary, the first thing to say is that some kind of tax rise is surely necessary. The Labour government spent taxpayers' money like a drunken sailor and left us with such a mind-bogglingly huge budget deficit that it is inconceivable that the hole could be plugged by either budget cuts or tax rises alone. Both are necessary. But as for whether VAT is necessary, that depends on how it stacks up against possible alternatives.
So on to the next question: is it fair? There seems to be a broad consensus among politicians that progressive taxes are fair and regressive taxes are not. Progressive taxes are those paid more by the poor than by the rich, and regressive taxes are those paid disproportionately by the poor.
So is VAT progressive or regressive?
Many commentators describe VAT as a regressive tax. See here, here, and here for examples. Even David Cameron himself described it as regressive, although it should be noted that that was what he said before the election, when he also said he wasn't going to put the VAT rate up.
And we all know that what politicians say before the election doesn't count.
However, I don't think it's as simple as that. In one sense, VAT is not as progressive as putting up the basic rate of income tax. People at the bottom end of the income distribution, who don't pay income tax, are not affected by a rise in the rate of income tax, but are hurt by a rise in VAT.
However, they are not hurt very much. Remember that VAT is not charged on most essential items, most notably food and rent. If you are poor, most of your expenditure goes on food and rent. If you are rich, a much higher proportion of your expenditure goes on luxury items which attract VAT, so you probably pay more VAT. So I suspect that overall, VAT is a lot more progressive than most people give it credit for. It would be interesting to know if there are any reliable statistics on how much VAT is paid as a proportion of income by different income groups, but I don't have those to hand.
So what about the effects on the economy?
I can think of 2 ways in which it could have an effect: reducing consumer demand, and increasing inflation.
There is no doubt that increasing VAT will reduce consumer demand. If prices go up, then demand must fall. I may not be an expert in economics, but that seems pretty basic. How much demand falls is, of course a harder question to answer. Will it fall be enough to make a big dent in the economy? I doubt it, but time will tell.
But it's also worth considering whether it's a good thing if consumer demand goes down. Didn't we end up in the mess we're in partly because everybody borrowed too much and spent too much? If people are less tempted to splash out on a 56 inch plasma screen TV and pay off a bit of their mortgage instead, would that be such a bad thing?
After all, one of the first signs of the current financial crisis was the run on Northern Rock. Northern Rock's problem was that they had lent far more in mortgages than they had received from savers, and they found themselves unable to fund all those mortgages when funding from wholesale money markets became harder. So their problem was caused by people borrowing too much and saving too little.
Of course we need people to spend money, because that's what keeps the economy going. As we attempt a fragile recovery from a nasty recession, it could be argued that spending money is more important than ever. However, is the domestic market the be-all and end-all of the recovery? I suspect that the economy needs to focus more on exports than on domestic demand if we are going to see our economy recover strongly from the recession, so perhaps a small dip in domestic demand is less of a problem than it seems.
The other effect of the VAT increase is that it fuels inflation. At first sight, that seems a bit artificial: underlying prices have not increased, any jump in inflation is due to a one-off tax increase. However, it will feed through to official inflation figures, and of course it does mean that there is a very real increase in the price that ordinary people pay for things, so it could feed through into higher wage increases, which would then cause further inflation. That doesn't seem too big a danger at the moment, when many people are thankful that they have a job at all and many employers, struggling to survive the harsh economic climate, are not contemplating any wage increases at the moment.
But the cynic in me wonders whether the government are actually quite keen to see rising inflation. Our national debt is huge, and is going to take a long time to pay back. One cunning plan for making it easier to pay back would be to have a period of high inflation, which would erode the real-terms value of the national debt, thus making it easier to pay back.
I have no idea whether the government are thinking along those lines or not, but I'm sure the idea must at least have crossed their mind.
Does it even matter if we do see a period of high inflation? It probably does if you're a pensioner and reliant on the value of your savings, which would be eroded by inflation, but I suspect it may not matter so much for others, and for anyone with a mortgage, inflation also erodes the value of the mortgage. Of course high inflation tends to lead to high interest rates, which is bad news for mortgage holders.
Clearly there are winners and losers from high inflation, and I suspect that overall it's a bad thing, but it may not be quite the apocalyptic scenario that some people believe.
So, after all that, do I think that the VAT increase is a good idea? On balance, probably yes. In an ideal world, I'd rather not have to face any tax increases at all, but given that we do have to have them, VAT is probably one of the least painful. Unlike income tax, paying VAT is largely voluntary, as it's charged mostly on things that you don't absolutely have to buy (although of course there are exceptions). I certainly think it's a better option than putting up employers' national insurance: when we are faced with rising unemployment, the last thing we should be doing is increasing taxes on job creation.
As for the effects on the economy, time will tell, but my guess is a VAT increase is probably less harmful than most of the alternatives.
What do you think? Do let me know with the comments form below.