Archive for January, 2011

Whatever else can be said about the British Chancellor, George Osborne, he certainly does not lack chutzpah. His latest canonical pronouncement is that VAT (value added tax) is a progressive tax. For sheer guile, this statement must rank alongside Arthur Laffer’s famously misleading advice to Ronald Reagan that cutting income tax for the rich would actually increase tax revenue, a statement (rightly) dismissed by the then US Vice-President, George H W Bush, as ‘vodoo economics’.

How does Osborne justify his position? The simplest argument–as advanced on 4 January by the BBC’s flagship Newsnight programme–is that VAT is progressive because the poor pay less in absolute terms than the rich; ie, if  (say) you earn only £10 a day, the £2 you pay in VAT is far less than the £20 in VAT paid by somebody on £100 a day. Since £20 is greater than £2, the conclusion is that the rich ‘shoulder the heaviest burden’. Note that this holds true even if the rich man saves half his £100-a-day income, paying total VAT of only £10. The accompanying diagram illustrates admirably how to mislead the public with numbers.

That television presents data in such a manner says a good deal about the near contempt with which our elite view the average member of the viewing public, but never mind. More to the point, the above argument is just plain wrong. A progressive tax is one which takes a larger proportion of one’s income as income rises. This is true by definition. The principle that tax should be linked to the ‘ability to pay’ comes from Adam Smith’s Canons of Taxation in The Wealth of Nations (1776).[1] We accept as fair an income tax system based on rising marginal rates of taxation, just as we reject (say) a flat poll tax. Equally, we make the distinction between a direct tax (such as income tax) which is progressive, and an indirect tax (such as VAT) which is regressive, precisely because it is thought unfair to tax the rich and poor at the same flat rate.

When I was an undergraduate, Alfred Marshall’s Principles was required reading: Marshall, perhaps Britain’s best known neo-classical economist, famously set out the principle of ‘diminishing marginal utility of money income’—in everyday English, that an extra daily £2 is worth much more to a poor man than to a rich one.

Consider the example. If the rich and poor consume all their income, each pays 20% of income in VAT. But if the rich man saves half his income and pays only £10 in VAT, he pays out only 10% of his income. So where the rich save more than the poor, the proportion of income paid out in VAT is actually lower for the rich; ie, the tax is highly regressive.

So far so good, but apologists for Osborne don’t stop there. Rather, they roll out three further (and logically distinct) arguments. The first argument can be dealt with fairly rapidly. Because some basic necessities (food, children’s clothing) are VAT exempt in the UK, it can be argued that VAT is ‘mildly progressive’, a view apparently shared by Vince Cable.[2] But for this to be true, the share of non-VAT rated items as a proportion of the bottom decile’s income would need to be greater than the savings propensity of the top decile.

In the UK, the poorest 10% of the population spend about 15% of their income on food.[3] Look again at the above example. For simplicity’s sake, let us assume I receive £10 per day but that instead of paying £2 per day in VAT, I pay £1.70 (because only £8.50 of my daily income is spent on VAT rated items); the effective rate of VAT I pay is 17% of income. Now look at savings behaviour. Roughly speaking, in normal times the average British household saves about 7% of its total income; moreover, the higher your ‘financial capability’ (the richer you are), the more likely it is that you will save more.[4] So take our rich man who receives £100 per day; he can safely be assumed to set aside twice this proportion (or £15), spending the remaining £85 on which he will pay 17% effective VAT—no progressive element discernible there.

The second argument is that the above calculations depend on looking at the economy in ‘snapshot’ mode rather than considering the lifetime behaviour of economic agents. When people are young—so goes the argument—they earn little and pay little VAT, but as they get older and earn more, their VAT increases (and of course when they retire, consumption falls as does the VAT burden). But the counter-argument is simply that the lifetime consumption profile doesn’t matter. What we want to know is the likely impact of the VAT rise today and in the months to come. For example: a tax/benefit system which comprised a tax system with a personal allowance of (say) £10,000, a 40% flat income tax rate above this, a proportional VAT on all goods and no benefit system at all (including pensions) might be highly progressive in a lifetime incomes context, but it would also leave a lot of low-income people dependent on charities, or dead in the streets.[5]

The third argument is perhaps the most important, since it comes from the much-respected Institute of Fiscal Studies (IFS). IFS argues that instead of looking at the distributional impact of VAT as a proportion of income, we should take income net of direct tax and savings and look at VAT as a proportion of consumption. Of course, if there was zero household savings and direct tax across the income distribution, using such a measure would make no difference. But since the rich consume less than they earn (and the poor use their credit cards to consume more), the consumption pyramid is far flatter than the income pyramid. Combining this with the fact that the poor spend more of their income of zero-rated essentials such as food produces a mildly progressive VAT impact.

However, such an argument is simply disingenuous. As a matter of accepted convention, calling a tax ‘progressive’ depends not on looking at consumption propensities but rather (as Adam Smith argued) on comparing people’s ability to pay. The IFS has simply dragged out yet again an old argument about ‘not taxing savings’ since future investment depends on the ‘supply of loanable funds’, an argument disposed of long ago by Keynes but still echoed by the UK Treasury.

Let me leave the reader to ponder the apparent paradox that according to Tim Montgomerie, a leading right-wing blogger, four of London’s leading conservative think-tanks have now attacked the rise in VAT as a bad idea.[6] We should perhaps recall that although George H W Bush was a fiscal conservative who attacked ascendant neo-liberalism as ‘vodoo economics’, much of that same voodo is still picked over today.

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[1] See Book V, Chap 2, part 2.
[2] See http://www.libdemvoice.org/vince-cable-why-the-vat-rise-had-to-happen-20039.html
[3] See http://www.foodsecurity.ac.uk/issue/uk.html
[4] See http://www.cfebuk.org.uk/pdfs/CRS02_Financial_capability_and_saving_summary.pdf
[5] This argument comes from Howard Reed who is gratefully acknowledged.
[6] See http://conservativehome.blogs.com/thinktankcentral/iea/