Value Added Tax Implementation in the United Kingdom - Literature review Example

?Introduction to Value Added Tax (VAT) The value added tax (VAT) mechanism is utilised for taxing the consumption of goods and services in an economy. Essentially, VAT is a consumption tax though its implementation differs from that of other consumption taxes such as sales tax. As the name implies, VAT is collected at each stage of the economic value addition process required to produce a good or service. This stands in contrast to the sales tax scheme where tax is charged to the end consumer directly. VAT receipts are paid for by the goods and services handler unlike the sales tax system where the end consumer pays up tax. However, the impact of tax travels to the end consumer in a VAT scheme much like other taxation systems since goods and services providers tend to move the taxed amount to the end consumer’s final price receipt (Ebrill et al., 2001). VAT Implementation in the United Kingdom VAT is not a new concept to the United Kingdom (UK) and was in place before the UK signed up for the European Union. The initial implementation of VAT in the UK dates back to 1973 when it was introduced by the national government as an entry condition to join the European Union (EU) (Warren, 1993) (IFS, 2009). VAT is not levied universally on all goods and services in the UK. Instead, VAT is applicable to certain goods and services at varying rates in the UK. Directives concerning the amount of VAT and its application to goods and services are provided both by the UK government and certain EU rules and guidelines. Moreover, VAT rates tend to vary for certain goods imported from outside the EU (HMRC, 2013). VAT Rates Her Majesty’s Revenue and Customs (HMRC) provides for three different VAT rates that are classified as (HMRC, 2013): Standard 20% Reduced 5% Zero 0% Standard VAT rates apply to most goods and services consumed in the UK while reduced rates apply to certain items such as fuels, energy savers, power items etc. On the other hand, zero rates apply to certain other items such as certain food items, public transportation, books, children’s clothes etc. (HMRC, 2013). It must be kept in mind that zero rate VAT items are differentiated from items exempted from VAT. Any items that are exempt from VAT cannot have VAT based taxed applied to them under the law such as on insurance, charitable fundraising, life saving services etc. In contrast, zero rate VAT items are taxable but are charged for at 0%. The retailer may lodge a reclaim with the HRMC for zero rate VAT items but not for VAT exempt items (HMRC, 2013). In addition, VAT law provided by the EU mandates that the minimum standard rate for EU members has to be 15%. Member states are also allowed to apply a maximum of two different reduced rates that should be at least 5% on certain goods (European Commission, 2006). Moreover, any changes in VAT especially changes concerning decreased VAT rates must be approved by the EU alone (Victor, 2010). Regional Comparisons VAT is applicable throughout the EU and certain member states exhibit exceptionally high VAT rates. Regional comparisons of VAT rates are presented in the table provided below. Table 1 - VAT regional comparison sourced from (Victor, 2010) Country VAT Rate (%) UK 20 Denmark 25 Hungary 25 Sweden 25 Iceland 25.5 Criticisms against VAT VAT is collected at each value addition stage in the provision of goods and services so ideally VAT’s burden should be borne by these stages and their stewards. However, practically VAT banks on the end consumer much like other forms of taxation. This tends to make VAT just as cumbersome for the average consumer as other forms of taxation. In addition, it has been argued that VAT is essentially a regressive form of taxation though proponents of VAT consider it as progressive. The graph presented below presents how different taxes on consumers in the UK tend to vary by the income quartiles. Figure 1 - Tax composiitons and their differences according to income groups in the UK sourced from (Murphy, 2010) Tax collection through VAT is generally lower than expected levels given the tax leakage due to impracticable tax collection schemes. Since VAT must be collected at various vertical and horizontal levels, it may not be implementable in each and every instance. Moreover, the varied nature of economic value addition processes means that VAT should be applied proportional to the amount of value addition rather than at a fixed rate. VAT also requires adjustments in other taxes such as personal income tax in order to ensure that it does not become aggressive towards low income earners (Schenk & Oldman, 2007). VAT has also come under harsh criticism for allowing a systemised non payment of taxes by large firms involved in carousel fraud. The common umbrella of the EU allows traders to move goods between borders without having to pay VAT at the same rates. One nation may charge VAT on certain goods while another may not and this allows traders to move the same goods around without paying the proper VAT rates (Tait, 1988). In another form of VAT fraud, the trader selling the goods keeps collecting VAT but does not pay up to the government and instead disappears altogether. This kind of fraud is also known as missing trader fraud and is the most common of VAT frauds given the ease of carrying it out (Tait, 1991). Estimates place the loss from VAT frauds in the UK for 2005-06 at some 3.7 billion pounds while estimates from Belgian authorities placed the figure much higher with the addition of another 8.5 billion pounds (Oliver, 2006). VAT Fluctuations in the UK The rate of VAT has been changed three different times in the UK since late 2008 as a means of dealing with the global economic crisis. The first change took place in December 2008 when the VAT rate was reduced to merely 15%, which represented the minimum allowable EU VAT level for member states (European Commission, 2006). This change, carried out by the Chancellor Alistair Darling, was meant to bolster the economy by spurring spending in the average consumer. The change in VAT rates seemed to be the right thing to do but this change essentially spurred larger problems later (Finch, 2008). VAT’s contribution to government income is shown in the graph below for comparison for the period 2001-02 to 2010-11. Figure 2 - VAT as a percentage of UK government income between 2001-02 and 2010-11 sourced from (Murphy, 2010) However, the VAT was changed again in January 2010 to support decreased governmental revenues. The VAT rate was revised to 17.5% since it was felt that the government could not meet its expenditures through the current rates alone. The VAT rates were increased once again in January 2011 to 20% by the then Chancellor George Osborne. The change was meant to bolster governmental revenue further that was depressed by a faltering economy. The increase in VAT rates to 20% was meant to provide the government with an additional 13 billion pounds in revenues (Centre for Retail Research, 2010). Since this change, there have been no changes to the VAT rate to date. The government’s actions though well intentioned have produced myriad problems for both end consumers and retailers alike. The fluctuations in the VAT rate are progressive that is the VAT rate has only increased over time after 2008. Continuous increase in the VAT rate has led to greater inflation especially in the Consumer Price Index (CPI) since VAT applies directly to consumption. Moreover, the prices of goods and services have increased for families leading to sizable changes in the disposable incomes. In addition, VAT has hit the lowest 20% the hardest in the UK fuelling the belief that VAT is regressive in nature. The implementation of increased VAT rates has also had the unwanted effect of arresting economic growth. Increases in CPI CPI provides for the most reflective account of inflation in terms of the end consumers. Increases and decreases in CPI are considered significant since inflation affects the end consumer directly and this in turn affects the political process through the vote bank. The latest increase in CPI to 20% from 17.5% will lead to an increase in CPI of between 0.6% and 0.8% which in turn will mean significant cost hikes (Centre for Retail Research, 2010). CPI levels in early 2011 stood at 3.3% which were already above the central bank’s targets of 2%. An increase in VAT rates only exacerbated this situation to push inflation towards 4% (Flanders, 2011). The purchasing power of the general population at large has been affected directly by the increases in VAT rates so that people are consuming less than before. Since the burden of VAT passes directly to the end consumer, retail businesses in the middle are affected but not as much as the end consumer. The greatest negative effects of the VAT increases have been felt by the end consumers. Increases in Cost of Living The increases in VAT have led to inflation that has increased the cost of living for the average consumer. A VAT rate increase from 17.5% to 20% has led to extra spending needs of 1.6 pounds per day or some 425 pounds per year for every family (Bloomfield, 2010). On the other hand, there are certain quarters that argue that the actual effect is much larger and that families will lose up to 520 pounds every year due to increases in VAT rates (Centre for Retail Research, 2010). This in turn will lead to net decreases in the savings and cash flows of consumers with low income levels. The hardest hit sections of society will be the people with the lowest incomes. The table presented below provides savings levels for various income levels provided by Department of Work and Pensions (DWP) in 2009. Table 2 - Savings and investments of various income level groups surveyed by the DWP sourced from (DWP, 2009) Such changes are expected due to decreases in liquid cash available to lower level income groups so that they do not have enough liquidity for savings or investments. It is expected that the increase in VAT rates has affected the lowest 20% of income groups the hardest (Centre for Retail Research, 2010). This is provided for by the diagram shown below which delineates how VAT tends to affect various income groups in terms of deciles. Figure 3 - Effect of VAT rise by income groups sourced from (Flanders, 2011) In turn, these changes are projected to be negative for VAT collection as well in the longer run. It is speculated that increases in VAT rates have led to lower spending in end consumers such that spending power has decreased by 1.25%. Consequently, consumer purchasing power and government revenue have gone down together. The annual VAT bill is speculated to be affected some 13.9% towards increases only (Centre for Retail Research, 2010). Decreases in Disposable Incomes Low income earners pay a sizable amount of their overall incomes as taxes. Roughly a quarter of the income of a low income earner is appropriated by taxes. VAT represented a 12% cut in the disposable incomes of low income earners from the bottom most quintile. In comparison, the average household in the UK had to face an income cut of around 7.4% through VAT cuts on procured goods and services. On the other hand, high income earners only faced a cut of 5.9% in their overall disposable incomes due to the increases in VAT rates (Bloomfield, 2010). In terms of fiscal numbers, the top quintile paid some 6.6 billion pounds in VAT compared to 2.4 billion pounds for the lowest quintile of income earners (Centre for Retail Research, 2010). Forcing the VAT to ever higher rates will only exacerbate the living conditions of the lowest tiers of income earners and their families. The real potential for revenue increases stems from the top quintile of income earners and VAT should be redesigned to reflect this reality. Implications for the Retail Sector The retail sector relies on the end consumer and earns its profits through the provision of goods and services to the end consumer. As the end consumer tends to spend smaller amounts of money, the retail sector witnesses lower levels of growth compared to the rest of the economy. The UK’s retail sector employs around 3 million people in various positions and adds a quarter of the value to the Gross Domestic Product (GDP). Slowed spending in the retail sector by end consumers due to increased VAT rates has led to decline of 0.5% in the overall economic growth rate (Centre for Retail Research, 2010). Reduced Economic Growth VAT rates were decreased in December 2008 to spur economic growth but this proved to be too little to save the faltering economy. The decreases in government revenues from reduced VAT levels and the overall economic inactivity meant that VAT rates had to be increased. The increased VAT rates have led to a slowdown of economic growth. It is hard to predict the actual impact of VAT rate increases but it is speculated that increases in VAT rates have led to slowdowns of between 0.6% and 0.8% in the economic growth rate (Bloomfield, 2010). Retailers have been complaining of reduced sales and overall slowdowns especially smaller retailers and retailers dealing with the lowest income earners in society. HMRC Position on the VAT Crisis With the changes in the VAT rates in the United Kingdom, tax evasion has shot up as more and more taxpayers are looking for loopholes to circumvent high taxation rates. It has been estimated that tax evasion (under VAT alone) has crossed the 3.3 billion pounds mark by January 2013. Alternatively, the amount of funds evaded under VAT is enough to allow each taxpayer in the United Kingdom a one pence reduction in their tax payments (Wilson, 2013). Currently, the greatest bleed on the national exchequer comes from VAT evasion. Critics see the current HMRC structure unable to tap into massive VAT evasion given the significant understaffing and limited resources provided to the HMRC. On the other hand, certain quarters see the current VAT evasion being handled by an evolving HMRC structure that has begun to catch up with the demands of the day. For instance, it has been argued that VAT based inquiries to foreign nations regarding taxpayers have decreased from 857 in 2010-11 to some 640 requests for 2011-12. Similarly, the VAT Gap according to the HMRC has decreased from 10.1% in 2010-11 to around 9.7% in 2011-12 (Sky News, 2013). It could be argued that VAT evasion is being reduced although the rate of reduction needs improvement since the current rate of reduction would require around another decade to take VAT evasion to zero levels. It has also been argued that during an economic crisis, such as the present one, it is not advisable to raise the taxation rate especially on consumer goods. In the case of the United Kingdom, VAT applies directly to a large amount of consumer goods and in turn it tends to affect a large number of average people. It has been speculated that raising tax rates would lead to tax evasion and hence a net reduction in collected taxes. HMRC has had to face similar circumstances after the VAT rate fluctuation began as the revenue collection fell by some 1.3% in 2009-10 or an overall seven billion pounds (Webb & Hussain, 2011). VAT fraud is a pervasive problem and estimates place organised VAT fraud at between 20 billion Euros to 35 billion Euros each year in the European Union alone (Borselli, 2011). The HMRC has had to face a similar situation where rising VAT rates have only fuelled concerns regarding tax evasion in the VAT sector. Analysis of VAT Fluctuations in the United Kingdom VAT applies to around half of all consumer expenditure so any changes are deemed significant. The reduction in VAT rates from 17.5% to 15% between December 2008 and December 2009 led to a cost of some twelve and a half billion pounds. The reduction can be seen as a failure on the part of the government because the subject funds were squandered at a time when they were needed most. Moreover, the temporary reduction in VAT rates was not able to spur consumer spending and the overall experiment can be deemed as a failure. The initial VAT reductions had two sizable impacts – income impacts and some substitution impacts. As far as the income impacts are concerned, a lowered tax rate would reduce prices and in turn the consumer would have more money in their pocket after a purchase. The substitution impact would occur as the consumer would perceive lowered prices in the present and perceiving higher prices in the future, the consumer would tend to spend more. The temporary reduction in VAT had only an income effect but the substitution effect failed to show through as the government hastily increased VAT rates. In the post global economic crisis scenario, substitution effects were the key to recovery but these were put off by the government’s injudicious decision making. Studies indicated that a 1.2% reduction in prices tend to augment sales between 0.6% and 0.8% per annum (Centre for Retail Research, 2010). Hence, if the complete impacts of the VAT cut were allowed to pass over to the general population, people would be able to purchase 1.2% more goods and services at a reduced rate of 1.2%. However, as a reduced amount of the unaffected spending is paid in the form of VAT, the retailers are able to cash in more than the average consumer. Given the current situation, it can be surmised that VAT cannot be used as an effective tool to stimulate the economy. The VAT fluctuations led to an increased VAT rate of 20% in January 2011. This is expected to drag in another thirteen billion pounds per annum for the government. Households on average were paying 3,240 pounds which will increase by another 520 pounds per annum (Centre for Retail Research, 2010). The increases in VAT will affect all sections of the society but the poorest will be hit hardest. The poorest sections pay an average of 12.1% of their disposable incomes as VAT while the average household pays some 7.4% of their disposable incomes as VAT. On the other hand, the richest sections of society will be paying some 6.6 billion pounds in VAT per annum compared to 2.4 billion pounds per annum in VAT for the poorest sections of society (Centre for Retail Research, 2010). It must be taken to note that VAT increases, especially its impacts on the poorest households, need to be looked into in the widest terms of austerity measures introduced by the government. The removal of benefits for poorer families such as child benefits, family tax credits etc. combined with the increased VAT rate present an extremely grim picture (Flanders, 2011). It could be argued that a long term reduction in VAT rates that would produce significant income and substitution impacts could be expected to alleviate consumer dilemmas. However, temporary VAT reductions are off the table as viable options. Additionally, raising VAT rates in hopes of raising greater revenues is even far less progressive. Research Direction The proposed research will look into various factors that are responsible for encouraging VAT evasion in the United Kingdom. The issues that prohibit the HMRC from functioning effectively in this regard will also be explored in detail to solicit areas where improvements could be introduced to bridge the leaking VAT taxation regime. In addition, the qualitative portion of the research would be augmented by quantitative research using surveys administered to HMRC officials as well as business people to solicit gaps in the taxation regime. The overall contention of the research would be to see how VAT based gaps can be closed in order to bolster revenues through the HMRC structure. References Bloomfield, J., 2010. Raising VAT to 20%: Effects on consumers, prices and the retail industry. Centre for Retail Research. Borselli, F., 2011. Organised Vat Fraud: Features, Magnitude, Policy Perspectives. Rome: Bank of Italy Occasional Paper No. 106. Centre for Retail Research, 2010. VAT hike to 20%: Effects on retailers and consumers. [Online] Available at: http://www.retailresearch.org/vatincrease.php [Accessed 27 March 2013]. DWP, 2009. Whole Population. [Electronic] DWP Available at: http://research.dwp.gov.uk/asd/hbai/hbai_2009/pdf_files/chapters/chapter_3_hbai10.pdf [Accessed 27 March 2013]. 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Oliver, J., 2006. VAT scams hit UK taxpayer hard. [Online] Available at: http://news.bbc.co.uk/2/hi/business/5369776.stm [Accessed 27 March 2013]. Schenk, A. & Oldman, O., 2007. Value Added Tax: A Comparative Approach (Cambridge Tax Law Series). 1st ed. Cambridge: Cambridge University Press. Sky News, 2013. VAT Evasion At Highest Level Since Start Of Crisis. [Online] Available at: http://news.sky.com/story/1034443/vat-evasion-at-highest-level-since-start-of-crisis [Accessed 30 April 2013]. Tait, A.A., 1988. The Value Added Tax: International Practice and Problems. International Monetary Fund. Tait, A.A., 1991. Value-Added Tax: Administrative and Policy Issues. International Monetary Fund. Victor, A., 2010. VAT: a brief history of tax. [Online] Available at: http://www.guardian.co.uk/money/2010/dec/31/vat-brief-history-tax [Accessed 27 March 2013]. Warren, N., 1993. The UK Experience with VAT. Revenue Law Journal, 3(2), pp.75-99. Webb, J. & Hussain, J.G., 2011. Developing an understanding of taxpayer perceptions in an economic crisis. Journal of Finance and Management in Public Services, 9(2), pp.13-24. Wilson, H., 2013. Tax fraud at highest level since start of crisis. [Online] Available at: http://www.telegraph.co.uk/finance/financial-crime/9783979/Tax-fraud-at-highest-level-since-start-of-crisis.html [Accessed 30 April 2013]. Read More