Should we broaden the base of VAT?

April 12, 2011 10:16 AM

In their March 2010 report Reality check: Fixing the UK’s tax system the think tank Reform proposed broadening the VAT base as the centrepiece of their proposed tax reforms.  They proposed to abolish zero and reduced rated items, so the same rate would be paid on all products.  That would mean that VAT would be charged at the standard rate – then 17.5 per cent, now 20 per cent – on items that currently face a rate of zero – like food – and items that receive a discount – like domestic electricity and gas.

Their view that reduced and zero ratings should be abolished is very much the mainstream opinion in the economic literature so it is worth considering for the 2020 Tax Commission.  I’m not convinced though, and I’ll set out why here.

There are essentially three main reasons why such a proposal is advanced:

  • It would allow for other taxes, particularly on income, to be lower.  Reform estimated that broadening the VAT base could increase revenue by up to £30.8 billion.

  • It would reduce economic distortion in the tax system.  Different rates of VAT could reduce efficiency by distorting consumer choice.

  • It would reduce administrative costs.  Reform argue that the Goods and Services Tax in New Zealand manages to reduce the need for a lengthy tax code with a broad base.


I think the economic distortion is overrated.  There are amusing cases like the dispute over whether Jaffa Cakes are biscuits (liable for VAT as a “luxury item”) or cakes (classified as a basic foodstuffs and therefore not liable for VAT), but that doesn’t tell us a lot about whether there is an important distortion.

Many of the key items that get more generous treatment are essentials.  What that term means in economics is that people don’t consume a lot more, or a lot less, of items like food and heating if prices change.  You need to keep warm and you need to eat.  While you might prefer to keep your home a little warmer or eat somewhat higher quality food if you can afford to, your appetite is limited.  The share of our incomes we spend on food has been declining for decades as we have been able to get the food we want for a smaller fraction of our total income.  As a result, I would expect that the distortion of consumer decisions from taxing food and domestic power less is pretty small.  People won’t consume much more food or energy because of it.

There might be more of a distortion in the narrow range of goods where substitutes are taxed differently.  Someone might eat a Jaffa Cake and not a Hob Nob because they pay VAT on the Hob Nob.  I’m not convinced that is particularly widespread or important.  I certainly don’t think a VAT-free diet is ever going to catch on.

It certainly would reduce administrative costs somewhat.  There have been major legal battles over the status of certain goods at the margin and long descriptions are needed to try and remove any ambiguity as to the status of different goods.  What seems less certain is the extent to which the different rates are the key source of the hassle associated with VAT.  After all, many businesses will have all their goods charged at the same rate.  There is another reason why VAT is a major administrative burden: the way it operates.

Under a sales tax or the old British purchase tax, businesses just pay a certain percentage of their total sales.  Under VAT, at every stage in the supply chain, a business will charge its customers and reclaim the amount it is charged in turn by its suppliers.  That creates the opportunity for missing trader fraud – where someone charges their customers for VAT but then absconds and doesn’t give the money to the Government – and more sophisticated variants of that crime known as carousel fraud which operate across the EU and have cost the Exchequer billions.  In just one incident recently criminals exploiting vulnerabilities in the EU Emissions Trading System made off with €5 billion.  A large part of the reasons for VAT’s high overheads must be the necessity of limiting such a pervasive and persistent fraud, rather than administering and defining different rates.  While broadening the VAT base would limit the administrative burden a bit, I think it is quite unclear how much the practical burden of complying with the tax would be eased.

The final argument for broadening the base of VAT is that it would raise money and therefore allow more economically harmful taxes to be cut.  My concern is that it would raise that revenue by increasing the cost of essentials like food and energy.  For that reason it seems essential that there would also be some kind of compensation for poorer families who spend more of their income on those kinds of basic goods.  There are two ways that could be organised: through the tax system or through the benefits system.

In the tax system that would probably mean relying more on income taxes and less on consumption taxes (perhaps through a lower headline rate) and/or altering those income taxes in some way to compensate.  That would introduce new distortions and new compliance costs.  The only exception would be increasing the personal allowance but that costs the Exchequer quite a lot.

Reform plan to compensate through the benefit system with a 7.5 per cent increase in all cash benefits.  That seems to be a particularly unwelcome trade off for two reasons:

First, there is something inherently unpleasant about removing people’s ability to stand on their own two feet.  Even if compensation through the benefit system means that higher taxes on the poor don’t increase poverty it does increase dependency and that seems regrettable.

Second, the benefit system has its own problems.  If you think VAT is complicated and distorts decisions, the benefit system makes it look like a beacon of simplicity, reason and consistency!  We have produced an extended report on the problems in the welfare system and this video sums it up:



Increasing reliance on tax credits and other benefits will exacerbate all the problems with the present system.  Even after Iain Duncan Smith’s welfare reforms there will still be high marginal deduction rates and the change Reform proposes would make that worse.  And increasing the extent to which we take people’s money in taxes and then give it back in benefits doesn’t sound like the best way of reducing administrative costs either.

Reform also argue that Britain is out of kilter with the rest of Europe.  Only Ireland, Cyprus and Malta put a zero rate on food for example.  But our somewhat narrower base fits with the historical pattern of British policy.  Before VAT was introduced here when we joined the EU, we had the purchase tax introduced in the war and that was levied on a pretty similar base to VAT (except that services and some other items weren’t included).  Maybe the established British policy is a relatively harmless way of easing the burden of consumption taxes on poor families, and therefore a better pragmatic way forward than the stricter approach taken by modern EU states with VAT?

It is also briefly worth mentioning that with climate change policies drastically increasing energy bills it will be particularly difficult to remove that reduced rate of VAT for the foreseeable future if those policies aren't reformed.

There is no doubt that it would be a huge challenge to persuade people that paying an extra fifth for their food is really a good idea.  I’m not sure that this tax reform is really worthwhile, let alone that it would be worth the considerable political effort it would take, and that could be put into working for other tax reforms.

An alternative, radical reform of consumption taxation would be to switch to a local sales tax.  There are challenges and risks that I wouldn’t want to gloss over, but the potential prize of fiscal decentralisation seems far more valuable.In their March 2010 report Reality check: Fixing the UK’s tax system the think tank Reform proposed broadening the VAT base as the centrepiece of their proposed tax reforms.  They proposed to abolish zero and reduced rated items, so the same rate would be paid on all products.  That would mean that VAT would be charged at the standard rate – then 17.5 per cent, now 20 per cent – on items that currently face a rate of zero – like food – and items that receive a discount – like domestic electricity and gas.

Their view that reduced and zero ratings should be abolished is very much the mainstream opinion in the economic literature so it is worth considering for the 2020 Tax Commission.  I’m not convinced though, and I’ll set out why here.

There are essentially three main reasons why such a proposal is advanced:

  • It would allow for other taxes, particularly on income, to be lower.  Reform estimated that broadening the VAT base could increase revenue by up to £30.8 billion.

  • It would reduce economic distortion in the tax system.  Different rates of VAT could reduce efficiency by distorting consumer choice.

  • It would reduce administrative costs.  Reform argue that the Goods and Services Tax in New Zealand manages to reduce the need for a lengthy tax code with a broad base.


I think the economic distortion is overrated.  There are amusing cases like the dispute over whether Jaffa Cakes are biscuits (liable for VAT as a “luxury item”) or cakes (classified as a basic foodstuffs and therefore not liable for VAT), but that doesn’t tell us a lot about whether there is an important distortion.

Many of the key items that get more generous treatment are essentials.  What that term means in economics is that people don’t consume a lot more, or a lot less, of items like food and heating if prices change.  You need to keep warm and you need to eat.  While you might prefer to keep your home a little warmer or eat somewhat higher quality food if you can afford to, your appetite is limited.  The share of our incomes we spend on food has been declining for decades as we have been able to get the food we want for a smaller fraction of our total income.  As a result, I would expect that the distortion of consumer decisions from taxing food and domestic power less is pretty small.  People won’t consume much more food or energy because of it.

There might be more of a distortion in the narrow range of goods where substitutes are taxed differently.  Someone might eat a Jaffa Cake and not a Hob Nob because they pay VAT on the Hob Nob.  I’m not convinced that is particularly widespread or important.  I certainly don’t think a VAT-free diet is ever going to catch on.

It certainly would reduce administrative costs somewhat.  There have been major legal battles over the status of certain goods at the margin and long descriptions are needed to try and remove any ambiguity as to the status of different goods.  What seems less certain is the extent to which the different rates are the key source of the hassle associated with VAT.  After all, many businesses will have all their goods charged at the same rate.  There is another reason why VAT is a major administrative burden: the way it operates.

Under a sales tax or the old British purchase tax, businesses just pay a certain percentage of their total sales.  Under VAT, at every stage in the supply chain, a business will charge its customers and reclaim the amount it is charged in turn by its suppliers.  That creates the opportunity for missing trader fraud – where someone charges their customers for VAT but then absconds and doesn’t give the money to the Government – and more sophisticated variants of that crime known as carousel fraud which operate across the EU and have cost the Exchequer billions.  In just one incident recently criminals exploiting vulnerabilities in the EU Emissions Trading System made off with €5 billion.  A large part of the reasons for VAT’s high overheads must be the necessity of limiting such a pervasive and persistent fraud, rather than administering and defining different rates.  While broadening the VAT base would limit the administrative burden a bit, I think it is quite unclear how much the practical burden of complying with the tax would be eased.

The final argument for broadening the base of VAT is that it would raise money and therefore allow more economically harmful taxes to be cut.  My concern is that it would raise that revenue by increasing the cost of essentials like food and energy.  For that reason it seems essential that there would also be some kind of compensation for poorer families who spend more of their income on those kinds of basic goods.  There are two ways that could be organised: through the tax system or through the benefits system.

In the tax system that would probably mean relying more on income taxes and less on consumption taxes (perhaps through a lower headline rate) and/or altering those income taxes in some way to compensate.  That would introduce new distortions and new compliance costs.  The only exception would be increasing the personal allowance but that costs the Exchequer quite a lot.

Reform plan to compensate through the benefit system with a 7.5 per cent increase in all cash benefits.  That seems to be a particularly unwelcome trade off for two reasons:

First, there is something inherently unpleasant about removing people’s ability to stand on their own two feet.  Even if compensation through the benefit system means that higher taxes on the poor don’t increase poverty it does increase dependency and that seems regrettable.

Second, the benefit system has its own problems.  If you think VAT is complicated and distorts decisions, the benefit system makes it look like a beacon of simplicity, reason and consistency!  We have produced an extended report on the problems in the welfare system and this video sums it up:



Increasing reliance on tax credits and other benefits will exacerbate all the problems with the present system.  Even after Iain Duncan Smith’s welfare reforms there will still be high marginal deduction rates and the change Reform proposes would make that worse.  And increasing the extent to which we take people’s money in taxes and then give it back in benefits doesn’t sound like the best way of reducing administrative costs either.

Reform also argue that Britain is out of kilter with the rest of Europe.  Only Ireland, Cyprus and Malta put a zero rate on food for example.  But our somewhat narrower base fits with the historical pattern of British policy.  Before VAT was introduced here when we joined the EU, we had the purchase tax introduced in the war and that was levied on a pretty similar base to VAT (except that services and some other items weren’t included).  Maybe the established British policy is a relatively harmless way of easing the burden of consumption taxes on poor families, and therefore a better pragmatic way forward than the stricter approach taken by modern EU states with VAT?

It is also briefly worth mentioning that with climate change policies drastically increasing energy bills it will be particularly difficult to remove that reduced rate of VAT for the foreseeable future if those policies aren't reformed.

There is no doubt that it would be a huge challenge to persuade people that paying an extra fifth for their food is really a good idea.  I’m not sure that this tax reform is really worthwhile, let alone that it would be worth the considerable political effort it would take, and that could be put into working for other tax reforms.

An alternative, radical reform of consumption taxation would be to switch to a local sales tax.  There are challenges and risks that I wouldn’t want to gloss over, but the potential prize of fiscal decentralisation seems far more valuable.

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