A taxing problem

Civitas, 4 January 2011

Today the top-rate of VAT has risen from 17.5% to 20%. The Government argues that the move is necessary to increase tax revenues and tackle the deficit, suggesting that once economic conditions improve the rate may be reduced. However, the increase has attracted criticism from an array of different sources, Ed Miliband has stated that it is the ‘wrong tax at the wrong time’ hitting the average family hardest, and business groups have warned that the tax may depress economic growth by decreasing consumer spending.

Ed Miliband has been accused by George Osborne of ‘jumping on the bandwagon of opportunism’ for opposing the rise that was also proposed by the previous (Labour) chancellor Alistair Darling. Yet behind this political rhetoric, is the increase in VAT a good idea for tackling the deficit?

As a tax on consumption the VAT rise will increase tax revenues if people continue to spend and consume at the same level as before. If people choose to reduce consumption as a result of the increase then tax revenues will not rise, and the country could also witness reduced growth as businesses see sales fall. This would increase the burden of debt in the long-term. The benefit of the increase hinges on consumer spending, which is difficult to forecast and so there is a lot of ‘ifs’ in this analysis. Yet if one accepts that tax revenues need to rise, it is worth asking if there is an alternative?

One alternative would be an increase in income tax. However, the UK already has a relatively high level of income tax and this year’s budget saw the current threshold for the 40% higher tax rate frozen at £37,400, capturing more earners as wages rise. Furthermore any increase in income tax could reduce people’s incentives to save, while saving is something the government is keen to encourage as people are increasingly forced to rely more on their savings in old age.

A third alternative which is little discussed in the UK and has not arisen in the current debates over tax reform is a progressive consumption tax. This form of tax has been proposed in the US as a way of reforming the country’s complex and inefficient tax system, but has gained little political attention in the UK. There are many formulations of a progressive consumption tax but one by Robert Frank has been generating interest, and is relatively simple in its operation:

Under such a system people would report not just their annual incomes but also their annual savings. The difference between these two is their consumption. This is what is taxed. Frank proposes that to make the tax progressive there should be a deduction to take into account standard consumption (Frank proposes $30,000 for a family of four) and then a tax on an increasing scale on the consumption above that. So a family of four whose earnings are £100,000 reports saving £10,000. Thus they consumed £90,000, subtract the £30,000 allowance and you have £60,000 that is taxable. To make this tax progressive you would have to set a lower tax rate for a lower amount of consumption, perhaps starting at £5,000 and finishing with a top-rate of tax at consumption over £1 million. The exact details would need to be worked out, but the benefits of such a tax fit in with many of the Government’s current goals:

First, the tax encourages saving and penalises immediate consumption. This would encourage investment which would serve the economy well in the long-term. Second, the tax would not overly penalise high-earners, those who saved and invested would be fairly rewarded for investing money that could benefit the whole economy. Third, the tax would be good for the long-term but the short-term worry is that it could discourage consumption and spending which could reduce business sales. Frank’s suggestion is that the tax would be publicised but not immediately implemented, thus encouraging spending in the short-term, the tax could also be reduced or suspended in the future if the economy would benefit from a ‘jolt’ of spending.

A progressive consumption tax is no panacea. It would be difficult to perfectly assess someone’s savings and there are some items which could plausibly be described as an item of consumption and one of investment. However, it surely deserves more examination by UK policy-makers keen on reforming the UK’s tax system.