31 August 2022

A ‘nuclear option’ VAT cut won’t fix the energy crisis


Liz Truss has proposed cutting VAT by 5% if she becomes Prime Minister, a move she is calling the ‘nuclear option’ to help tackle the cost of living crisis. Though it’s welcome to hear her addressing the deep concerns people have about rising prices, cutting VAT isn’t the way to go about it.

The main issue is that it would be a poorly targeted policy. More than anything, policy needs to focus on those on low incomes and business that risk going under, whereas a VAT cut disproportionately benefits those on higher incomes. This is particularly the case when you consider that many basic goods, including most food, are already zero-rated. Rishi Sunak might be over-egging things when he calls a VAT cut ‘incredibly regressive’, but it certainly wouldn’t be a particularly progressive option either.

It is also unlikely that businesses will pass the savings on to consumers. Companies may choose to hold on to the savings in order to tackle their own cash flow problems. Now, this is not necessarily a bad thing – businesses do need help so that they remain open and keep paying their staff – but let’s not pretend it’s an effective way to help the very poorest people cope with soaring bills.

At approximately £38bn a 5% VAT cut is also a pretty expensive measure – one which will ultimately mean higher borrowing and taxes being raised down the line, assuming the next PM isn’t slating some pretty serious public spending cuts.

It’s also worth pointing out that VAT is one of the least bad taxes out there. It is an effective revenue raiser for the Treasury while also being non-distortionary, and it doesn’t deter investment. If we are going to cut rates, we ought to start with more economically damaging taxes first. Indeed, in an ideal world we would levy VAT on everything albeit at a lower rate while also providing more generous and targeted support to those on the lowest incomes.

There are some reasonable arguments in favour of cutting VAT. One is that it would be easy to implement and immediate – which is a big plus when we’re facing imminent, steep price rises. It might also help some businesses stay afloat who otherwise risk going to the wall.

But it still feels like a poorly targeted way of spending just shy of £40bn. It would be equally simple to raise Universal Credit, perhaps with some means-tested support for middle-income households who are also going to feel the pinch.

As for businesses, under normal circumstances the Government would not be countenancing stepping in to save unprofitable firms. However, these are very far from normal circumstances. We are not talking about poorly run zombie companies, but businesses that would be perfectly viable were it not for such a profound economic shock.

As with households, not all businesses will be impacted to the same degree. Larger firms can probably weather the storm more easily, so if there is to be support it should be aimed at SMEs who are already struggling to cope (horror stories of hospitality businesses whose energy bills have quadrupled abound).

How should all this support be funded, then? Neither tax rises nor spending cuts would be appropriate, given the existing pressures on people’s budgets. That leaves the imperfect but feasible option of borrowing more – on the proviso that this really is a temporary set of measures, and bearing in mind that rates are still pretty darn low.

Whoever succeeds Boris Johnson in Number 10 will be under immense pressure – not just to act, but to do so in a way that maximises support for the most vulnerable and keeps as many business afloat as possible. A 5% VAT cut simply won’t cut it.

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Ben Ramanauskas is a research economist at Oxford University.