In praise of VAT

As the Wall Street Journal puts it: VAT is “baked into the retail price”. VAT (also known as value added tax) is a method of taxation placed on consumer goods. Some goods and services in the UK are exempt from VAT such as lottery ticket sales, items from charity shops, babywear and children’s clothes and footwear. Although it is widely argued that VAT is actually a regressive tax that hurts the less well off, a more uniform system of VAT is actually more desirable for every group in society. It is easier to understand this model if we consider that VAT actually is more progressive over the lifecycle of a person, and through measuring by expenditure instead of income.

It is a widespread belief that allowing some goods and services to be completely exempt from this consumption tax actually helps the worse off.  However, eliminating these exclusions would widen the VAT base which will in turn, provide a stable revenue base as it is based on consumption, therefore removing distortions and providing funds for redistribution. 

In fact, a study by UCL, mirroring the Mirrlees’ Review on tax policy has shown that if VAT exemptions and zero-ratings were actually scrapped, the government will raise £24bn, which could then be utilised to increase what is given via means-tested benefits and tax credits, and still leaving a surplus to be invested elsewhere.

Some argue that this shift from income taxes to consumption taxes in effect imposes a windfall tax on “old capital”, thus purchasing power of people’s existing assets is reduced. This is actually efficient since the assets already exist, the revenue they provide doesn’t involve discouraging any new activity thus wouldn’t stagnate any growth. The tax is also theoretically neutral for producers, unless the good/service is exempt as they cannot be refunded for the VAT paid on their inputs, thus bearing the tax burden.

Lastly, to make sure that any taxation system is desirable, we should test it using the famous 4 canons of taxation by Adam Smith. These include: 1) canon of equality (meaning equality of justice, not equality of tax amount), 2) canon of certainty, 3) canon of convenience and 4) canon of economy. As the earnings received from removing VAT exemptions could be put back towards those who are least well off, the first canon can be fulfilled (as the tax and benefit system would be progressive overall).  The second canon of certainty ensures that the taxpayer is aware of the tax, which is clear with VAT. The canon of convenience works as the VAT is built into the price of the good or service, thus cannot be avoided either. Lastly, to fulfill the canon of economy, broadening the VAT base creates a comparatively minor administrative burden.

Shradha Badiani is a research intern at the Adam Smith Institute.