The pros (and cons) of cutting VAT

Liz Truss is apparently mulling the ‘nuclear’ option of cutting the standard rate of VAT by five percentage points to support the economy. This has triggered a predictable backlash from my fellow policy wonks, led by the Institute for Fiscal Studies (IFS). However, in these extraordinary times, every lever may have to be pulled.

The case for a temporary cut in VAT is straightforward. The UK is on the brink of a massive economic and social crisis. Lowering VAT would be a simple and quick way to boost spending power. The annual saving would average out at around £1,300 per household, returning some of the extra tax that people are paying as a result of higher nominal incomes and prices.

Headline inflation would also be lower as a result, albeit just for one year. And even if the VAT cut is not passed on in full to customers, struggling businesses could use the savings to help stay afloat.

Of course, no option is without its downsides. VAT is one of the least bad taxes, raising a large amount of money with few distortions, and cutting it would have limited supply-side benefits. Any cut should therefore only be temporary.

Reducing VAT by five percentage point cut would also ‘cost’ about £38 billion. The Treasury’s loss here would be others’ gain, but it is still right to ask whether the money could be better deployed in other ways.

But the loudest objections from the IFS (and others) are that a cut in VAT would be ‘regressive’, meaning it would provide most help to higher-income households rather than those that need it most, and that the boost to spending might just stoke inflation further. In my view, these are not strong points.

Economists have long debated whether VAT is ‘progressive’ or ‘regressive’. Most agree that it is regressive when looking at incomes, because poorer households pay more of their income in VAT than richer ones. So on this basis, cutting VAT would actually be progressive.

However, most economists also prefer to judge expenditure taxes by looking at the burden as a share of spending. On this basis, VAT is moderately progressive, because low income households spend proportionately more on lower or zero-rated goods, such as domestic energy, and food.

It is therefore correct to say that low-income households would benefit less than high income ones from a cut in the standard rate of VAT, and that this difference might be larger now that food and energy bills are so much higher.

But, so what? Any cut in VAT would presumably be part of a broader package, including more support targeted at the households and businesses that do need it most. It is not necessarily a case of choosing one option or the other.

The cost of living crisis has also spread well beyond the lowest income groups, including to the ‘squeezed middle’. It would be certainly be going too far to claim (as some in the Sunak camp have) that cutting VAT would be ‘incredibly’ regressive.

Finally, it is wrong to judge any tax measure purely by its direct effects on household budgets. A temporary VAT cut would support the wider economy, and protects jobs and businesses, thus helping everybody.

The IFS has also led the charge on concerns that cutting VAT would ‘stoke inflation’, and that higher inflation means we cannot afford to lower taxes anyway. These fears are misplaced, too.

Dire forecasts for the public finances tend to take the economic outlook as given. But you do not have to agree that tax cuts can fully pay for themselves in order to believe that they will have some favourable effects on growth and inflation.

The largest part of the expected jump in government spending is due to the impact of higher RPI inflation on the principal value of index-linked gilts. But this will only fall due when each bond matures, spread over many years, and is not a real constraint on the scope for tax cuts now.

And even if the absolute amount of borrowing is higher in absolute terms, a bigger increase in nominal GDP should still reduce the debt-to-GDP ratio, which is what really matters.

As for whether tax cuts are inflationary, this depends crucially on the response of monetary policy. Tax and spending financed by money printing would be inflationary, and that is partly why we are in the mess we are now. But that is not what Liz Truss is proposing.

Looser fiscal policy can also enhance the credibility of monetary policy, rather than make the Bank of England’s job more difficult. Inflation expectations are higher than they need to be, partly because people think the Bank will keep monetary policy loose to offset tax hikes.

It would also be no bad thing if we did end up with looser fiscal policy and tighter monetary policy. Most economists agree that the UK has got this mix wrong. A shift in the balance here should support sterling, which would help with inflation as well.

Above all, loosening fiscal policy during a downturn makes perfect sense, both in the short term and the long term. The economic fallout from a deep recession would be far worse for the public finances.

My verdict, then, is that is it right to consider cutting VAT across the board, and not just on energy. It should only be a ‘nuclear’ option, as part of a broader package, but the scale of the crisis means that everything should be on the table.

This article was first published by the Daily Telegraph on 31st August 2022

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