The perils of an emergency VAT cut

An emergency VAT cut has become one of the more popular suggestions on how to dig a developed economy out of the lockdown hole.

The perils of an emergency VAT cut

An emergency VAT cut has become one of the more popular suggestions on how to dig a developed economy out of the lockdown hole. The concept has really gained ground in Europe where the biggest EU nation, Germany, cut its VAT rate from 1 July, at a cost of 20bn euros to its treasury. The UK may be about to follow the herd, although at the time of writing the Chancellor is waiting on more economic data.

An emergency VAT cut has the potential to be a great boon for the economy. Restaurants, cafes, bars, travel agents and hotels have suffered more than most under the lockdown. A VAT cut would allow them to cut prices just as people are starting to think about spending on their services again. However, a quick VAT cut can prove a double-edged sword, especially if it’s applied across the whole economy.

For a start, although designed to boost consumer confidence quick VAT cuts can cause significant problems for retailers. The UK experimented with a VAT cut in response to the 2008 financial crisis, but it wasn’t as successful as hoped. A major problem was the chaos it caused for retailers, who struggled to implement it quickly. It’s actually far more difficult to change prices than we might intuitively suppose. In 2008 some supermarkets were assured by HMRC that altering their prices would take only a few hours, but instead, they spent over a week in crisis mode.

To avoid this from happening again, HMRC needs to lay the groundwork and make sure the affected sectors are properly prepared. However, too much preparation comes with its own problems. If you announce a VAT cut too far in advance you can depress spending in the short term, because people wait for the new cheaper prices to kick in before parting with their cash. The trick is to time the announcement just right, with enough time to avoid administrative chaos but not enough to induce a pre-VAT cut spending slump.

The Chancellor must also weigh up the economic benefits of a surge in consumer confidence, against the fall in revenue that results from cutting VAT. In 2008 VAT raised £78bn before falling to £70bn as a result of the emergency cut. Today VAT accounts for £132bn in revenue, while the UK’s economy itself is only about 5% larger than in 2008. Along with income tax and national insurance, VAT is one of the Treasury’s biggest revenue raisers and the government can ill afford to lose the money it brings in.*

It might be worth it if VAT cuts generated a big economic stimulus. However, the evidence suggests the effect is usually much more modest. The policy may be a great boost to morale and will keep the UK in line with our European peers, but that’s unlikely to translate into a huge upswing in demand.

Is a VAT cut worth doing then? Overall hospitality and tourism deserve a break. Even if the effect is small those sectors need all the help they can get. And the good news is that technology has moved on since 2008, making quick prices changes easier to implement. If the government plays its cards right we shouldn’t see too much disruption.

In addition the Treasury should also be able to just about cope with losing VAT revenue from two sectors of the economy, such as hospitality and tourism; a more general VAT would likely prove too expensive. If the Chancellor does opt for a VAT cut, targeting it at the most distressed sectors is definitely the way to go.

*Figures from HM Treasury and HMRC

Alison Horner
Alison Horner

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