Every tax has a silver lining

As promised back in June, the Chancellor George Osborne raised value-added tax (VAT) last week from seventeen-and-a-half to twenty per cent. The tax, which falls on every purchase you make – with the exception of certain necessities like food, children’s clothing and heating – is a measure designed to tackle the UK’s structural deficit and deter the risk of economic ruin – a scary reminder of which was provided by Portugal last week, when it became the latest European economy to be lined up for a Bundesbank bailout.

VAT is a good way of tackling the deficit because it hardly affects the retail sector at all. The percentage point rise of two and a half per cent really translates into an increase in value-added tax revenues by just over fourteen per cent. The cost however – just over a two per cent rise in prices – is unlikely to be the most significant pressure on the retail sector. The last movement in VAT (down two and a half per cent to fifteen per cent) in December 2008 was too small to make a difference (and negligible compared to the effect of last month’s heavy snowfall). In fact, when sales tax returned to seventeen and a half per cent early last year, shoppers largely took it in their stride. A philosophical spendaholic could therefore see this week’s rise as a confidence-inspiring token of the government’s deficit-taming intent.

The potential pressure this puts on above target inflation – and consequently on interest rate fearing borrowers – is not immediately obvious. The truth of the matter is that it is unlikely to be exacerbated by reports that firms, like Next, are looking to use the VAT rise to disguise price rises as high as 8 per cent. As much as they would like to, populist, recession-beating stores such as Primark and Poundland can’t yield to this pressure without losing their hard fought-for niche, as the low price budget store. Nor, must we remember, is VAT going to exacerbate the rise in global food prices (for food is VAT exempt). And similarly as much as its is its price and income inelastic quality that allows suppliers of fuel to pass on the VAT rise at the pump, it is precisely the inelastic nature of fuel that means that the rise will only deplete the income that consumers can spend on anything else – hardly the recipe for inflation.

Where the problem could lay however is the fact that this ‘anything else’ is precisely the engine of change upon which economic recovery relies. Such pessimism however is unfounded. The rise will be partly compensated for by the pre-rise Christmas splurge, as Sainsburys, John Lewis and Marks & Spencer’s encouraging profit figures would testify. More importantly however is the fact that such a rise will hardly need compensating for. An extra 500 pounds on the 15,000 pound price tag for a new Ford Mondeo is unlikely to serve as the largest deterrent to your purchase, for a VAT rise on expensive luxuries is simply negligible.

Instead VAT provides a solution to the structural deficit that is progressive. We know that over a lifetime people’s expenditure must match their income, so if someone is spending (and therefore losing) a lot relative to their income at the moment, they must be spending (and therefore losing) little relative to their incomes at other times. Looking over the lifetime as a whole, what matters is whether the lifetime-rich or the lifetime-poor see a larger share of their lifetime resources taken in VAT. On that basis VAT is progressive because necessities (consumed disproportionately by the lifetime-poor) are typically subject to zero or reduced rates of VAT.

What would be regressive is a rise in both employer and employee National Insurance contributions, which would stifle job creation and consequently deny a would-be tax-paying recruit, any sort of salary at all.