The UK’s VAT system isn’t like everyone else’s – who’d have thought?

When the subject of tax appears in the media, its normally direct tax that’s discussed, mainly income tax, otherwise its national insurance, capital gains tax, inheritance tax, etc that the spotlight falls on.

Keith Miller Associate VAT Director keith.miller@etctax.co.uk

Value Added Tax (‘VAT’ to most people) hardly ever gets a mention unless there’s a major change, which there hardly ever is.

VAT turned 50 this year, too, and in ‘celebrating’ its 50th anniversary, most commentators focused on its quirkiness (ha, ha, Jaffa Cakes, ha, ha) rather than considering its merits.

One of the reasons for this is that most people don’t truly understand VAT, especially the UK version.

VAT was introduced in the UK in 1973 as a condition of joining the European Economic Community (now the ‘EU’). The standard rate was originally 10%, then fell to 8% before gradually rising to its current 20% peak.

Now that the UK has left the EU, we are no longer tied to the EU VAT model, so the government could decide to reform the VAT system in ways that have never before been contemplated, or even abolish it, but there appears to be no appetite to any of this.

The main reason is that VAT appears to be a very efficient tax raiser. This year it is expected to raise £150bn, with the Office For Budget Responsibility expecting this to rise to £180bn by 2027/28.

This is currently equivalent to £5,500 per household and roughly 20% of all tax receipts. 70% of VAT receipts are derived from household spending.

In short, VAT appears to be a relatively easy way of collecting large sums of money from taxpayers.

Given all of that, it is interesting to read a recent report written by Heather McCauley, an experienced former Civil Servant who has worked with the UK, Scottish and New Zealand governments. Her report (“Fit For Consumption? Examining the case for devolution of VAT & sales taxes”) is primarily focused on the arguments for Scotland being able to retain its own VAT revenue, but it also contains lots of fascinating (yes, fascinating) information on the UK VAT system and how it compares to other countries.

It also looks at arguments for reform of the UK VAT system. For example, the Organisation for Economic Co-operation and Development (‘OECD’) has called for a comprehensive review of the UK’s VAT reliefs (the zero-rates, reduced-rates, and exemptions), whereas the International Monetery Fund (‘IMF’) has recommended that some UK VAT reliefs were removed to “increase efficiency, increase tax neutrality, and reduce pressure to cut more productive public spending.”

It is the last quote from the IMF that is particularly interesting, as it hints at one of the ways that the UK is different from other countries, who often manage their VAT systems quite differently.

To start with, the UK has more complex VAT reliefs than most other countries, who tend to have fewer, less complex reliefs and a much broader VAT base and, despite the UK’s VAT take appearing to be significant, most other countries see VAT as a much bigger revenue raiser than the UK does.

The VAT Revenue Ratio (‘VRR’) is a measure that the OECD use to calculate how much VAT is actually collected by each country compared to the amount that could be collected if standard-rate VAT was collected on all consumer goods and services.

The UK’s VRR is 45%, compared to the OECD average of 56%.

It has been calculated that the ‘lost’ 55% is largely made up from VAT zero-rates applied to food (£20bn) and the construction and sale of new dwellings (£17bn), with the 5% reduced rate of VAT on domestic fuel and power accounting for a further £4.5bn ‘lost’ revenue each year.

It is argued (and is evidenced) that having a lower VAT standard-rate, but a broader VAT base can enable a government to collect more VAT revenue, and in the words of the IMF “reduce pressure to cut more productive public spending”. New Zealand is cited as a good example of this in an OECD report that uses data from 2015. Although New Zealand’s VAT standard-rate (15%) was significantly lower than the OECD average (20%), VAT revenue as a percentage of GDP (10%) was the highest of all OECD countries.

The UK’s VAT revenue was closer to 7% of GDP, despite a much higher standard-rate of VAT. One of the main reasons, as suggested above, was the UK’s widespread VAT reliefs. Although some of these are simple, many are not, and the complexity of the UK’s VAT reliefs is a long-standing joke that just isn’t very funny anymore.

The UK’s overly complex VAT rules are perhaps another reason to follow the lead of other more progressive countries, and simplify our VAT rules to increase overall VAT revenue.

So, although there may be a strong temptation to reduce VAT on ‘essential’ goods and services, in response to a cost-of-living crisis for example, there appears to be strong evidence that reducing VAT on such items only benefits lower income households in the short term whilst disproportionately benefitting those on higher incomes. Rather than hand out cost savings to those who don’t need them, the evidence points to the better solutions being those where the VAT base is broader, VAT revenues are higher, and additional revenues are targeted at those most in need of support.

McCauley expands this argument to suggest that the zero-rate that applies to books favours consumers with higher income because they are more likely to buy books than those on lower incomes.

A real-life example of a UK political party adopting this approach is Labour’s commitment to removing the VAT exemption that applies to private education in order to increase state education provision.

It’s also worth mentioning another feature of the UK VAT system that goes against the grain, the VAT registration threshold, which at £85,000 is by far the highest in Europe; the average being around £20,000.

There are a number of issues with the UK’s high threshold, but I think this perhaps warrants an article of its own, so watch this space.

To conclude, perhaps it’s appropriate to remember Lord Justice Sedley’s words as he oversaw a complex VAT case a few years ago: “Beyond the everyday world lies the world of VAT, a kind of fiscal theme park in which factual and legal realities are suspended or inverted.”

Funny though this comment is, I think that it’s about time we moved away from having to echo Lord Justice Sedley’s frustration when describing our VAT system, or having to explain why an oversized Jaffa cake was baked to help confirm its VAT treatment, to a simpler, more effective system that ultimately helps place the burden of the tax where it belongs. If you have any questions regarding VAT please get in touch.