Milton Friedman once said “I am in favor of cutting taxes under any circumstance and for any excuse, for any reason, whenever it’s possible."
Now I try not to make it habit of disagreeing with Milton, but, following Sam Bowman's post on good and bad ways to do redistribution, I want to explain why I think free marketeers should oppose Vote Leave's recent proposal to scrap the 5% VAT on Household Gas and Electricity.
Currently the EU restricts the ability of member states to vary rates of VAT on different products like tampons or fuel. This is done to promote trade across the EU. Without this power, there's a risk that nations will exempt products that can be made cheaply at home and raise VAT on products that tend to be imported, creating tariffs by proxy.
But, even putting free trade to one side, there are good reasons to oppose exempting certain goods and services from VAT. Free marketeers know that flatter, simpler taxes are vital to encouraging growth and reducing unemployment, but tinkering around the edges with VAT exemptions takes us even further away from that goal.
There are better ways to help the poorest. Vote Leave argue that the 5% tax on household energy bills is regressive because the poorest spend three times as big of a proportion of their income on energy costs compared to the well-off. But if you're aim is to help those on low incomes, VAT exemptions are a staggeringly inefficient way of doing it.
Sticking with fuel. Let's look at who'd benefits. Someone living in a small flat will typically pay about £26 a year in VAT on fuel, but someone on a larger income living in a large house will pay £76. So while that extra £26 will certainly mean a lot to the someone living hand to mouth, you have to spend an extra £74 in handouts to relatively wealthy people to that £26.
In fact, the IFS ran the numbers and found that if you scrapped every single VAT exemption and replaced them with tax cuts for low paid workers (e.g. raising the personal tax free allowance) and increased means-tested benefits (e.g. Working Tax Credits), you could preserve the existing progressivity of the system and still raise an extra £3bn to fund further tax cuts or pay down the deficit. (Note: This was calculated when VAT was 17.5% rather than the current 20%, so this change would probably raise more revenue now, even more once you factor in growth and inflation.)
Exemptions distort consumer choices. By taxing some goods less than others, the state nudges consumers to spend more on certain goods and less on others. In the case of fuel, it might encourage people to leave their heating on, when otherwise they would have instead put an extra layer of clothing on. While such a case might seem small or trivial, if you add up every single VAT exemption and add it up across the economy, you end up with very large distortions and inefficiencies.
These distortions can also discourage innovation. Take the case of E-Cigarettes. They're taxed at the full whack of VAT while other highly regulated anti-smoking products like Nicotine patches and gum are taxed at 5%. At the margin, this gives less of an incentive for businesses to invest in e-cigs and more of an incentive for them to invest in nicotine gum.
They create unnecessary complexity, which encourages wasteful avoidance. Is a Jaffa Cake a biscuit or a cake? (Likewise is a burrito a sandwich?) A question that should have been left to philosophers, instead is brought into the courtroom. McVities fought a hard battle (and baked a massive Jaffa Cake) to prove that Jaffa Cakes are cakes and not biscuits, thus qualifying them for a lower rate of VAT. Again, the money wasted here might seem silly or trivial, but it adds up.
This is bad for two reasons. First, it's a misallocation of resources. Every pound McVities spend on tax lawyers is a pound they're not spending on investing in new products (although in the case of Jaffa Cakes maybe that's a good thing.)
Second, it can actually lead to worse products. Take the case of Cornish Pasties. In theory, hot prepared food should be taxed at the standard rate of VAT. Straightforward enough, but according to tax law, products that are incidentally hot (e.g. freshly baked bread) are not taxed at the standard rate and instead taxed at the same rate as cold groceries (if this weren't the case, bakers would have to wait till their bread had cooled down to avoid tax). So whether or not you end up paying a Pasty Tax depends on whether it's incidentally hot (i.e. it's just come out of the oven) or deliberately hot (it's been kept in a heated cabinet). At the margin, this encourages bakers to sell cold pasties when they could be selling hot ones.
Indeed the deeper you get, the more maddening it becomes.
I'll leave you with a puzzle.
Do I have to pay VAT on these Heart Shaped Marshmallows?
According to VAT Notice 701/14, edible cake decorations are zero-rated but marshmallows aren't. So what is it?