The VAT hike : right or wrong?

May 16, 2011, 12:59 AM GMT+0

The festive season is now well and truly over. At midnight on Monday reality reasserted itself with the rise in VAT from 17.5% to 20%. Ed Miliband, the Labour leader, has condemned the increase as 'the wrong tax at the wrong time'. The Government says it is necessary to secure Britain’s economic future. Who’s right?

We had plenty of warning that this was going to happen. Almost as soon as he became Chancellor back last summer, George Osborne announced that in order to reduce the huge deficit in the Government’s finances not only would there be big spending cuts but taxes would rise too and he had chosen the hike in VAT as the main way to raise more revenue.

The case in favour of the increase goes something like this. Almost everyone agrees that the deficit has to be reduced. Some of it will disappear of its own accord as economic growth picks up, tax revenues rise as a consequence and there become fewer unemployed for the Government to support through benefits. Even so, there will remain what’s called the ‘structural deficit’, the overdraft that will persist even if economic growth fulfils our best hopes. The Government says it wants to eliminate this structural deficit in fours years, in order to need to pay out less in interest payments to service it and to fend off any threat that interest rates would need to rise to attract lenders. Labour says it wants to do the same thing only more slowly, halving the structural deficit during this parliament.

In order to get rid of the deficit, Mr Osborne has split the pain between spending cuts and tax rises. He defends the VAT increase on the grounds that it is a tax that is easy to collect and hard to avoid, and is likely to raise a substantial £13bn a year by the end of the parliament. He gives every impression that the 20% rate is here to stay and argues that, unlike some other taxes, VAT does give people some room for manoeuvre in that if they don’t buy things, they won’t have to pay the tax.

The case against it is basically made up of three elements. Firstly, critics say that it is socially unfair in that it hits the poorest hardest. That’s because poorer people tend to have to spend more of their income than those rich enough to be able to forego some of their spending. It’s true that some of the staples of spending, such as food and children’s clothes, are exempt from VAT, but there is plenty else in an average budget, such as petrol and beer, which will be hit by the increase.

The second line of attack says that the VAT increase is self-defeating in that it will hit economic growth. The tax rise will act as a disincentive to spend, so lowering overall demand in the economy, threatening economic growth and so prolonging the deficit for longer than it would otherwise last. Surveys of retailers suggest that around four fifths of them believe that the VAT increase will undermine sales. Two thirds of small businesses think it will damage their businesses. Brewers think the rate of closure of pubs will accelerate.

Thirdly, there is the potential impact of the VAT increase on inflation, which has been persistently much higher than the Government’s target of 2% for a couple of years. The worry is that if people start to expect inflation to go on being as high as it is, or even higher, they will start pressing for higher wages, so adding yet a further boost to inflation.

From an economic point of view, the VAT increase is clearly a gamble but one that the Government thinks will pay off. Although no one disputes that the VAT hike, like any tax increase, will depress demand in the economy and so put a brake on growth, the Government will take heart from the fact that most economists seem to think that the combination of higher VAT and the public spending cuts that will really start to bite this year is unlikely to plunge the economy back into recession. Talk of the need for a ‘Plan B’ is itself receding.

Politically, both sides have all to play for in the row over the VAT increase, which is why they are attacking each other so furiously. Mr Miliband said: 'The squeeze starts here. The squeeze designed in Downing Street will come to your street, to the high street, to every street up and down this country… Most people take at least a week to break their new year’s promises. This Conservative-led Government has begun 2011 breaking the promises they made in 2010.'

Mr Osborne responded by saying; 'VAT is a powerful weapon to tackle debt and if we don’t use it then the spending cuts would be over £13bn bigger. When Labour was in government they accepted this, which is why Alistair Darling says he wanted to put up VAT. Now Labour is in opposition, Ed Miliband has shown weak leadership by jumping on the bandwagon of opportunism.'

Labour’s Shadow Chancellor, Alan Johnson, has said that his preferred way of tackling the structural deficit is not only to do it more slowly but also to put more of the strain on raising taxes rather than cutting spending. But his choice of tax increase would not be VAT but national insurance contributions. No doubt this will lead to a further row about which tax increase is fairer, less likely to impede growth and so on. But it’s what this Government is actually doing rather than what a Labour government might do that will be in the public’s mind. So the question of whether the VAT increase is the right or wrong thing to do is the one that’s going to dominate politics in the immediate future.

What’s your view?

  • Do you support the VAT increase or not?
  • Do you think the Government is trying to reduce the deficit too quickly or not?
  • If you don’t back the VAT increase but think something needs doing about the deficit, what would you suggest?
  • What do you think of Labour’s idea of increasing national insurance contributions?
  • How much, if at all, will the VAT increase affect your spending habits?
  • What do you think will be the effect of it on economic growth?
  • And, in general, how optimistic or pessimistic are you about the economy over the next year?