VAT: Who Pays?

No, You’re Not

This post is respectfully dedicated to Mark Wadsworth, who has pointed all this out many times before on his own blog.

The BBC website has published an explanation of the VAT system.

The page describes the different rates charged on various items in different EU countries. And then it mentions how much would be raised by increasing the VAT rate, or by extending VAT to items that are zero rated, like food and children’s clothes.

The piece finishes with this priceless sentence:

Of course, all of these figures for VAT ignore the possibility that higher prices would mean people would buy fewer of the more expensive items.

In reality, the analysis ignores something more than that. People have a certain amount to spend. If VAT goes up, people don’t have any more money. Therefore they can’t simply pay more. So what happens?

Either suppliers reduce their prices, which means that effectively they are paying the extra VAT and not the consumers.

Or they leave the prices high and sell less – meaning their profits fall because their turnover is lower. In this case, consumers and businesses are sharing the pain of the higher tax, because turnover is lower. But the government is gaining nothing, because the overall tax take is the same.

In truth, what happens is a little bit of both. So the government raises more – but not as much as it expects. And economic output drops (an example of the “Laffer Curve”).

Here’s the key point: what extra tax is raised is not paid by the consumers, but by the businesses who didn’t pass on the full cost of the VAT increase. I fear Britain’s businesses are going to be hit in the budget.

By the way, the BBC article also doesn’t mention that EU rules prevent the VAT rate being reduced below 5 percent for any item upon which VAT is already charged.