Curing A Cancer In The Tax System
It's time to reform VAT
Parliament is in recess, politicians are on their holidays, and the silly season is in full swing. This is but the calm before the storm, as the Government finds itself in an agonising fiscal position. This autumn, the Chancellor, Rachel Reeves, will have to reckon with the consequences of playing a bad hand badly.
Government debt stands at 96% of GDP – its highest level since the 1960s. The deficit, meanwhile, has reached 5.7% of GDP, the fifth highest amongst the large European economies, and the headroom Reeves's left herself in last year’s budget has been eaten away by lower-than-expected growth and the higher-than-expected cost of Government borrowing.
The gloom is spreading; the Institute of Directors reports that business confidence has plummeted to its lowest ever level, lower than during the Truss mini-budget fiasco, lower even than at the height of the pandemic.
I mentioned before that Reeves has played a bad hand badly. Much of what we are experiencing now is the consequence of nearly two decades of low growth and a failure to stimulate productivity or get Britain building.
Most of this has not been on Labour’s watch. But the £40 billion worth of tax rises in last year’s budget served to tighten the chokehold on an already asphyxiated economy. Not just because she decided to raise taxes but also because of the taxes she chose to raise. National Insurance is a tax on jobs, stamp duty gums up the housing market, and attempts to close “loopholes” for the rich have led to capital flight.
Part of the reason for these poor choices was that Reeves was boxed in by Labour’s ill-thought-out manifesto commitment not to raise income tax, National Insurance (later interpreted to mean employee National Insurance), or VAT.
Perhaps things wouldn’t be so bad if the Government had been able to follow through on its promises to reform welfare, if it hadn’t begun to row back on its planning reforms, or if it had a meaningful plan to increase public sector productivity.
This tension – between the need for revenue and the political constraints on finding it – is the defining feature of the current political moment. The current trajectory is unsustainable. It leads inevitably to a combination of stealth taxes (which are economically inefficient) and increasingly fictional spending plans for unprotected departments.
If the government is to escape this stagnation trap, it cannot rely on incremental efficiency savings or wishful thinking about productivity growth appearing ex nihilo. It requires a fundamental reappraisal of the UK’s tax architecture, starting with VAT.
Inefficiencies in the Machine
Economic consensus is clear on the hierarchy of harm within taxation. The most damaging are those on transactions – like Stamp Duty, and capital – like Corporation Tax, as they directly inhibit mobility and investment. Taxes on labour – Income Tax and National Insurance – particularly with the current thresholds, are also damaging, creating a wedge that discourages employment and work effort.
The least damaging are taxes on consumption.
A well-designed consumption tax is so great because it doesn’t punish savings or investment. By taxing what individuals take out of the economy, rather than what they contribute, it avoids the double taxation of savings inherent in income tax systems. In theory, VAT should be this efficient mechanism.
In practice, the UK’s VAT system is a case study in how political expediency degrades sound policy. Introduced in 1973 as a simple consumption tax, it has become a labyrinth of exemptions, reliefs, and special rates. We have the standard 20% rate, a 5% reduced rate (mainly for domestic fuel), and a vast array of zero-rated goods (food, children's clothing, books, new housing construction).
This complexity imposes significant deadweight costs. It necessitates endless arguments about definitions. The infamous legal battles over whether a Jaffa Cake is a cake (zero-rated) or a biscuit (standard-rated), or the VAT status of different types of savoury snacks, are not mere eccentricities. They represent a profound misallocation of resources, diverting intellectual energy and capital towards litigation and compliance rather than innovation and productivity.
The Cost of Complexity and the Cancer of Exemptions
The fiscal cost of this complexity is enormous. HMRC estimates the cost of VAT reliefs at roughly £70 billion per year1. To put this in context, this is vastly more than the entire tax gap caused by evasion and avoidance.
To understand the economic damage, it's important to grasp the distinction between zero-rating and exemption. Zero-rating (like on most food) means the business charges 0% VAT but can reclaim VAT on its inputs. This keeps the final product entirely free of tax.
Exemption (like for healthcare or universities) is fundamentally different and far more pernicious. An exempt business does not charge VAT on its sales, but crucially, it cannot reclaim VAT on its inputs. This irrecoverable input VAT becomes a hidden cost. When the NHS contracts IT services, or a university builds a new facility, the 20% VAT on those costs is simply lost.
This is what Maurice Lauré, the architect of VAT, called the "cancer" of the system. It distorts business decisions, incentivising organisations to provide services inefficiently in-house rather than outsourcing to specialised providers, simply to avoid the VAT penalty. It is a stealth tax on essential services.
The Fallacy of Inefficient Fairness
The political defence of the current system rests entirely on the argument of fairness. Taxing essentials, it is argued, is regressive, as poorer households spend a greater proportion of their income on items like food and energy.
This analysis is superficially correct but misses the fundamental inefficiency of using VAT reliefs as a redistributive tool. While the poor spend a higher proportion of their income on zero-rated goods, the wealthy spend far more in absolute terms.
The zero-rating on food, costing the Exchequer over £25 billion a year, provides a much larger cash subsidy to the wealthiest households than to the poorest.
It is a blanket subsidy, delivered indiscriminately. Using the tax system to subsidise specific consumption patterns is a profoundly inefficient way to support low-income households. We are currently opting for a system of inefficient fairness.
The alternative is efficient fairness. If the goal is to support the living standards of the least well-off, the most effective mechanism is direct cash transfers through the benefits system.
A Pro-Growth, Progressive Tax Shift
The path forward involves a radical simplification of the VAT system, modelled on the international gold standard: New Zealand’s GST. This involves applying the standard 20% rate to the vast majority of goods and services currently zero-rated, reduced-rated, or exempt.
This reform cannot, and should not, be implemented in isolation. It must be part of a comprehensive, revenue-neutral package – a Grand Bargain – designed to be both pro-growth and progressive. This package has three essential components:
Broaden the Base. Apply 20% VAT across the board. This eliminates the distortions, the complexity, and the hidden costs of the current system, raising tens of billions in gross revenue.
Direct Compensation. A significant portion of this revenue must be immediately recycled into a permanent and generous uprating of Universal Credit.
The Growth Dividend. The net revenue gain, even after generous compensation, would be substantial. This must be used to cut the taxes that are actively strangling the UK economy.
The priorities for these cuts are clear. First, the abolition of Stamp Duty on both property and shares – costing somewhere in the region of £15 billion. This is arguably the single most damaging tax in the UK, inhibiting labour mobility and the efficient allocation of housing and capital.
Second, significant cuts to National Insurance Contributions – a direct tax on jobs. Reducing the cost of employment and increasing take-home pay would sharpen work incentives and boost hiring.
Third, improving the environment for capital investment, either by reducing the headline rate of Corporation Tax or the expansion of full expensing. This shifts the tax burden from investment and labour onto consumption, unlocking growth while improving the distributional fairness of the system.
The Necessity of Hard Choices
The barrier, of course, is political. It requires confronting decades of entrenched assumptions about the taxation of specific goods. It would involve breaking the spirit, if not the letter, of the manifesto pledge not to raise VAT (as the rate remains 20%, but the scope expands dramatically). The immediate impact on headline inflation would also need careful management by the Bank of England.
However, the alternatives are worse. A continued reliance on taxing capital and labour will perpetuate the low-investment, low-productivity cycle that has plagued the UK for 15 years.
Reforming the VAT is a powerful lever available to the Chancellor to stimulate growth. It is a test of whether this government is willing to take difficult, structural decisions to move Britain from stagnation to abundance, or whether it will be defined by the constraints it inherited.
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https://www.gov.uk/government/statistics/main-tax-expenditures-and-structural-reliefs/non-structural-tax-relief-statistics-december-2024