Economic Dilemma: VAT Hikes vs Income Tax Increases
The Chancellor faces a tough decision as economic experts highlight the potential consequences of raising Value Added Tax (VAT) in the upcoming Autumn Budget. While some economists argue that increasing VAT could have a more severe impact on the economy than raising income tax, others suggest that it might be necessary to address financial challenges.
Rachel Reeves has committed to not raising VAT, aligning with her manifesto pledge. However, this stance may not be sustainable given the financial pressures she is facing. According to the Institute of Fiscal Studies (IFS), increasing the main rate of VAT by 1 percentage point could generate £9.9 billion annually by 2029-30. This significant revenue boost could help meet financial targets, but it comes with risks.
The National Institute of Economic and Social Research (NIESR) has conducted analysis showing that raising VAT would lower real incomes by nearly three percent—twice as much as an equivalent increase in income tax—and reduce real GDP by one percent. Real income refers to household spending power adjusted for inflation. This suggests that VAT increases could have a more pronounced effect on consumer spending and overall economic growth.
VAT is a crucial source of revenue for the Treasury, generating £222 billion annually. It ranks behind National Insurance contributions (£226 billion) and income tax (£398 billion). Given its importance, any changes to VAT could have wide-reaching implications.
Reeves needs to raise as much as £40 billion, according to economists, while balancing this with economic growth amid persistent inflation and higher unemployment. NIESR warns that increasing VAT could push inflation, interest rates, and unemployment even higher than if income or corporation tax were raised. Ed Cornforth, an economist at NIESR, emphasized that VAT would put pressure on prices, which is undesirable given current inflation expectations. Additionally, higher business taxes could harm investment incentives at a time when employer NICs have already dampened business confidence.
Although avoiding income tax increases may seem politically appealing, it could force the Chancellor into worse options. Cornforth stated that tinkering around the edges will not make a significant difference. The analysis suggests that a rise in income tax would be the least economically damaging option available to the Chancellor at this time.
However, higher income taxes come with their own set of challenges. They may discourage people from saving in taxed forms, such as investing in companies or property. NIESR also notes that higher income taxes could hurt labor supply or lead to a larger-than-expected reduction in consumption.
David Aikman, director of NIESR, highlighted that the Chancellor’s priority should be to rebuild fiscal resilience by putting public finances on a stable and sustainable path. Achieving this would signal to markets that the government is serious about restoring fiscal discipline, which could help reduce borrowing costs. This would require either cuts to public spending or higher taxes.
In its pre-Budget analysis, the IFS suggested that Reeves could raise tens of billions of pounds in revenue without raising the ‘big three’ taxes. However, this would require reforming the tax system rather than making what the IFS calls a ‘half-baked dash for revenue’. This approach would ensure long-term stability and sustainability for the economy.
