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, for example. 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.

4 January 2011, IEA Blog

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