Value added tax (VAT) at 50

1. Indirect taxation and the introduction of VAT

In his book ‘Just Taxes: The Politics of Taxation in Britain, 1914–1979’, the historian Martin Daunton outlines how, in the decades preceding the second world war, the UK relied largely on direct rather than indirect taxation. This means taxation was weighted more heavily towards incomes and profits, rather than consumption. However, from the war onwards, this began to shift.

Mr Daunton writes that the Conservative Party had long been enthusiastic about shifting towards indirect taxation. He observed how Conservative politicians understood it to be “axiomatic” that the tax system should be used to provide economic incentives, and that lower taxes on profits and income would encourage production and entrepreneurship. The Labour Party, on the other hand, had historically been opposed to indirect taxation, believing that it put the burden of taxation onto working people less able to afford it. However, by the 1940s Labour figures argued that inequality had been reduced sufficiently to mitigate this concern. Moreover, income tax had, by that point, been expanded significantly and it was believed that further action on direct taxation would be neither popular nor likely to yield much further revenue.

During the war the share of indirect taxation therefore began to rise “for the first time in a century”. A purchase tax had been introduced in 1940, targeting non-essential goods, and duty rates on alcohol, tobacco and entertainment were increased. However, in the decades after the war both parties shied away from introducing a broad-based sales tax, with there being concerns that such a tax would increase the cost of basic necessities (while reducing the cost of luxuries) and lead to demands for compensating wage increases.

In lieu of a general sales tax, Harold Wilson’s Labour government introduced the selective employment tax (SET) in 1966. The SET was levied on employment in service industries, supplementing the existing purchase tax which already applied to certain goods. However, the SET did not last long. Edward Heath’s Conservative government took office in 1970 with the intention of joining the European Economic Community, with a value added tax (VAT) a requirement for entry. The Heath government therefore abolished the SET and the purchase tax, and introduced the UK’s first general sales tax in the form of VAT in 1973.

2. VAT 1973–2023

VAT was introduced by the Finance Act 1972 and came into effect on 1 April 1973. Essential goods—such as food, fuel and housing—were exempted, but all other goods and services were charged at a single rate of 10%. The introduction of VAT was combined with reductions in the standard rate of income tax, an increase in earned income relief for those on high incomes, and a cut in estate duty. The Labour Party criticised the reforms, on the basis that they benefited the better off. Labour reduced the standard rate of VAT to 8% when they came back into office in 1974. In the same year, a higher rate of 25% for petrol was also introduced—for reasons of energy conservation—which subsequently morphed into a ‘luxury’ rate, covering a series of non-essential goods such as electrical appliances, boats and aircraft, and furs and jewellery. However, the higher rate was halved in 1976, with Chancellor Denis Healey citing concerns that such a high rate “could damage some parts of manufacturing industry and jeopardise employment”.

Table 1. Rates of VAT since its introduction

(Institute for Fiscal Studies compilation of HMRC data)

In 1979, Margaret Thatcher’s incoming Conservative government made a significant change to the VAT regime: the higher rate was abolished and the new unified standard rate was to be charged at 15%, almost double the previous standard rate. As explained by then Chancellor Geoffrey Howe in his 1979 budget speech, these reforms were part of a concerted effort to switch the incidence of taxation away from earnings and towards spending. Howe said he expected the move to increase inflation by 3.5 percentage points, but income taxes were being reduced to compensate. Indeed, over the course of the Thatcher government (1979–90), VAT revenue growth significantly outpaced revenues from income and wealth taxation, resulting in VAT taking up an increasingly large share of central government revenue, as illustrated in figure 1.

Figure 1. VAT revenues as a proportion of total central government revenue

(ONS data series NZGF and ANBV.)

In the 1990s, John Major’s Conservative government expanded VAT further. First, it raised the standard rate from 15% to 17.5%, with the stated purpose of funding a reduction of the community charge (often referred to as the ‘poll tax’). Second, it introduced VAT on ‘domestic’ supplies of fuel and power. Fuel and power were exempted from VAT when it was initially introduced, but ‘non-domestic’ supplies to industry and commerce became liable to the standard rate of VAT in 1990. In 1994 domestic supplies (for example, to houses, flats and dwellings) were charged for the first time at a reduced rate of 8%. The Major government had initially intended for domestic supplies to then be charged at the standard rate the following year. However, the increase proved controversial, and in December 1994 a backbench rebellion in the House of Commons resulted in VAT remaining at the reduced rate.

In 1997 the incoming Labour government lowered the reduced rate further, from 8% to 5%. Bar the reclassification of certain goods and services—such as the installation of energy saving materials, children’s car seats, and sanitary protection products—to be charged at the reduced rate, no major changes to the VAT regime were then made for the next 11 years.

In 2008 the standard rate was cut for the first time since 1974 as part of an attempt to stimulate economic activity in the aftermath of the financial crisis and its associated recession. Then Chancellor Alistair Darling argued that the government needed to “put money into the economy immediately” to prevent the recession from deepening and that a cut in the main rate of VAT—from 17.5% to 15%—was the “best and fairest” way to do so, on the basis that it helped everyone (including people who paid no direct tax) and could be implemented straight away.

The rate returned to 17.5% at the beginning of 2010 and was then raised to 20% in 2011. The latter increase was announced as part of Chancellor George Osborne’s first post-election budget designed to reduce the post-financial crisis fiscal deficit. According to the 2010 budget document, the government prioritised VAT as a tax raising measure because it is a “sustainable source of revenue and is less distortionary than other major tax bases”. As can be seen in figure 1, this move further cemented VAT’s status as a key revenue raiser, with it accounting for around 20% of central government revenues from 2011 to 2019.

From July 2020, in the wake of the coronavirus pandemic, Boris Johnson’s Conservative government temporarily reduced VAT for certain goods and services associated with the tourism and hospitality sectors, reinstating the main rate from April 2022. Therefore, bar some reclassifications to rating bands—such as charging women’s sanitary products at the zero rate and removing VAT-free shopping for international visitors—the VAT regime has remained broadly the same as that instituted in 2011.

3. Contemporary debate

Since its introduction, VAT has grown to become one of the UK’s most important taxes. In 1973, its first year of collection, it accounted for 6% of central government revenues and 1.7% of gross domestic product (GDP). In comparison, in 2022 it accounted for 20% of central government revenue, or 7.3% of GDP. It is now the third largest revenue raiser behind income tax and national insurance contributions. As a result of such growth—both in the UK and other countries—VAT has been described as “unquestionably the most successful fiscal innovation of the last half-century” by the Mirrlees review of tax design and “perhaps the most economically efficient way in which countries can raise significant tax revenues”.

However, despite its apparent success as a revenue raiser, the VAT regime is still subject to criticism. For example, in principle, VAT is simple to administer, yet the differential rating of various goods and services (zero rate, reduced rate, standard rate) has led to the system becoming increasingly complex, with there being constant legal challenges regarding which band various goods and services should be included in and at what rate. Moreover, rather than these cases gradually reducing uncertainty around the operation of VAT, “every question answered seems to give rise to three more” according to one legal firm. Legislation pertaining to VAT has also proliferated. As of 2017 the Office of Tax Simplification reported that legislation relevant to VAT had grown such that it is now spread across 42 acts of Parliament and 132 statutory instruments.

Reflecting earlier concerns about the rise of indirect taxation, VAT is also criticised as being regressive. In 2011 the then Labour leader, Ed Miliband, criticised the recent increasing of the standard rate to 20%, claiming that “it’s the poor and middle-income families that will be hit the hardest”. In 2013 the Institute for Economic Affairs researcher Christopher Snowdon made a similar critique, claiming that “the poorest income group spends twice as much on sin taxes and VAT than the wealthiest income group as a proportion of their income”.

Office for National Statistics data affirms the basis of this critique, reporting that in 2021/22 VAT accounted for 4.7% of household disposable income for the top income quintile, but 12.4% for the bottom income quintile. However, the same data also shows how, in absolute terms, those on higher incomes pay more. In 2021/22 the top income quintile paid an average of £4,716 worth of VAT, compared with an average of £2,083 for the bottom income quintile. Therefore, proposals for cutting VAT have also been criticised for being regressive, on the basis that the largest cash benefit would be to higher income groups who spend more.

Paul Johnson, director of the Institute for Fiscal Studies, suggests that these issues are not fundamental problems. For example, he accepts that VAT is “not progressive in the way that income tax is” but argues that it does not need to be. He suggests that income tax “does the job of introducing serious progressivity into the tax system” and not every tax needs to do that. Rather than continuing with a system of widespread differential rating that “makes little sense”, he suggests that up to £50bn additional revenue could be raised by applying the standard rate to all goods and services. He argues this would be more than enough to compensate those on lower incomes most affected by the move (through changes elsewhere in the tax and benefit system) and would result in the tax system being far more straightforward. Mr Johnson acknowledges, however, that previous chancellors have faced significant political challenges when attempting to broaden VAT’s coverage.

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