One tax hike I'll be hoping for in the Budget (and some cuts as well)

Back home in Ireland, it’s said that asking for directions will often get you the reply, “I wouldn’t start from here.” We might say the same thing about the UK’s tax code. Nobody drawing up a tax system for the country would create anything like what we have right now, and when it comes to reform – well, I wouldn’t start from here. One example, which I talked about on the Today Programme this morning, is VAT. VAT is usually considered to be one of the least bad taxes around: in theory, it doesn’t discourage production, it isn’t very regressive, and it doesn’t distort the economy.

I say “in theory” because in practice the UK’s VAT system is a mess. It is riddled with exemptions (I am including zero-rated and reduced-rated goods in this) that distort people’s spending, which means that resources are being wasted, because people are buying relatively more of the untaxed goods and less of the taxed ones than they would be if the playing field was level.

The usual argument for these exemptions is that they are needed to reduce the burden on the poor. This is a powerful argument but it is wrong.

Many of the exempted items are unlikely to benefit the poor anyway – financial services, the construction of new dwellings, domestic passenger transport – but even for things like children’s clothes and food the argument is wrong. Although poor people spend a greater fraction of their budgets on exempted items like these, total spending on these goods rises with income, so most of the forgone revenue is actually from the rich.

The extra money raised could easily offset the extra cost to the poor by reducing income taxes on them (including national insurance contributions) or by raising the Universal Credit payment level. We could actually offset the extra cost to almost everyone, but except for people on low pay I think there are better taxes we could cut with the money left over.

The IFS estimated in 2010 that scrapping all VAT exemptions would raise an extra £26-28bn, based on 2010-11 numbers. Conservatively, rounding that up to £30bn to account for the larger economy, and spending half on boosting the incomes of the poor, we have £15bn left to play with. We’ve suggested scrapping capital gains tax to boost investment and using the rest to reduce the deficit.

In simplifying VAT we can make one important tax much less destructive without hurting the poor and use the money left over to cut taxes that are even worse.

Politically, this might not deliver good headlines, but if it was done at the start of the next Parliament the boost to people’s living standards by the next election could, improbably, make raising taxes on food and children’s clothes a real winner.

We might not want to start from here to get our sensible tax system, but this is one reform that could be a good step in the right direction.