Business

Tax review urges overhaul on VAT

A sign advertising a VAT cut
Image caption VAT is overly complex and should be simplified, the report says

Value Added Tax (VAT) should be applied to most goods in the UK, a report by a leading think tank has said.

The move would simplify indirect taxation and raise money which could be spent on cutting income taxes and raising benefits, the Institute for Fiscal Studies (IFS) suggests.

Its report calls for radical reforms of the UK tax system.

The government called the review an "important contribution" and said it would consider the findings.

"The Government has already set out steps to simplify the tax and benefits system by setting up the Office of Tax Simplification, " a Treasury spokesperson said.

"[It] is consulting on reforms to improve the tax policymaking process, as well as undertaking fundamental reforms to the welfare system, including the introduction of a Universal Credit."

The report's author, Sir James Mirrlees accepted that "some of the proposed changes would be politically difficult".

But he added: "Failure to reform imposes enduring costs."

Some of the other suggestions set out in the review include:

  • merging income tax and National Insurance contributions
  • making all interest on savings tax-free - as is currently the case with cash Individual Savings Accounts (Isas)
  • overhauling environmental taxes including a consistent price put on carbon emissions and a system of congestion charging on roads to replace most of the fuel duty charges
  • changing corporation tax to encourage investment funded by equity rather than by debt.

'Reduce complexity'

VAT is a sales tax applied at different rates according to the product or service. The top rate - which applies to items including electronics and take-away food - is 17.5%, though this will rise to 20% early next year.

However, many items including domestic gas and electricity attract VAT at a rate of 5% while others, such as children's clothing, food and books are taxed at 0%.

Extending VAT to most spending would "reduce complexity and avoid costly distortions to consumption choices", the report said.

Sir James added that the tax system should be designed in conjunction with the benefits system as a whole. Environmental taxes should become increasingly important, he added, saying the system should also be progressive - meaning those who could afford to pay most, were taxed most.

"The review shows that the UK system falls short of the ideal in costly and inequitable ways," said Sir James.

"It discourages saving and investment, and distorts the form they take. It favours corporate debt over equity finance. It fails to deal effectively with either greenhouse gas emissions or road congestion. The revenue it raises, and the redistribution it does, could be achieved in less costly ways."

"We propose both a long-term vision of a better system, and directions for reform. Some of the recommended reforms involve tweaks to current policy; others involve radical change, and are probably for the longer term."

'Fair choices'

The IFS clashed with the government after it said last month's Spending Review would hit the poorest families harder than the better off.

It said the tax and benefit changes were "regressive", and would have a greater impact, relative to income, on people at the lower end of the scale, and added that families with children would be the "biggest losers".

The IFS said that while the richest 10% of society - and primarily the top 2% - would pay the most under the government's changes, the poorest families would be the worst off out of the remaining population.

Chancellor George Osborne has denied that the poor will be most affected, saying he had made "fair choices".

image showing different items and one of the three VAT rates.

There are three bands of VAT: zero, 5% and 20%. Many regular purchases such as food and children's clothing are zero-rated. Domestic fuel and wind-turbine installation are 5%. Other things like hot take-aways and televisions are 20%.

image showing three teddy bears marked up at different prices with different VAT rates.

The government has raised the standard VAT rate to 20%. This is the effect that has had on a teddy that previously cost 9.99.

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