It Was One Of Wilde's

FRIDAY, MAY 14, 2010

It Was One Of Wilde's

Don't blame us - it was St Vince's idea

The Times headline says it all:

"Get ready for VAT rise to pay for £17bn Lib Dem tax cuts, economists warn"

So in the noble spirit of compromise and The National Interest, George will set aside narrow party politics and grant the LibDems their much-trailed £10 grand personal tax allowance. However, sadly, our present grim fiscal circumstances dictate the LD policy can only be afforded by simultaneously and reluctantly increasing VAT to 20%, or maybe more.

Now, as it happens, there are very many Tories - including Tyler - who think there is much merit in such a tax switch. Of course, we don't want to increase VAT or any other tax - we want to see the whole lot lower. But in the circs, this is a least bad option. And it's not a million miles from what Thatcher/Howe did in 1979 (albeit they cut rates rather than increasing allowances).

You will be familiar with the key argument: that cutting the tax on work will incentivise people to get off their butts, while increasing the tax on consumption will incentivise people to save. Sound Victorian values all round, nudging us once again to become the nation of hard-working, prudent folk that God intended us to be*.

What's more, our 17.5% standard VAT rate is quite low by European standards. Germany is on 19%, France on 19.6%, and Italy on 20%, with further increases looking quite likely. Lucky old Sweden, Denmark, and Hungary are already on 25%.

Of course, increasing the personal tax allowance all the way to £10 grand would be expensive. St Vince costed it at £17bn, and to fund that we'd need to whack up the standard rate of VAT to around 21%. But that would still leave us comfortably in the European pack.

And there is another option, which is that instead of increasing the standard rate, George could extend the standard VAT rate to cover more items, such a food and children's clothing, both currently on a VAT rate of 0%.

That was the approach proposed by the Reform think tank in March. They pointed out that "the UK is one of only four EU countries to apply a zero rate to food and one of only three to apply a zero or reduced rate to children’s clothes". Overall, the items on zero or reduced VAT rates are extimated by the Treasury to cost over £30bn pa in lost revenue. Here's Reform's useful summary:

So simply by extending the standard rate of VAT to all items, HMT could raise another £30bn (well, maybe not quite that much because of behavioural changes - but still A Lot).

Now there is a well-known objection to VAT, which is that it's a regressive tax. In other words, because the poor consume a greater proportion of their incomes than the rich, they end up paying proportionately more tax. When the TPA looked at this just before the election, they found the poorest 20% shell out around 11% of their gross incomes on VAT, whereas it only costs the richest 20% just over 4%.

That's something we should all take very seriously, and extending the standard 17.5% rate to all the items shown in Reform's chart would make the problem much worse.

Which is why Reform coupled its proposal with a recommendation to cushion the poorest with a compensating increase in cash benefits. According to their calculations that could be done for around half the extra revenue flowing from the increase in VAT.

So in summary, making everything subject to 17.5% VAT, and cushioning the poor, would still leave enough to pretty well fund the £17bn pa estimated cost of the LD's £10 grand personal tax allowance.

And the very best bit?

George can say the whole shooting match was one of Wilde's.

*Footnote - for economics fetishists only Although Tyler's gut tells him that switching the tax burden from income taxes to consumption taxes would be A Good Thing Ltd, it has to be said that the econometric evidence is mixed. Indeed, even the theory is mixed - after all, we work to earn to consume, so it shouldn't make too much difference whether we pay our taxes in our wage packets or at the shop counter. Yes, I know we also save, but theoretically we save so we can consume later in life after we retire (indeed one Nobel winning economist built his early career on the proposition that the fully rational, fully informed man spends his last and final penny on having the last and final screw driven into his coffin lid).

M'learned friend Andrew Lilico at Policy Exchange is big on this, and in arecent paper we've already blogged, he used an economic model to compare the economic impact of changes in the basic income tax rate with changes in the standard VAT rate. He concluded:

"...recent academic evidence and experiments on the model suggest that increasing VAT may be as bad as, or worse, than increasing the basic rate of income. Some firms will try to absorb some of the effects of a VAT rise – e.g. because they do not operate in competitive markets, or because they are in financial difficulties and need to maintain turnover. Consequently, not all prices will necessarily rise by the same amount, distorting relative prices, re-directing economic activity inefficiently and so reducing growth. Not all goods attract the same level of VAT – e.g. some are subject to reduced or zero rates increasing the distorting effect."

So - shamelessly putting words into his mouth - Andrew might agree with Reform's proposal to extend the standard VAT rate in order to remove distortions, but would seriously doubt that an overall switch from income tax to VAT would have much long-term beneficial effect on the stuff wereally care about - GDP growth, employment, etc.

He goes on to make another interesting point:

"In the 1970s, rates of income tax were high, income tax complexities excessive, and union power higher (increasing the distorting effects of income tax) whilst rates of VAT were low (so that the effects of distortions were small). Until the index-linking of benefits during the 1980s,VAT increases also effectively reduced the value of benefits, increasing work incentives. At this point the trade-off may well have been more favourable to increasing VAT and reducing income tax. Now the rate of VAT is approaching the basic rate of income tax it may be the case that VAT rises will dominate over income tax related distortions."

On one level that would suggest George shouldn't do a Thatcher/Howe because the 70s were another country. But on the other hand, increasing VAT would be a way of whittling down the real value of welfare benefits in a world of low inflation - ie freeze benefits as part of the cuts package and let the simultaneous VAT hike do its work.

That's how you start thinking when you shack up with the Lib Dems.