United Kingdom - Feature: What a VAT rise would mean for you  

Since the formation of the coalition government speculation has been rife that changes to value added tax (VAT) may be needed. A hike to 20% is possible. The exemptions enjoyed by many goods may be withdrawn. This isn't a case of either/or - both may be possible.

A VAT rise of 2.5% may not sound all that much. It would make the cost of the average iPod £3 more expensive. But the reality is it will maintain the current unfairness within our tax system and leave the poorest paying the most in terms of a proportion of their income.

This arises from a shift in our economy to a greater reliance on consumerism, something our economy is already highly dependent on as it is. Essentially it's a piece of taxation trickery.

A hike seems unavoidable

Why this is necessary is simple. The Liberal Democrats stood their ground on raising the income tax threshold to £10,000 but gave a crucial concession that this would be achieved over the life of this parliament. Within five years, but more practically no earlier than 2015, the income tax threshold will rise to £10,000.

But in order to pay for that the Lib Dem manifesto proposed a raft of measures to raise money elsewhere, largely from the wealthier end of society.

The problem the coalition government now has is the Lib Dems did not get all of their manifesto tax reforms agreed with the Conservatives. Several were dropped - or at least no mention of them has yet been made.

These included:

- The restriction of tax relief on pension contributions to the basic rate which would have raised £4.6 billion

- A realignment of capital gains tax to income tax rates, raising £3.2 billion

- A reduction of the annual exemption of capital gains tax to £2,000 raising £900 million (although in fairness this is still being hammered out with the Tories. While they are not keen to lower the threshold from its current £10,000 to £2,000, it's likely the two parties will have to meet somewhere in the middle)

- A one per cent levy on the value of properties over £2 million raising an estimated £1.7 billion

- Introducing a levy on domestic flights raising £400 million

Anti avoidance measures for income tax, capital gains tax and national insurance contributions all of which the Lib Dems said would raise £1.9 billion

- Anti-avoidance measures for corporation tax which would have raised £2.1 billion

- Anti-avoidances measures for stamp duty which would have raised £700 million

Taken as a whole and assuming that the Lib Dems can't push through the change to the capital gains tax threshold, that's a shortfall of £15.5 billion.

The cost to the Treasury of raising the income tax threshold to £10,000 has been estimated at around £16.5 billion per year. So the coalition government is well short of the money it needs to make this increase in the threshold possible - and also has a £167 billion deficit to reduce over the next five years, starting with a reduction in public spending of £6 billion this year.

This is why most economists think a rise in VAT is unavoidable.

Don't get excited by the £10k rise

Moreover, raising the income tax threshold to £10,000 by 2015 doesn't help the poor in the way that was intended. In fact, it waters down the original Lib Dem proposal quite significantly.

The income tax threshold usually rises in line with, or slightly above, inflation each year. The only time that this hasn't happened was under the Labour Budget in March when income tax thresholds remained at the same level as in 2009. This means we are all ever so slightly poorer than last year: we're paying the same amount of tax on our earnings while inflation at three per cent pushes up the price of the goods we're paying.

Over the life of the parliament, therefore, you could reasonably expect that the income tax threshold would rise. Yes, not as much as £10,000, but certainly somewhere towards £8,000 by 2015 if inflation were to remain at its current level.
To give you some idea of the kind of increases that it would be reasonable to expect in the tax year 2007/08 the income tax threshold was £5,225. The following year it rose to £6,035 and the year after that it rose to £6,475, which is where it has been since April 2009.

If the income tax threshold were to rise by an average of £500 a year, then by 2015 the income tax threshold would be £8,975 anyway. So, the Lib Dems will have gained very little indeed unless they manage to increase the income tax threshold to £10,000 several years earlier. Of course, the income tax threshold might not have risen by anything like this much particularly given the current economic climate. After all, between 1999 and 2002 the income tax threshold only rose from £4,195 to £4,535. That's a rise of £340 over four years, so nothing is certain.

Turning into America

What is certain is the direction the government will be steering the economy in. By raising the rate of VAT to 20% the government would be seeking to claw back the tax that it was giving away by raising the threshold to £10,000. While the direct tax the estimated 3.6 million people affected by the change would pay would be significantly less, the indirect tax they would pay could be quite high.

The rise would bring the UK in line with its European neighbours but the tax take would be highly dependent on how much everyone in the UK spent on the high street. Giving people more money in their pockets is designed to make them spend more as consumers. That's the American way of doing things. US citizens brag about how little tax they pay but they conveniently ignore the amount of money they give the government through sales tax. Such a system creates a degree of instability as well.

The thinking behind raising VAT and the income tax threshold together is simple. Most people, feeling they have more money in their pockets, will go out and spend that money on goods and services which are charged at a higher rate of VAT than before.
As a result the money that would have gone directly to the Treasury from your pay packet gets funnelled through your increased spending power on the high street.

You, the consumer, get something - but so does the government.

There are other problems, particularly if some of the current VAT exemptions on essentials are removed. Food currently is one commodity that VAT is not applied to. If that exemption were removed then families would find their food bills increase by 20%, leaving the poorest of them not much better off than they are currently - income tax threshold increase notwithstanding.

Another problem is if people decide not to spend their money on the high street and save the additional money in their pocket for a rainy day instead. If that happens and the government is unable to raise the money it needs to through the increase in VAT then tax rises will have to come elsewhere and an economy that has been made more reliant on consumer spending could be put in further jeopardy. And this morning already Jonathan Loynes of think-tank Capital Economics has warned that the Office for Budget Responsibility, the three-man independent committee charged with assessing how much to cut the deficit, could urge the government to raise taxes by £50bn, which would imply that a 9.5p increase in the basic rate of income tax would be necessary on top of a VAT rise.

Retailers' concerns

Retailers have already expressed concerns about what a rise in VAT could mean.

Bruce Fair, managing director of Kelkoo UK, said: "While it is widely recognised that urgent action is required to plug the hole in the UK's finances, it is imperative to avoid a sharp drop in consumer spending, as it could derail the country's fragile recovery from the recession. An increase in VAT would increase government revenues significantly, but it could also have serious repercussions for consumers, retailers and the economy."

And Sainsbury's chief executive, Justin King, has urged the government to get the timing of any VAT hike right and give retailers plenty of notice. A rise in VAT on non-food items looks "more likely than not," he added, but imposing VAT on food would be "bizarre" and "regressive" as it would hit poorer families the most.

That retailers might at first try to absorb any VAT rise to counteract a reduction in footfall on the high street is extremely likely given the fragile state of retail sales this year.

But eventually they would have to put prices back up to account for the VAT rise and also for their own costs as well. The effect this could have on inflation should not be ignored.

Were inflation to stick at the current government target levels of two per cent per year, goods and services will still cost ten per cent more by 2015 than they do now.
Add in the additional 2.5% VAT increase and that pushes prices up by a further 12.5% over the course of the next five years, meaning goods and services will cost the average family 22.5% more than they did five years earlier.

In order for the poorest in society to be in the same position as they are now the income tax threshold would need to rise in line with inflation and the VAT rise to a minimum of £7,931. Increasing the income tax threshold to £10,000, a total of £2,069 above the £7,931 figure, will not improve their lot significantly at all. And that's if it works.

Then, as if to pour salt into the wound, the coalition government is set to carry out the national insurance increase proposed by Labour in the last Budget in March, adding a further one per cent to the tax take through NI for employees but letting employers off the hook.

It is suggested by the coalition government that this increase, as well as a shift in emphasis in air traffic duty to a per plane tax rather than per passenger tax, will help to meet the proposed initial increase in the income tax threshold - probably slated for April 2011 - which according to some estimates is likely to be increased to £7,300.

So the government is asking us to pay for our own income tax threshold increase by going through with the increase in NI. It's robbing Peter to pay Paul, just as any potential VAT rise would be.

Essentially raising VAT is a gamble. It could lead to the poorer paying more for things than they currently do, instead of really being able to improve their lot and leaves the rich untouched.

It increases rather than decreases inequality. And it makes our economy further reliant on consumer spending power rather than allowing people to save towards their futures. Critics will argue it's a fudge and, if the government goes through with it, a pretty awful one at that.

Source: Politics.co.uk, United Kingdom, dated 14/05/2010