Call to abolish zero and reduced rates of VAT

1 August 2008

A new study has put forward the argument for scrapping zero and reduced rates of VAT.

According to the study, which was commissioned by the Mirrlees Review of the UK tax system for the Institute for Fiscal Studies (IFS), the move would cut compliance and administration costs for business, interfere less with people’s spending decisions, and raise enough revenue both to improve the living standards of poorer families and to cut other taxes by £11 billion.

The report argued that, although the current standard rate of 17.5 per cent VAT is about average for industrial economies, the UK’s zero rates apply more extensively than in other countries.

Zero-rated items include children’s clothing, most foodstuffs and residential housing, while a reduced rate of 5 per cent applies to domestic energy and other items such as some energy saving products.

The report said that comparing the revenue currently raised from VAT with the amount that would be raised if the standard rate were applied to all consumer spending shows the UK has a relatively narrow VAT base by industrial standards.

Scrapping the existing zero and reduced rates of VAT would raise around £23 billion, the study continued. If £12 billion of this extra revenue were spent increasing means-tested benefit and tax credit rates by 15 per cent, this would leave the poorest three-tenths of the population better off on average while still raising £11 billion to cut other taxes or to spend in other ways.

It would also have only a modest and temporary effect on inflation, increasing the non-housing retail prices index by around 0.35 per cent.

The study further argued that the government should urge its fellow member states to remove a range of outdated exemptions under the common EU VAT rules, especially with regard to financial services. One potentially attractive reform would be to treat all cash inflows into financial services companies as VAT-able sales by them and all outflows as purchases, while zero-rating transactions with registered businesses. Removing exemptions in the financial and other sectors would raise revenue for the government, cut compliance and administration costs, and reduce distortions to competition and trade.

Robert Chote, director of the IFS, said: “VAT is widely recognised as one of the most efficient taxes in the policymaker’s armoury. But these contributions to the Mirrlees Review suggest that there are real improvements to be made, both through domestic reform and efforts to change EU rules.

“The authors make a powerful case on efficiency, fairness and practical grounds for moving to a uniform rate of VAT, rather than the complex mix of full, zero and reduced rates and exemptions we have at the moment. The main obstacle to such a reform appears to be a lack of political leadership, which is perhaps understandable when the public focus on individual elements of the tax system rather than on the whole.”