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VAT

A tax on luxuries?

 

VAT was preceded in the UK by Purchase Tax, a tax on the price of various luxury goods which was introduced in 1940 in order to reduce waste and raise revenue for World War II [1]. Purchase Tax was replaced by Value Added Tax (VAT) in 1973 in order to align with European standards as the UK joined the EC (now EU); today the EU requires member states to levy VAT at a standard rate of at least 15% [2]. VAT applies to a much wider ranges of goods and services than the old Purchase Tax did [3].

 

VAT differs from a simpler sales tax as it is levied upon the amount of value added at each stage of production – hence the name – rather than the full price. So if, e.g., a retailer purchased a good from a manufacturer and then sold it for a profit, the retailer would only be liable to pay VAT on the difference between the price they paid and the price they sold at [4].

 

The standard rate of VAT has been 20% since 2011, this applies to most goods and services [5]. VAT is a vital source of government revenue: raising the 3rd greatest share of total receipts after Income Tax and National Insurance contributions [6]. VAT raised about £136.6 billion in 2019-20: 17% of total tax receipts; about 6% of GDP; and roughly £4,800 per household. About half of household expenditure is on goods and services subject to the standard VAT rate [7].

 

A reduced rate of 5% is applied to certain goods and services, such as electricity and heating for residential or charity use, heating equipment, energy-saving materials, and safety equipment such as children’s car seats.

 

Other goods and services are zero-rated. Notably, food and drink is zero-rated with exceptions for what could be considered ‘luxury’ items: alcoholic drinks, soft drinks, mineral water, sweets, ice creams, crisps and other savoury snacks, restaurant food (eaten in) and hot takeaways.

 

Other zero-rated items include many goods and services related to: gambling, charity, welfare, healthcare, household water and sewerage, residential constructions and conversions, freight, books, magazines, newspapers, children’s clothes, financial services, and insurance [8].Some of these could be reasonably described as essentials, some could be classified as luxury items.

 

The definition of luxury is of course subjective. Trying to draw distinctions has created some of the most bizarre elements of UK VAT law. Famously, a 1991 legal case determined whether Jaffa Cakes should be categorised as a chocolate-covered biscuit (VAT-applicable) or a small cake (zero-rated). Similarly, a 2008 case concerned whether Pringles should be VAT exempt on the basis that their unusual shape and low potato content meant that they should not be classed as a (VAT-applicable) potato snack. Other odd inconsistencies include books being VAT-exempt except for e-books; frozen foods being VAT-exempt except for ice creams; and energy-saving installations being VAT-exempt except for double-glazing [9]. This is partly evidence of the problems with the existing VAT regime, but also shows the difficult in distinguishing between essential and luxury items.

 

Those with assets enjoy them VAT-free.

 

As VAT is a tax on consumption it is charged upon transactions and purchases rather than ownership. For example, booking a stay at a hotel or holiday home is subject to VAT [10] but owning your own holiday home carries no such charge and is sometimes subsidised by policies such as Council Tax reliefs. In general, VAT is another feature of the tax system which makes it more expensive to earn a living from employment and spend that income on consumption while rewarding those who are wealthy enough to simply own a portfolio of assets that they can both enjoy themselves and derive an income from when not using them.

 

As mentioned above, financial service and insurance – key services for asset-holders – are exempt from VAT. This can be justified on the basis that financial services are generally not simple purchases which standard VAT regimes can make sense of; banks profit instead from interest rate ‘spreads’ – charging borrowers more interest than is given to savers. This may not be an insurmountable problem: one proposal is a ‘cash-flow VAT’ – depositing money in an savings account could be treated as a purchase from the bank and withdrawing money as a sale to the bank; vice versa for borrowing. The bank could be charged VAT on the purchase and recoup VAT on the sale [11].

 

VAT is a regressive tax.

 

A common criticism of VAT is that it is a regressive tax, meaning it impacts low-income taxpayers more than those on higher incomes. An ONS study from 2011, when the standard rate of VAT was raised from 17.5% to the current 20%, found that the poorest 20% spent a greater proportion of their disposable income (income after taxes and transfers) on VAT than the richest 20% – about 10% vs 5% respectively. Both groups allocated a similar proportion of total consumption to VAT-applicable items: just over half [12].

 

This a typical feature of taxes on consumption. Poorer households tend to have to spend most or all of their income on necessities such as food, energy, shelter, etc., whereas richer households can afford much more and so have leeway to spend on discretionary items or savings. Higher-income households generally have higher savings rate – meaning a smaller proportion of their income is allocated to potentially VAT-applicable consumption [13, 14]. This feature of consumption taxes can be at least partially alleviated by exempting necessities such as food and imposing higher rates on luxury items, as UK VAT does to a certain degree [15].

 

It might be noteworthy that VAT has generally risen over the past few decades – the standard rate was 8% when first introduced and is now 20%, whereas income tax rates have been on a downward trend over the same period. Arguably, regressive taxation of consumption has funded cuts to more progressive taxation of income.

 

The IFS study does also show that the poorest 20% of households spend more on VAT-applicable items than in 1986, including a 250% increase in spending on discretionary items such as new cars, holidays, meals out, and audio/visual goods (e.g. TVs), compared to a 20% increase in spending on such items for the richest fifth. This arguably shows that poorer households are better off and so spending more on ‘luxury items’, which would at least partly explain their VAT liabilities [16].

 

Level the playing field.

 

A re-rating of VAT geared towards charging luxuries and reducing the cost of essentials seems very justifiable and would be a progressive change.

 

The UK’s membership of the EU obligated it to impose VAT with restrictions on what rates could be applied and what goods and services could be subject to reliefs. Having now left the EU the UK could, if it wanted, implement substantial reforms such as creating new zero-rated items, applying reduced rates to whatever goods and services it wants, raising or lowering the standard rates as much as it likes, and potentially levying a higher rate for luxury goods [17]. This has already resulted in the abolition of the so-called “tampon tax”, with the 5% rate on sanitary products to be reduced to zero from the beginning of 2021 [18].

 

Reforms to VAT should be considered holistically, as part of a broader reform of the tax system rebalancing the burdens on work and wealth. If savings and accumulations of wealth were taxed properly it would be possible to reduce the burden of consumption and transaction taxes such as VAT, especially on basic and essential goods.

1http://www.peterice.com/purchasetax.htm

2https://www.theguardian.com/money/2010/dec/31/vat-brief-history-tax

3https://www.parliament.uk/about/living-heritage/transformingsociety/private-lives/taxation/overview/postwar/

4https://obr.uk/forecasts-in-depth/tax-by-tax-spend-by-spend/vat/

5https://www.gov.uk/vat-rates

6https://www.ifs.org.uk/publications/9178

7https://obr.uk/forecasts-in-depth/tax-by-tax-spend-by-spend/vat/

8https://www.gov.uk/guidance/rates-of-vat-on-different-goods-and-services

9http://home.bt.com/lifestyle/money/money-tips/11-strange-things-we-pay-vat-on-in-the-uk-11364013797693

10https://www.gov.uk/guidance/vat-reduced-rate-for-hospitality-holiday-accommodation-and-attractions

11https://www.ifs.org.uk/uploads/mirrleesreview/design/ch8.pdf

12https://webarchive.nationalarchives.gov.uk/20160108231342/http://www.ons.gov.uk/ons/dcp171776_239565.pdf

13https://academic.oup.com/oep/article/69/4/1101/3805117

14https://www.theguardian.com/uk-news/2014/may/29/richest-uk-save-poorest-spend-crisis-post-office-data

15https://www.ifs.org.uk/fs/articles/tamaoka_may94.pdf?origin

16https://webarchive.nationalarchives.gov.uk/20160108231342/http://www.ons.gov.uk/ons/dcp171776_239565.pdf

17https://www.instituteforgovernment.org.uk/explainers/tax-brexit

18https://www.theguardian.com/uk-news/2020/mar/06/budget-2020-chancellor-plans-to-finally-end-tampon-tax

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