With inflation rising, is it time to cut the VAT rate?

As the inflation rate continues to creep up, there are increasing calls for the VAT rate to be cut. This was the approach taken by the Government in December 2008 at the start of the financial crisis when the standard rate of VAT was temporarily cut by 2.5% for a year.

Many commentators are now calling for a similar reduction to help combat the decline in consumer spending power caused by the inflation rate hitting 2.9%

But what are the economics of a cut in the VAT rate?

The obvious mechanism whereby a cut in the VAT rate will impact on consumer spending is that when goods are cheaper because of lower tax, consumers will effectively have more purchasing power. Put simply, after buying the weekly basket of goods, they will have more money left over, therefore they may spend this additional cash to buy a bit more.

In addition, for the temporary cut in 2008, as consumers knew that it would rise again after a year, the additional effect was to advance spending on larger items as consumers could see that the cost of goods bought in 2009 would be cheaper that the same goods bought the following year.

The obvious benefit of a financial stimulus such as a temporary cut in the VAT rate is that this is seen as being fairer than, for example, a short term cut in the interest rate. Although both measures make the price of spending today lower compared to next year, a cut in interest rates penalises savers, whose spending power falls, and rewards borrowers. By contrast, the cut in VAT increases the spending power of savers as well as borrowers.

What are the arguments against a rate cut?

Advocates against a VAT rate cut point to the following factors which do not support the economic case.  Firstly, as VAT applies only to around 50% of the household basket, the 2008 cut of 2.5% equated to a 1.25% boost to spending power.  However, does this really lead to an increase in spending?

Looking at the first of the mechanisms outlined above, if your household basket costs £110 before the cut, allowing for a 2.5% VAT rate change, and assuming that the retailers pass on the benefit of the cut, the same basket costs £108.75 afterwards. This means you will have £1.25 of extra cash to spend.

The choice remains, do you spend this extra cash or do you save more. If you save the additional money, your consumer spending actually goes down and, even if you do spend this extra cash, your household spending will still be £110. Consumer spending will only increase if you save less and borrow more.

But what about the other mechanism? The bringing forward of spending will only be a factor if you are aware that the rate will increase again in the future. If it is a permanent cut, the same incentive to advance purchases is not as strong. If it is a temporary cut, this may lead to an increase in consumer spending now, but will it just lead to a corresponding drop in the future once the rate returns to its higher value?

What can be stated with some certainty is that a cut in the VAT rate will reduce the tax revenues generated by the Government. VAT revenues for the current financial year are expected to be around £120bn. A 2.5% cut in the VAT rate would see a reduction in the tax take of around 1/8^th; a reduction of around £1.25bn per month.

Most commentators agree that the 2008 rate cut did lead to a boost in consumer spending during 2009. What is less clear is what impact the cut had on public sector borrowing and the subsequent austerity programme.

This is clearly a difficult issue and with other uncertainties such as Brexit, the volatility of Sterling and the hung parliament impacting business confidence and consumer spending, what is not clear is whether a cut in the VAT rate is the best approach to tackle that uncertainty.

For more information contact Alistair Duncan, Indirect Tax Director.