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Brexit miss #1 – mind the gap

One of the striking things that has happened since Brexit is the failure of the UK government to take advantage of the potential benefits.

First of these is the opportunity to scrap the Eurotax, VAT. It would be difficult to conceive of a more inefficient and damaging tax. VAT fails all the criteria for a sound tax, as set out in the Canons of Taxation.

It is an open goal for fraudsters. The official estimate, for what it is worth, is that about 8% is lost in the so-called “VAT Gap”, with the gross yield being around £135 billion. Nevertheles. It is claimed that VAT is the government’s second largest source of revenue, but as was explained in more detail in another article on this website, the net gain to the exchequer is much less than this, compared to what the yield would be if the tax did not exist.

VAT itself is a major cost to the government. To start with there is the administrative cost, thought to be about 1% of the yield. That the figure is so low is because the lion’s share of administrative costs – around 80%, are loaded onto business. The total costs of administration are about 5% of the yield, which makes it one of the most inefficient taxes in existence.

But that is only the beginning. There is churning ie people such as benefit recipients, pensioners and public sector employers receive money from taxpayers to pay their VAT with  – in other words it is money-in and money-out again. On top of all that there are the deadweight losses. People have been deceived into thinking that VAT is a tax on consumers, but that is an over-simplification. Tax incidence must be taken into account. A good example is the period 2008 to 2011, when the main rate of VAT in the UK was reduced from 17.5% to 15%; then increased back to 17.5%; and subsequently to the present 20%. According to the retail price index, prices including VAT remained relatively stable  – the inflation rate for goods and service subject to VAT was no different to the inflation rate for VAT-exempt and VAT zero-rated goods and services. In other words, businesses (retailers and producers) absorbed most of the VAT and accepted lower margins in order to maintain volumes of sales. Prices in duty-free areas such as airport shopping malls are not materially lower than normal prices. From this it can be concluded that the incidence of VAT is primarily on the retailer and their suppliers and cuts into their profits. At the margin, it means that businesses which might have been viable in the absence of VAT fall below the margin of profitability.

This gives rise to a deadweight loss. At a conservative guess, with a VAT rate of 20%, this loss amounts to at least 5% of national GDP, with corresponding losses of revenue from other taxes, and additional costs of welfare.

VAT was adopted by the European Economic Community at its inception; this was a gross error of judgment and mark of economic ignorance which set the tone for European policies ever after. The UK was required to introduced it in 1973 as a condition for membership. It then replaced the previous UK sales tax, Purchase Tax. The latter was an emergency measure introduced in 1940 to release materials and skilled labour for war production by cutting demand for luxury products like jewellery, watches, cameras and clothing; a dumb Labour government had forgotten to repeal the purchase tax in 1946. Any revenue it raised could perfectly well have been collected by increasing the rate of one of the plethora of other taxes levied at the time.

Unlike VAT, Purchase Tax at least had the advantage that it did not apply to repairs and services, such as building maintenance or professional services. Its manner of operation was completely different. Purchase Tax did not have the complicated system of repayment of VAT tax paid on goods and services purchased by businesses along the supply chain, which gives rise to cash flow problems and is at the same time an open door for fraud. Additionally, the administrative costs of Purchase Tax were not loaded onto business. In short, VAT operates in a way that is nothing like the UK sales tax it replaced.

There is no need for any kind of general sales tax. Value Added Tax is in fact exactly what the name suggests – a tax on “value added” i.e. a tax on business profits and wages, so is not really any different to a 20% increase in corporation tax or a 20% increase in the basic rate of income tax, which push either past the top of the Laffer Curve. At a generous estimate, the net yield to the exchequer from VAT is half the headline yield, due to all the costs and losses to which it gives rise. It could be as low as one-third, and possibly nothing at all.

The country cannot afford it. Following the profligacy of the corona relief measures, the Chancellor is going to have to reconstruct the tax system in a way that does not bring the British economy to its knees. Scrapping VAT could usefully be part of the package. As the son of the Ugandan immigrant who ran a small business, Sunak of all people should be aware of the trouble it causes.