UHY Hacker Young | Chartered Accountants

What is VAT?

8 February 2019

VAT or Value Added Tax is a form of consumption tax which is an increasingly prevalent source of revenue for governments across the globe. Some 166 countries currently have implemented VAT or its equivalent, GST (Goods and Sales Tax).

In the UK, VAT is the one tax that is suffered by every single person in the country. Unlike some other taxes, it is a relative newcomer. For instance, taxes on income and business profits date back to 1799; inheritance tax (in the guise of its forerunner, Death Duty) to 1796; and stamp duty all the way back to 1694. Even Johnny-come-lately taxes like National Insurance predate WW1. VAT, however, only dates back to the 1950s.

So when, and how, did it come about?

A brief history of VAT

A system of VAT was initially conceived by the Germans in the aftermath of WW1 but was first implemented by the French in 1954 in its former African colony of the Ivory Coast. It was so successful that it was rolled out to France-proper in 1958.

By that stage, the other five members of the EEC (Germany, Italy and the Benelux countries) were operating variations of sales taxes which were cascade taxes in nature. Cascade taxes are those applied at every stage in the supply chain, without any deduction for the tax paid at earlier stages. Any supply chain longer than two participants means that the real amount of tax included in the final price of a particular product is obscured and impossible to determine.

Why was this bad?

Firstly, there was always the risk that EEC countries would – deliberately or accidentally – subsidise exports by overestimating the taxes refundable on exportation. Secondly, it created an artificial incentive for vertical integration, thus reducing the tax-take in the intermediary stages. Finally, vertical integration can lead to monopolisation of the markets, so was anti-competitive.

VAT schemes, on the other hand, solve all three of those problems. The deductibility of tax paid at each level of the supply process means that the actual amount of tax paid (only on final sale) is known; nothing is gained tax-wise from vertical integration; and, therefore, monopolies are avoided and competition protected.

This led to the EEC First Directive in the late-1960s which replaced the existing multi-level sales taxes operated by the other member states with the VAT system operated by the French. Henceforth, every new member would be compelled to follow suit.

The UK’s experience

The UK had been operating its own consumption tax since 1940.  Rather than going down the route of the sales taxes preferred by the other EEC members, the UK adopted a purchase tax, applied at the point of manufacture, not sale. The reason for this was to avoid wasting precious resources at a time of conflict (WWII) and the tax was levied at different rates depending on the individual goods’ ‘luxuriousness’. As WWII progressed, the main rate increased, peaking at 100% in 1943, before falling to 33.33% immediately after the war. By 1973, the rate of Purchase Tax in the UK was 25%. Purchase Tax was abolished upon the UK’s accession to the EEC on 1 January 1973 and replaced by VAT, which was initially set at 10%.

Because prices already bore some element of consumption tax, the move to VAT was not as big a shock as it was perhaps for countries like Spain – when they acceded to the EU in 1986, VAT resulted in an immediate price hike on Day 1, as they had not previously had a consumption tax in any form whatsoever.

So, what is VAT?

VAT is a general tax which applies in principle to all commercial activities involving the production and distribution of goods and provision of services. It is a consumption tax because it is borne ultimately by the consumer. It is not a charge on business. Because it is charged as a % of price and collected fractionally, the tax burden is visible at each stage of production. Because it is not paid by the buyer to the government directly, but is routed via the seller, it is an indirect tax.

Is it a good tax?

That is a matter for conjecture! It’s certainly important to UK government finances, as it is the second largest revenue generator for the Treasury, after Income Tax, representing around 21% of government receipts.1

As a tax, it is efficient, as it is relatively simple to administer. Because it’s based on consumption, rather than income or profit, it is relatively stable as a revenue base, which is why it tends to work very well in those countries with less stable economies, and why it is so prevalent throughout the world.

VAT is egalitarian, in that it affects most business sectors and is “suffered” by every single person in the country to one degree or another. Its egalitarianism is also its major weakness; because it is levied on everyday purchases, like adult clothing, fuel, domestic heating costs and snack foods, it absorbs a greater proportion of the disposable income of the poor (around 12% according to the Office for National Statistics) than the rich (around 7%) and is therefore seen by some as being regressive in nature.

What is certain, however, is that the impact of VAT on the poorer sections of the economy could have been much worse, had the Heath Government not negotiated the zero-rating of certain essential supplies like:

  • Basic foodstuffs
  • Medicines
  • Household water supplies
  • Sewerage supplies
  • Books, newspapers and periodicals
  • Passenger transport by bus, boat, train and plane
  • Children’s clothing

A lot of the above goods and services are subject to VAT elsewhere in the EU, albeit at reduced rates. The UK also has the most generous registration threshold for VAT in the EU at £85,000, which permits some goods and services to be secured VAT-free. The ONS calculates that the average VAT proportion of disposable income in the UK is 9%. Without the zero-rated relaxation and the large registration threshold, the proportion of VAT to disposable income for the average household would be much higher, perhaps by as much as 50%, to approximately the levels experienced by French households. And that is one of the reasons why the gilet jaunes protests in France have progressed far beyond the date that the initial fuel duty complaints were dealt with.

The future of VAT in the UK

Mrs May’s Withdrawal Agreement potentially ties us into EU VAT decision-making until December 2022. The EU is currently trying to further harmonise VAT across the EU, and, whilst the UK’s zero-rating relaxation would appear to be safe for now, the EU is looking to reduce the maximum registration threshold to €85,000 – around £76,000. If this were to be implemented before 2022, the UK would be obliged to implement it too, bringing more businesses into the scope of VAT and potentially increasing the burden of VAT on the poorer sections of society. And the UK would be powerless to reverse that decision until we finally cut our ties with the EU.

In 2017, Chancellor of the Exchequer Philip Hammond mooted that he might reduce the VAT registration by up to half because of the perception that businesses were deliberately avoiding going over the VAT threshold, often by “shutting up shop” for the rest of the year, once their turnover got near to £85,000. This was seen to be holding the economy back and reducing the government’s tax take. After consultation, he pulled back from the abyss and instead froze the threshold for 2 years. In 2018, he appeared to pull back even further from unilaterally reducing the threshold, indicating that he would hold it at the current level until 2022 (unless, of course he is compelled to reduce it to £76,000 by the EU) and now favours a graduated implementation so that it no longer represents a fiscal cliff for the businesses concerned. Unfortunately, such a scheme is not permitted under current EU rules, so he can only bring that in when we eventually leave the EU.

If anyone harboured the thought that VAT could be abolished following Brexit, that is unlikely ever to happen. It is far too important a source of government revenue, and it is difficult to see how the government could guarantee the receipt of the same level of revenue from other sources. Whatever one thinks of its benefits and weaknesses, VAT is here to stay.

If you have any questions about VAT or how it affects your business, then please call Paul Newbold on 0191 567 8611 or email p.newbold@uhy-torgersens.com.

As one of the leading firms of accountants in the North East, with offices in Newcastle, Sunderland and Jarrow, we have the expertise to advise you on a wide range of tax-related issues.  If you would like to speak to one of our local experts, please call 0191 567 8611 or e-mail info@uhy-torgersens.com.

1 OECD Revenue Statistics 2018