VAT changes?

VAT is one of the UK's important taxes - it typically contributes about 15% ot the total. In 2008-09, it raised £78 billion out of £507 billion and, after a dip last year due to the VAT cut implemented by the former Labour Government, is expected to return to a similar level this year.

VAT is a European tax, which means that individual countries have limited room for differentiation. Countries choose their own rates, but are allowed only one standard rate and two reduced rates. There is no provision for a 'luxury' rate.

When the UK joined the EEC in 1972, it negotiated zero-rating for a range of items - food being the best known. However, the rules don't allow the UK to add to the list, or to revert to zero-rating, should it choose to levy VAT.

Some think tanks and other commentators have argued that the UK should abandon zero-rating and instead charge standard VAT rate on the full range of goods and services.

The main categories - and the amount in £billion that would be raised from charging VAT at 17½% are:

• Food 11
• Children's clothing 1
• Books, magazines and newspapers 1.3
• Water and sewerage 1.3
• Public transport 2.6
• New Housing 4

Additionally, £3.6 billion would be raised from charging 17½% VAT on domestic fuel (gas, electricity etc.), instead of the current 5%.

Our view is that widening the VAT base would not be a good idea - primarily because the impact would be felt most by the less well-off. The ONS Family Expenditure Survey shows that those on less than median income spend more than half their budget on zero and low-rated items. Consequently, this group would be more affected by widening the base. Some argue that this group could be compensated through increasing benefits, or tax credits. However, the experience of the aboliton of the 10% tax rate showed that there are about 1 million people on low income who do not receive benefits or credits. The biggest group is people without children - the majority under 25.

However, this same logic shows that VAT is not a regressive tax, as is sometimes supposed. We calculate that even a large VAT increase - from 17½% to 20% - would cost someone on median income about £150pa. Given that the Coalition Government plans making changes to the personal allowance and to national insurance contributions from April 2011, it's worth considering the impact on someone with median earnings or below, should all three changes come in at the same time.

It's quite possible that the personal allowance could increase by £1,000 - worth £200pa to a basic rate taxpayer. At the same time, the NIC changes are likely to benefit employees earning up to £20,000pa and also their employers. It's thus quite possible that no one on median earnings or below would be worse off - and those with much lower earnings could be better off. The cost would be borne by those earning above median earnings - together with their employers.

This isn't to suggest that a VAT increase is inevitable - but if there is one, at least those on lower earnings should be protected.