As the hospitality sector and high street shops begin to re-open, should the UK government introduce a temporary VAT rate cut to boost consumer spending? Other European countries are considering such a measure, and Germany has already cut its VAT rate from 19% to 16% until the end of the year.
The aim of a temporary VAT rate cut would of course be to stimulate demand to help a speedy recovery from the economic downturn. But will it have the desired effect? Two questions arise. First, will it succeed in increasing demand? And second, is the recovery more likely to be held back by a shortage of demand or supply?
Shoppers would of course be happy to see lower VAT charges if that means they pay less – and, in general, that will stimulate demand. But how far will a lower VAT rate actually lower prices? That is a question of tax incidence - a temporary VAT rate cut would not be fully passed on to consumers if it induces retailers to raise their prices. And spending will only rise to the extent that prices to the consumer fall, though of course businesses may also benefit from raising prices. The extent of any price fall will depend on the demand and supply for different goods – and it is largely an empirical question (as you will know if you have tried to buy a dog during the lock-down).
There is an encouraging pointer from past experience. The UK government introduced a temporary VAT tax rate cut from 17.5 to 15 percent for a period of 13 months in 2008-2009 in response to the financial crisis. Research on that rate cut suggests that it was largely passed on to consumers in the early months, though with prices rising progressively back to their previous levels towards the end of the temporary rate cut period.
The immediate impact on consumer demand of a VAT rate cut should be significantly greater if it is temporary. This creates an incentive for consumers to bring forward their spending while the rate is lower, since prices can be expected to rise in the future. This would not occur if the cut is believed to be permanent, in which case current prices would not be lower than future prices.
A temporary VAT rate cut could have a stronger effect in encouraging credit-constrained households to spend more. For those who need extra cash to pay bills but struggle to borrow, lower prices due to a VAT rate cut are an immediate relief. The many jobs losses, combined with the extended lockdown period may have reduced household savings, suggests that more households are credit-constrained than is normally the case. So this may mean that a temporary VAT rate cut could have a stronger effect on consumer spending. On the other hand, a VAT rate cut will not help those worried about their next rent payments, which are typically exempt from VAT.
Bringing forward spending is likely to have to have larger effects in some sectors than others. Consumers are likely to bring forward purchases of consumer durables that were already planned, for example. But this effect is likely to be much weaker in the hospitality sector – which has suffered most under the lockdown. It is hard to believe that consumers will flock back to pubs and restaurants earlier because prices will be higher in a year’s time.
This differential impact across sectors is also important on the supply side. In particular, the hospitality sector simply may not be able to increase supply effectively due to the requirements of social distancing. A reduced price for beer could encourage drinkers to have one more pint in newly re-opened pubs, but the requirement to stay one or two metres apart means fewer customers can be served in one evening. These supply-side constraints are likely to dampen the effects of any reduction in VAT on demand in the hospitality sector. That would also be true of a voucher scheme aimed at the hospitality sector.
By contrast, sectors that are less affected by social distancing are more likely to benefit from a boost to demand thanks to a temporary cut in the VAT rate. That would still be welcome, of course. Businesses throughout the economy have been hit as social distancing measures have spread and multiplied both through reduced demand, but also through interrupting supply chain networks.
For those sectors less immediately affected by social distancing, weak demand during the nascent recovery could be their most significant business challenge. A temporary VAT rate cut that encourages spending in the immediate term could therefore be a useful stimulus for these sectors - and the overall economy. Our research suggests that a temporary VAT rate cut could be complementary to other fiscal and monetary measures in helping the economy to recover more quickly.
A temporary VAT rate cut for an extended period would be appropriate given the depth of the current crisis. An initial rate cut could be followed by gradual rate rises in multiple phases, for example over a period of one to two years’ time, back to the previous level. That would allow for some flexibility while delivering policy certainty, as well as encouraging earlier spending.
Recent relevant research from the Centre for Business Taxation:
Discretionary Fiscal Responses to the Covid-19 Pandemic, Michael P. Devereux, İrem Güçeri, Martin Simmler and Eddy Tam, Oxford Review of Economic Policy, June 2020.
Tax Policy and the COVID-19 Crisis, Richard Collier, Alice Pirlot, John Vella, Intertax, forthcoming.
COVID-19 Challenges for the Arm’s-Length Principle, Matt Andrew and Richard Collier, Tax Notes June 19, 2020.
 Crossley, T. F., Low, H. W., & Sleeman, C. (2014). Using a temporary indirect tax cut as a fiscal stimulus: evidence from the UK (No. W14/16). IFS Working Papers.