Why raising VAT destroys wealth

In the context of Britain’s fiscal crisis, today’s rise in VAT from 17.5% to 20% may be seen by some as a necessary evil. Moreover, indirect taxes such as VAT are often regarded as less harmful than direct taxes such as income tax. Certainly, the economic effects of rises in VAT are dispersed and difficult to quantify. Nevertheless, it is important to recognise the negative economic impacts of raising VAT. Indeed, there are good reasons to be sceptical that raising the tax will deliver significant additional revenues in the long term.

Increasing VAT prevents mutually beneficial exchanges from taking place – trades that are no longer worthwhile at the higher rate. Thus there is an immediate welfare loss. But the repercussions are far more profound. In particular, raising VAT will have a negative effect on productivity growth. Increasing its rate reduces the economic incentives to trade and therefore hampers the division of labour and the associated productivity gains from increased specialisation, economies of scale and so on. General tax revenues will suffer eventually as lower productivity growth reduces overall output.

Further harmful effects include reduced work incentives, as individuals can buy less with every extra pound they earn, and a greater distortion between vatable and non-vatable goods. Given that most of what people earn is spent, an increase in VAT has much the same effect on incentives as an increase in income tax – it reduces real, take-home pay.

A higher rate of VAT also encourages individuals and firms to conduct business in the informal economy. Accordingly, the “black market” tends to be larger in countries with high rates of VAT, even in cultures where corruption is relatively weak, as in Scandinavia. Yet investment is a problem for informal businesses – they cannot expand like formal businesses and therefore may hinder the creation of wealth in the long-term. Black market businesses also expend resources on avoiding detection, corrupting officials, paying participants a risk premium and so on. Furthermore, an expanding informal economy may encourage draconian and costly countermeasures by tax authorities, which also impose additional costs on legitimate businesses.

Richard Wellings was formerly Deputy Research Director at the Institute of Economic Affairs. He was educated at Oxford and the London School of Economics, completing a PhD on transport and environmental policy at the latter in 2004. He joined the Institute in 2006 as Deputy Editorial Director. Richard is the author, co-author or editor of several papers, books and reports, including Towards Better Transport (Policy Exchange, 2008), A Beginner’s Guide to Liberty (Adam Smith Institute, 2009), High Speed 2: The Next Government Project Disaster? (IEA , 2011) and Which Road Ahead - Government or Market? (IEA, 2012). He is a Senior Fellow of the Cobden Centre and the Economic Policy Centre.

2 thoughts on “Why raising VAT destroys wealth”

  1. Posted 05/01/2011 at 14:05 | Permalink

    What percentage of VAT is sent on to Brussels?

  2. Posted 25/11/2011 at 09:05 | Permalink

    I agree that in the context of European fiscal crisis today’s rise in VAT may be a necessary evil. Moreover, I disagree that indirect taxes such as VAT are less harmful.
    According to S. Strogatz theory of social networks VAT should menace the weak ties (which are the cement of economical society) between economical operators/agents preventing mutually beneficial exchanges from taking place. Also economical hubs could be menaced. For example, Italian government raised VAT to 21%. Here the problem: why not considering the theory of social network of Strogatz as mathematical reason against this provision? The theory forecasts that an attack (fiscal in this case) against the hubs (enterprises and businessman) of a social network (economy network) can make the network collapse.

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