Rachel Reeves could solve all her problems with a VAT raid
Abandoning our fiscal rules is a non-starter. These are a weak enough constraint as it is, and with the UK already borrowing more, and at higher costs, than most other major economies, our room to ramp up debt is severely limited.
Spending cuts are neither impossible nor impractical. Current plans suggest that annual government spending in the 2029-30 tax year will be about £60 billion higher in real terms than it is now. Limiting the overall increase to inflation over the next few years would solve the problem.
Yet a large part of government spending — on debt interest, pensions and an ailing NHS — is hard to manage in the short term. The result is that spending uplifts linked only to inflation would require a degree of radicalism that the government lacks the policy-thinking, democratic mandate and political will to deliver. If ministers couldn't trim around the edges of the welfare bill, then saving £50 billion is going to be a tall order.
And so we come, inevitably, to tax increases. The National Institute for Economic and Social Research correctly argues against further taxes on jobs, savings, investment and profits, noting their anti-growth impact. It correctly points out that revenue increases on this scale must come from the big, broad-based taxes: namely, income tax or VAT.
The conventional wisdom prefers to raise income tax rates because it's a progressive tax, meaning that the burden is spread more 'fairly', with the better-off bearing a relatively higher burden. But I believe there is a better option from an economic standpoint.
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Britain's VAT base is exceptionally narrow by international standards. Broadening it could raise huge amounts of revenue while also simplifying the tax system and removing some of the economic distortions it creates. Both the politics and the policy design of such a move would be challenging, to say the least, but they are not insurmountable.
Why VAT? First, properly structured consumption taxes are relatively benign from an economic standpoint. Unlike taxes on income or profits, they don't discourage saving and investment.
Second, a narrow VAT base — the result of too many exemptions, reduced and zero rates, and a high registration threshold — causes all kinds of problems of its own. It makes VAT extremely complicated and burdensome to administer. It distorts economic decision-making in a variety of unhelpful ways, like the huge pile-up of small businesses that are just below the registration threshold.
A narrow VAT base is also a very inefficient way to help the poor, since most of the benefit in cash terms goes to those who spend the most — that is, the rich — even if that spending is a relatively smaller share of their household disposable income.
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Third, the potential revenue gains are huge. To use an extreme example, if our VAT base were as broad as New Zealand's (the global paragon of simplicity and efficiency) we could raise at least an extra £150 billion by 2029/30. That's enough to balance the budget, compensate lower-income households, and introduce offsetting pro-growth tax cuts all at the same time.
Of course, there would be downsides. We would see a one-off boost to inflation (of perhaps 3-4 per cent) when the standard rate of VAT was applied to a much wider range of goods and services. And small companies would complain loudly about being dragged into the VAT net, even if, in the long run, businesses overall would benefit mightily from simplification.
But when we're talking about fiscal consolidation on this scale, there are no pain-free options; it is all about trade-offs. The government ought to prioritise spending restraint as well as pro-growth regulatory reforms to boost the economy. But if higher taxes are unavoidable, broadening the VAT base has much more to recommend it economically than any other option.
Tom Clougherty is the executive director at the Institute of Economic Affairs, a free-market think tank based in London
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