One of the many thought provoking ideas put out in Policy Exchange’s latest report is that VAT is really no better than income tax; both simply reduce the value of your income, either by raising the prices of the things you want to buy (VAT), or taking income directly.
To quote directly:
“Suppose a worker earns £100 and pays £20 tax on it, and there is no VAT or other taxes. Then she has £80 to spend, and her £80 goes on goods with a real vale of £80 … Suppose now that income tax is abolished and instead a flat VAT of 25% is imposed. Then she earns £100 and she uses it to buy goods with a real value of £80 on which a 25% tax is imposed, raising the price from £80 to £100. So the real value of her consumption is again £80”.
I think this thinking is flawed, because it ignores how income tax is not flat, and has thresholds. I have structured the problem around how much of an incentive a person has to do some extra work under two regimes: income tax only, or VAT only. And the tax gained is meant to be the same – no cheating by not making it fiscally neutral.
The thinking is really simple. I have arranged the thresholds so they roughly resemble ours in the UK. There is single product (“fun”) which is going to either cost $1 or some higher number if the tax chosen is VAT. All consumption is spent, thereby avoiding the complexities that PX admirably look at in terms of savings/deferred consumption/etc.
In each scenario, a person has a choice whether to work for an extra $5000 or not. For the Income Tax payer, it is easy to work out the value of working more. Just take the marginal rate at their current rate of income. For the VAT-only guy, he is considering whether to take $5000, but with a higher price for a unit of FUN*.
As you might expect, the VAT system being flat beats the income tax system, particularly when the incomes are close to thresholds. If you make incomes very very high, then the two approximate, because the VAT required to raise the same as an income tax tends towards the 40% rate. If you programme all thresholds to zero, you get the PX thought experiment:
I have graphed how this advantage varies with the income:
but realise that this is a slightly unrealistic way of showing things. In the real world, there are a range of incomes and work-leisure decisions, but only one VAT rate. So if you assume you need an average VAT rate of 20%, and then look at individual work incentives, you get a chart like this:
This is more realistic, because the upper-rate earner faces a choice between his 40% tax rate, and the VAT rate required for the whole of society to pay the income tax. So for him the incentive advantage of changing the overall tax rate towards VAT is undoubtedly good (that flat line is around 38% when the VAT presumed to be needed is 20%). Think it through: if you earned 40k, and the VAT rate for society was 20%, pushing prices up by 20%, you would be able to get $4166 of real goods for your extra $5k of work. In zero-vat world, you would get $3000 after paying 40% on your marginal income.
If I were really clever, or had the time, I would try to model the entire work/leisure payoff, including benefits and tax credits. Then you might be modelling an increase in VAT that could be used to fund a lower tapering of benefits/credits. Since the people at the bottom of the earnings face such high withdrawal rates, I would again argue that the change would greatly improve work incentives.
Now I appreciate that I have been perhaps over-influenced by an OECD finding (June 2009 Economic Outlook) that the worst taxes for growth are corporate taxes, followed by personal income taxes, then consumption taxes, then taxes on immovable property. I often criticize others for extending results gained during non-deflationary periods into today’s crisis; I agree with Robert Reich today that with corporate profits increasing and labour income stagnant, and big companies not knowing what to do with their cash, it is ‘absurd’ to call for a tax cut for big corporates to boost recovery. So I don’t intend to use this OECD result as ‘proof’ that a rise in VAT is better for the economy – no-one should be citing piles of pre-crisis results as proof of anything right now.
But I am unconvinced that this simple thought experiment proves how VAT is really just a disguised income tax**. Sometimes the conventional wisdom is correct.
UPDATE: I have put the scrappy little Excel sheet here, if you want to play with the numbers.
*Note: if total income is 20k, and VAT is 15%, the VAT raised is not 15% of 20k = 3k. If it raises the price by 15%, 100/115 fewer units are bought. To raise £3k from the £20k you need to choose X so that X/(1+X)*20 = 3 ….)
**interestingly, Mark Wadsworth has elsewhere complained that it is a gross margins tax. I have a radical idea. Maybe it is a consumption tax.
Freethinking Economist 
It is not a ‘consumption tax’. It is a tax on gross margins. The clue is in the name “VALUE ADDED tax”.
And how is VAT “flat”? If some businesses are exempt or zero rated and others VAT-able in full, how is that “flat”? Surely taxes cause the least damage if they are levied at the same rate on all types of income? This is an argument against higher rate income as well, of course.
No, it is not entirely flat. They should deal with that too.
Does it act like a gross margin tax? I would have thought in a competitive market it enters all companies’ calculations on the cost line.
In any event, your comparison is flawed as it can only lead to one outcome, because you assume VAT 17% on all spending, but the income tax has a personal allowance so the marginal rate has to be higher 20%. If we scrapped the personal allowance, then the income tax rate would also be only 17%.
yes, but we are not proposing that. Taking a comparison between income taxes as currently structured, and VAT, is the simplifying assumption.
“I would have thought in a competitive market it enters all companies’ calculations on the cost line”
?? So does corporation tax or PAYE or hte cost of meaningless form filling and compliance??
The point is, in real life, most businesses have a net profit margin after VAT (where applicable) of about 5% to 10% – any more gets competed away, any less and they go out of business (which is how things should be).
So in the absence of VAT, the average overall profit margin is (say) 7.5% (some will make only 1% or 2%, some will make 20% or 50%, of course)
Hey presto, we introduce VAT and all those businesses who previously had a profit margin of 17.5% or less go out of business. That sounds like rubbish plan to me. However high corporation tax is (and it currently raises only half as much as VAT from half as much economic activity), its effect on the low profit margin business ( high volume/high turnover) is no worse than its effect on the high margin business (low volume/low turnover).
No, surely corporation tax enters the equation ONCE YOU HAVE MADE A PROFIT – ie after the unavoidable costs of doing business have been taken out?
Excellent post. But presumably VAT and income tax would have identical marginal effects on consumption if the income tax was flat and had no threshold?
A point that’s being overlooked here is VAT might reduce consumption by making it relatively less attractive than saving – income tax is levied before people choose what to do with their money, while VAT is levied on one of those choices.
On the gross margins vs. consumption tax debate, VAT is passed on to consumers if it is universally enforced. The mechanics of the system bear this out: if you run a VAT-registered company, you do not pay VAT on your inputs; instead all of the accumulated value-added is taxed at the point of sale to the consumer. I don’t see how VAT changes firms’ behaviour beyond the indirect effect from reducing consumer demand.
On the other hand, if VAT is not universal, then it does become a tax on margins. The best example is actually from the USA, where sales taxes* are levied on retailers “on the ground” but not on mail-order or internet shops. For example, Amazon is sales tax-free in most US states. Thus Amazon and a traditional bookstore have different margins on the same books sold at the same price to the consumer – thus the traditional bookstore is paying a gross margins tax.
*I know a sales tax is not the same as a value-added tax, but if we assume the book is being sold at the same post-tax price to the consumer the effect is the same.
I agree about universality. On the point that if IT was flat and had no thresholds, then, yeah, well sure. But it is not. We are trying to propose policy changes for this world …
I quite agree wie should make it as universal as poss, to avoid distortions. Disappointingly, I am not sure PX went after this angle. It was perhaps not easy to programme into the Oxford model.
And if you had a poll tax, there would be even better incentives to work. We know that there is a trade off between a tax free element of any tax, and the tax rate on the remainder. We have always known this!
But in general – as Steve Nickell used to teach us when I was a grad student – the incentive effects of income tax vs VAT come out in the wash, in aggregate
Indeed, for those not in work, the tax free threshold means that they have a greater incentive to work under higher income tax than under higher VAT. It really is a wash, economy wide.
Tim
PS The only exception would be that tourists pay a bit of VAT. But that is small beer.
Hi Tim, it was not aimed at what you may or may not have always known, but what was in the paper, which was the implication that a fiscally neutral rise in VAT was really no difference from the same in income tax, from the point of view of the supply capacity of the economy. While the argument from authority is always quite convincing, this rather large difference between the way the taxes work was entirely neglected in the paper.
And, just to be clear, does this mean that you think that if we put VAT up to 30%, raising about £150bn, the incentive effects in years 1, 2, 3, and so on would be the same as an equivalent income tax hike (which would mean putting the taxes up, I guess, by 10-20p ) – in every subsequent year? If so, I would love to tell the OECD ….
“Hey presto, we introduce VAT and all those businesses who previously had a profit margin of 17.5% or less go out of business”
Wouldn’t this mean the introduction of VAT wiped out a large proportion – 50%? – of all businesses?
Exactly. It is a common cost-of-business collected by the government, and so raises prices, which tends to suit businesses by about the same amount as costs rising hurts them … therefore not a gross margin tax
But I know Mark doesn’t agree with that. I suppose another example would be VAT on new books – that presumably would wipe out every bookseller, as I assume none has a profit margin above 17.5% (Amazon might, albeit perhaps not on books only)