George Kerevan: VAT's the way to do it if we have hope of balancing the books

Published on Tuesday 2 March 2010 20:22

THERE is an Alice in Wonderland quality about the current general election debate.

The pound is tanking in the exchange markets yet neither Labour nor the Conservatives are willing to admit that the first thing likely to happen after the ballots are counted is that taxes are going up – starting with VAT.

Britain's annual budget deficit, as a proportion of national income, is now bigger than that of Greece. We need a fiscal tightening of 8 or 9 per cent of GDP to balance the books, otherwise interest rates are headed for the stratosphere and your mortgage with it. Ergo, tax rises are in the pipeline.

But the marginal rate of income tax is already at 50 per cent. Any higher will lead to more avoidance (and more evasion).

Taxing business is hardly credible given the need to switch the engine of growth from consumer spending to exports. Which leaves VAT.

Of all the EU members, only Luxembourg and Cyprus (at 15 per cent) and Spain (16 per cent) have lower standard rates of VAT than the UK – though Spain is raising its VAT to 18 per cent next year. Germany sets its standard rate at 19 per cent compared to 17.5 per cent in the UK.

Every extra percentage point a chancellor slaps on VAT is reckoned to bring in 4.5 billion. Bumping VAT up to 20 per cent would net over 11bn.

Whoever is the next chancellor can also increase the VAT harvest by extending the tax to goods and services that presently are exempt or zero-rated. This is where the fun and games start. We all know that food is zero-rated, but why caravans and houseboats?

Transport is zero-rated while energy is VATed at 5 per cent. I am not promoting it, but I can see how a desperate chancellor, with an eye on the green agenda, might be tempted to squeeze a bit extra on these big-ticket items while simultaneously cutting emissions.

Books are zero-rated for educational reasons. But is buying the latest Jeffrey Archer educational? Instead of slashing university spending, as Lord Mandelson is doing, would it not be better to VAT books at 5 per cent and hypothecate the income to education spending? I make no recommendations, but I can see how the Treasury mind might work.

VAT is not charged on a host of services (in distinction to the wonderful fiction of zero-rating). Exempt services include private education and health care, insurance, private post, selling works of art, buying gold for investment purposes, buying a movie ticket to see the latest James Bond, and betting and gaming.

If you fancy buying a boat or private jet, you can escape VAT. Of course, you'll need to set up a special tax vehicle to offer "leasing services" of your new toy to third parties, but that's why you have an accountant.

Just how much extra VAT could be raised if a chancellor goes to town is a guessing game. I doubt if any chancellor would go for it, but removing the zero-rate on food would bring in a staggering 27bn alone.

There are big downsides, of course. Leaving aside the ethical problems – VAT falls disproportionately on the poor – there are negative economic side effects. Because it is complicated, VAT is heavily evaded. The Commons public accounts committee reckons the evasion rate is between about 14 and 17 per cent. That would shoot up if the VAT regime becomes more onerous.

A big VAT rise would impact negatively on fragile retail sales and could hurt business confidence. It would also push up the inflation rate, adding to the pressure on wages.

My guess is that VAT will go up, but in stages so as to minimise the political fallout. The best indication as to the future was Alistair Darling's Pre-Budget Report in November 2008.

In the final version of the report, he announced the 13-month temporary cut in VAT from 17.5 to 15 per cent. But an early draft accidentally found its way into the public domain. This stated that VAT would "subsequently increase to 18.5 per cent in 2011-12".

That proposal was vetoed by a nervous Gordon Brown. When the next Budget comes – the betting is on 17 or 24 March – I wonder if Alistair Darling will revert to Plan A and set VAT at 18.5 per cent?

That would leave the Tories with the tricky task of saying what they would do. Will George Osborne get his retaliation in early?