Value added tax

VAT is an important source of government revenue, forecast to raise £82.6 billion or 16% of total tax receipts in 2008–09. Like taxes on earnings, VAT distorts the choice between leisure and consumption. Because VAT is applied at different rates to different goods and services, it also distorts people’s spending decisions and firms’ production decisions. In its current form, it is mildly progressive, not regressive as some commentators suggest. The temporary cut in the standard VAT rate from 17.5% to 15% is a better stimulus measure than its critics suggest. We estimate that the VAT cut will reduce prices on average by 1.2%. Past experience suggests this may lead people to buy 1.2% more goods and services. Those dismissing it as a failure ignore the likelihood that things would have been even worse without it. The government considered an increase in the rate of VAT to 18.5% in 2011–12. This would have acted as a stimulus to expenditure before that date, as well as raising about £5 billion per year thereafter. Whilst, on its own, such a change would be less progressive than further increases in National Insurance, it would be possible to compensate most poorer households. Broadening the VAT base by extending the standard rate to most goods and services would remove many of the distortions to consumption decisions caused by the current system and would raise significant revenue even after more than compensating poorer households on average. For instance, a net £10 billion could be raised, with the rest of the revenues used to help meet the child poverty targets and compensate poorer households, households with children, those with disabilities and pensioners.