Let's Not Forget The Increased VAT As Prices Rise Making Things Even More Expensive

27th November 2022

A report by The Energy Shop estimated that the Treasury is set to receive £2.6 billion from the rise of the cost of gas and electricity through the 5% VAT on bills.

But VAT is charged on a wide range of goods and services so with rising prices the VAT amount also increases adding to the governments income without lifting a finger. Thee are arguments for and against a VAT reduction.

Recently the Institute for Fiscal Studies looked at this -
A temporary VAT cut has the advantage that it is a ‘shovel-ready' measure, which is easy to implement quickly. It can provide a short-term boost to the economy by giving people more money to spend and by incentivising consumers to bring purchases forward to take advantage of temporarily lower prices

At the moment, supply is still restrained by social distancing measures and it is not clear yet how much stimulus will be needed when consumers are able to spend more freely.

A temporary VAT cut would be most effective as a stimulus: i) when we are confident social distancing measures will continue to be eased and that these measures are no longer limiting supply; ii) when firms that would be affected by the cut are able to accommodate additional demand and are likely to respond by passing a VAT cut onto prices; iii) when uncertainty and fear of the virus is lower so that consumers would be willing to increase spending; iv) if demand is still low even when these other conditions hold.

These conditions are not met now, but it is possible they will be met in the near future. The government should carefully assess the situation over the coming weeks. The government should certainly not preannounce a VAT cut because that would lead consumers to delay purchases to when the cut comes into effect (in fact, speculation about a cut could depress current sales). If a cut is enacted, its expiration should be timed to coincide with, or made conditional on, a return to sustained economic growth, so as not to choke off a nascent recovery.

But and its a Big But
Again the Institute for Fiscal Studies says -
The cost of living crisis isn't going away. People are feeling the pinch, and policymakers are looking with alarm at forecasts of inflation hitting 10% or more this autumn. The idea of a single intervention that both puts money in people's pockets and also cuts headline inflation is therefore very alluring. Hence the calls for a temporary VAT cut coming from Downing Street, some Conservative backbenchers and the Liberal Democrats.

You can understand the appeal. At £18bn, a 2.5% cut in the top rate of VAT injects enough funds into the economy for people to notice. Superficially, the timing is right because the economy appears to be slowing down in real terms - there have been signs of growth tailing off to around zero. Retailers would normally pass most of any cut through to shop prices, so ordinary households benefit. The prime minister and chancellor get to deliver on their promise to cut taxes. What is not to like? Unfortunately, the answer is: plenty.

A VAT cut could stimulate spending...

A temporary VAT cut could be used to stimulate demand if economic growth remains weak after social distancing measures are eased. Relative to some other forms of stimulus, a VAT cut is quick to implement. There is also evidence that cutting VAT has been effective at stimulating consumer demand in the past; a temporary VAT cut was in place from December 2008 until December 2009 and succeeded in boosting consumer sentiment and retail sales.

Temporary VAT cuts stimulate consumer purchases by reducing the post-tax prices individuals pay for goods and services. This in turn increases consumers' purchases of goods through two channels.

Firstly, there is an income effect. Put simply, by reducing consumers' bills, a VAT cut puts money in their pockets. To the extent consumers use these funds to make additional purchases, this stimulates spending and economic activity. They may of course also save any windfall or use it to pay down debts.
Secondly, there is a substitution effect. Households have an incentive to bring forward purchases to take advantage of lower prices when the VAT cut is in effect. This leads to a temporary boost to demand. We would expect this effect to be particularly large for spending on durable goods such as cars or TVs, or other non-perishable goods that consumers can stock-up on.
These two forces boost output through a multiplier effect. Greater purchases during the period of the VAT cut leads to more work for those producing that output, and in turn higher employment and earnings, which in turns leads to greater spending, and so on. This would be especially valuable at a time when unemployment is relatively high and much of the workforce remains on furlough.

...but past success does not necessarily make it an appropriate tool for the current crisis

There are a number of reasons why a temporary VAT cut may be less effective in the current crisis. A key consideration is how much of the forgone revenue from the VAT cut leads to more purchases (and therefore output) and how much is saved, or spent on imports in a way that does not boost short-term UK output and employment.

Since the stimulus relies on firms' actually reducing prices, the ‘pass-through' of the tax cut to consumer prices is crucial. The 2008 temporary VAT cut led to a substantial reduction in consumer prices. Whether this would be true in the current situation is unclear and may vary by sector. Some firms may have limited ability to meet increases in demand if supply chains are disrupted and social distancing makes it difficult to take on new staff (or even to reinstate previous staff). Until these supply constraints ease, these firms will be less likely to cut the prices they charge consumers if VAT rates fall. Other firms may have difficulty clearing old stock or attracting customers and may be able to hire or recall additional worker easily. These firms would be more likely to pass through price reductions to consumers.

The size of the income effect will depend on the degree to which consumers save or spend any additional funds. Continued fear of the virus and its longer-run impact on the economy may depress consumers' responsiveness to price falls.

The size of the substitution effect in particular depends on uncertainty. In an uncertain economic climate, consumers are likely to be particularly careful about purchasing expensive durable goods (such as cars or fridges). This will dampen the stimulus effect of a VAT cut by making consumers reluctant to bring forward purchases. Uncertainty over future economic conditions is likely to be an important consideration for the coming months. The increase in measures of uncertainty following the COVID-19 pandemic are greater in magnitude than they were following the 2008 financial crisis.

Even without a stimulus, we expect an increase in consumer demand as more parts of the economy are opened. If purchases would rebound towards more normal levels even without stimulus, cutting VAT would lead to a large amount of deadweight - i.e. the government would be cutting taxes on purchases that would have happened anyway.

The Treasury is right to be wary of a temporary VAT cut
As calls intensify for a temporary cut to VAT, Giles finds plenty of reasons, both political and economic, to be wary

The cost of living crisis isn't going away. People are feeling the pinch, and policymakers are looking with alarm at forecasts of inflation hitting 10% or more this autumn. The idea of a single intervention that both puts money in people's pockets and also cuts headline inflation is therefore very alluring. Hence the calls for a temporary VAT cut coming from Downing Street, some Conservative backbenchers and the Liberal Democrats.

You can understand the appeal. At £18bn, a 2.5% cut in the top rate of VAT injects enough funds into the economy for people to notice. Superficially, the timing is right because the economy appears to be slowing down in real terms - there have been signs of growth tailing off to around zero. Retailers would normally pass most of any cut through to shop prices, so ordinary households benefit. The prime minister and chancellor get to deliver on their promise to cut taxes. What is not to like? Unfortunately, the answer is: plenty.

Stimulus is not an answer to inflation
A VAT cut is a broad-based stimulus - the equivalent of sending a cheque to everyone in proportion to how they shop, roughly speaking. Just because it manifests as prices being lower than otherwise does not change this. And the message of high inflation is that the economy does not cry out for more stimulus. Demand has been outmatching supply. If this was only about energy prices, then the Bank of England might be more relaxed - and the government could restrict its response to the energy sector alone. But OECD figures show that around two-thirds of items in the CPI basket are rising in price at over 4% a year. A further fifth are rising at over 2.5%. Meanwhile, the labour market is as tight as it has been this century, in terms of the numbers of workers available for each job vacancy.

Stimulus is not an answer to inflation, no matter where it ends up. Moreover, businesses struggling to find the staff or pay their bills are less likely to pass on a VAT windfall than they would during times of low demand, such as when VAT was (correctly) cut in 2009. This is just one reason that the inflation-cutting attractions of a VAT cut are not that great either. Another is that when the headline figure is likely to hit double figures, it is fanciful to think wage demands will be substantially moderated by a slight change in the number. The difference between 2% and 4% inflation is much more noticeable than between 8 and 10.

If the aim is to reassure that inflation has not become de-anchored from people's expectations, then a temporary cut is also a problem. When the VAT cut expires, whatever price-lowering effect it might have had at the outset is likely to be reversed, causing headline inflation to rise again. While it may lower the peak rate, this means it may mean headline inflation staying higher than its range for longer.

The temporary aspect is a problem for another reason. How credible is it that a government facing a general election will stick to a promise to raise taxes by returning VAT to its previous level? The Treasury must be at least a little concerned that the prime minister will lobby to keep lower VAT in place, thereby continuing to pour stimulative fuel on the fire.

A possible counter-argument is that extra stimulus is no particular problem, so long as the Bank of England is free to react and raise interest rates more. This is technically true - there is no limit to the Bank's powers to slow down the economy, just as there is no ceiling on the base rate.

This is not the same as saying the Bank would welcome the challenge, however. The more stimulus it has to counteract, the more risk there is of a mistake - the Bank tightening so much there is a recession, or falling behind and letting inflation really let rip.

And I doubt it is the Treasury's preference either. It is reasonable to argue that a mixture of tighter monetary and looser fiscal policy is a better combination for the UK than what it has experienced since 2008. But with government liabilities highly sensitive to short term rates (thanks to QE), just one per cent higher rates leads to a £21bn higher deficit, which will have to be closed somehow.

For a while it was natural to accuse the Treasury of crying wolf about the risk of a serious debt crisis. But picture this: a VAT cut at risk of becoming permanent, in the face of intense pressure from parliament; interest rates rising faster than expected just last March; inflationary expectations becoming more unanchored as consumers are given the message that the government wants them to shop; and a winter fuel crisis with spikes in the price of unobtainable gas. Maybe this is not the likeliest outcome. But governments need to act with the worst outcome in mind. Sometimes the wolf does indeed rush out of the woods.

Sources
https://ifs.org.uk/publications/temporary-vat-cut-could-help-stimulate-economy-only-if-timed-correctly

https://www.instituteforgovernment.org.uk/blog/treasury-right-be-wary-temporary-vat-cut

To read about VAT in the UK go to
https://en.wikipedia.org/wiki/Value-added_tax_in_the_United_Kingdom