Why a cut in VAT would NOT solve the cost of living crisis

an VAT save the economy? Probably not.

As a VAT consultant I tend to view much of life through a VAT lens. Most of the time VAT has little relevance to the wider world, apart from adding 20% to most goods and services we consume in the UK. Occasionally, it does raise its head, for example in the infamous Jaffa Cake test (are they cakes or biscuits?)as well as the more recent ‘Pasty tax’. For those short periods, VAT becomes interesting to a wider section of the population.

During the pandemic, VAT was deployed to assist the hospitality industry, initially being lowered to 5% in July 2020 then raised up to 12.5% in October 2021, before going back up to 20% in April 2022.

VAT has been discussed very recently in response to the cost of living crisis and I will attempt to explain the issues, current proposals being suggested by politicians and finally my own ideas on possible solutions.

The latest politician to suggest that VAT could be a partial answer to the current cost of living crisis is Ed Davey the leader of the Lib Dems, fresh from electoral success in Tiverton. In his recent appearance on the BBC1 Sunday Morning show he explained that VAT could be used to tackle inflation, via two routes, by cutting VAT on fuel and power, and also by reducing the standard rate of VAT from 20% to 17.5%.

Cutting VAT on fuel and power

VAT on gas and electricity for domestic use is currently levied at the reduced rate of 5%, and the suggestion is that this should be cut to zero. As an aside, it is perhaps a little ironic that the Lib Dems are suggesting this cut, which would have been contrary to EU law and therefore not available to the UK before leaving the single market. The Lib Dems were the main party advocating that we remain in the EU of course.

It is worth noting that as fuel bills have or will double or treble over a very short period of time, the VAT collected by HMRC has also doubled or trebled at the same rate – it is not only some energy companies that have benefited from the surge in energy prices but also the Exchequer!

By zero rating electricity and gas all things being even, would also lead to a cut of approximately 5% too (being the VAT), which in turn would help reduce inflation a little and ease the burden of fuel costs. This could clearly work but only as long as the fuel cap itself was adjusted to remove VAT. However, as most gas and electricity used by businesses attracts VAT at 20%, and businesses can recover that VAT, any cut to the VAT for domestic use would not have any effect on the wider economy.

Reducing the standard rate of VAT

Mr Davey also suggested that the standard rate of VAT should be cut from 20% to 17.5%. This is a tried and tested tactic and was last used during the financial crisis, where it was hoped it would give the economy a boost. The jury is out on how useful it actually was in the end.

The main drawback to a reduction in the standard rate of VAT is that the supplier is not obliged to pass those savings on to consumers, which means that a cut to the standard rate may have little or no effect on prices but create a small hole in the overall VAT take, as the only certainty with a VAT cut is that the supplier declares less VAT.

During the pandemic, it was often the case that restaurants would not pass on VAT savings to customers. My view was that that the VAT cut was about helping the severely hit hospitality sector rather than the man on the street.

Therefore, I would suggest that a VAT cut would have very little impact on inflation and therefore would have limited benefit to those suffering from rising prices.

VAT could make a difference…

So far so negative. However, there are ways in which VAT could make a difference. One idea could be that petrol and diesel have a temporary VAT rate of say 10% applied. This would, for the consumer almost directly lead to a ten pence reduction in the price at the petrol station. This assumes that the saving is passed on, although as we are all aware of the price of fuel and as the reduction of VAT would be noticeable, it would be difficult for the retailer not to.

Also, as fuel has risen by so much in the previous six months, the actual VAT collected would remain relatively unchanged, pleasing the Chancellor. Once the crisis was over, the emergency VAT rate could be removed.

This idea may not directly reduce inflation in the economy as a whole. However, it would directly help motorists, and of course could be applied to other areas as and when required.

Clearly VAT is not the solution to all of life’s problems (if only), but with some imagination it could help alleviate short term issues.

Richard Staunton is a partner at Gerald Edelman