Recent reports indicate the government is considering a temporary VAT cut despite historical evidence that it makes little difference to UK consumption. The proposed cut is also terribly targeted to current needs, although a selective re-rating might work. If a headline cut is popular enough, it will probably happen irrespective of the merits. I estimate the pass-through of a 1yr cut at about 50% to the price level.
UK’s Last Temporary VAT Cut Produced Negligible Benefits
Lockdown has crushed supply and demand over the past few months and is set to leave a legacy of business failures in its wake. Anguished cries for help are motivating a search for new interventions that offset the undesirable consequences of the previous ones. Rather than respond to the specificities of the current recession and the evidence of the past, though, the government is widely reported to be considering a temporary VAT cut. Former Chancellor Alastair Darling is a keen advocate, though it is hardly surprising that he holds his own playbook in high regard. However, his experience should serve as a cautionary tale. Unlike in some other countries, the UK’s temporary 2.5pp VAT cut had no immediate impact on the level of sales, and they were still broadly unchanged after a few months. Despite the lack of benefit at the beginning, the reversal of the temporary cut hit sales by about 3% on impact before rebounding to a level about 1% lower than before. A negligible benefit that ended badly is not a legacy to repeat. Moreover, the most recent ‘permanent’ increase to 20% did not dent sales initially but left them 1% higher after three months (Figure 1).
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Recent reports indicate the government is considering a temporary VAT cut despite historical evidence that it makes little difference to UK consumption. The proposed cut is also terribly targeted to current needs, although a selective re-rating might work. If a headline cut is popular enough, it will probably happen irrespective of the merits. I estimate the pass-through of a 1yr cut at about 50% to the price level.
UK’s Last Temporary VAT Cut Produced Negligible Benefits
Lockdown has crushed supply and demand over the past few months and is set to leave a legacy of business failures in its wake. Anguished cries for help are motivating a search for new interventions that offset the undesirable consequences of the previous ones. Rather than respond to the specificities of the current recession and the evidence of the past, though, the government is widely reported to be considering a temporary VAT cut. Former Chancellor Alastair Darling is a keen advocate, though it is hardly surprising that he holds his own playbook in high regard. However, his experience should serve as a cautionary tale. Unlike in some other countries, the UK’s temporary 2.5pp VAT cut had no immediate impact on the level of sales, and they were still broadly unchanged after a few months. Despite the lack of benefit at the beginning, the reversal of the temporary cut hit sales by about 3% on impact before rebounding to a level about 1% lower than before. A negligible benefit that ended badly is not a legacy to repeat. Moreover, the most recent ‘permanent’ increase to 20% did not dent sales initially but left them 1% higher after three months (Figure 1).
Chart 1: Retail Sales Around Previous VAT Changes
Source: ONS, Heteronomics
Averaging across the three headline VAT changes indicates a zero effect on retail sales volumes after three months. I hope the government looks at the data here and does not move beyond the pleasantries of paying heed to previous chancellors. Nonetheless, if it polls well, the government may deliver this expensive policy change regardless. However, British consumers are bludgeoned by deals like 50% or more off, so there is no traction with a tax change of a few percent. Furthermore, retailers typically set prices in reference to key thresholds, so such small effects disappear within the margins for most things and appear in other items moving to the next round level. Estimates of the consumer price elasticity within my macro model suggest total pass-through eventually, but the horizon is too long to fit a temporary change, with negligible real effects in the interim. Over a year of impact and convergence towards equilibrium, the elasticity of the price level to VAT is about 50% in this model (Chart 2).
Chart 2: Headline VAT Cut Simulations (Top-Down)
Source: Heteronomics
VAT Exemptions May Be Adjusted
It’s important to note that press reports have suggested that it is not just the headline rate that the government is considering for change with VAT. So they may not have suffered a total failure of imagination. It is possible that the government is instead mulling over a change in the exemptions. As an EU regulated tax, the UK was hamstrung into moving the main rate back in November 2008, but now it has options. It could temporarily set a lower or zero rate of VAT on the consumption of hospitality and travel goods and services, for example, which would deliver far more stimulus to the suffering sectors at a much lower cost. Doing so would also allow the government to highlight this benefit of leaving the EU. More generally, VAT is largely an irrelevance to businesses that sell to other businesses or for export, and a well-targeted package might want to support those business as well.
Extending a business rates holiday from hospitality to others would also support many others in need, irrespective of their VAT position. These sorts of policies would make far more sense to me than a headline VAT cut, which would raise profit margins of giant and online retailers like Amazon but do little for the real economy. I assume economic rationality prevails and the headline rate remains at 20%, but I acknowledge the risk and the need to price that.
Phil Rush is the Founder and Chief Economist at Heteronomics, an independent macroeconomic research consultancy specialising in the UK economy. Prior to this, Phil spent 10 years on the sell-side, with his previous role being at Nomura as a Senior European Economist.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)