Raising VAT from 17.5% to 20% is a central plank of the Chancellor’s deficit reduction programme. The Treasury estimates it will raise around £13 billion a year, a large sum from a single tax increase and a major contribution to the planned reduction in borrowing. Perhaps most importantly for the government, alternative ways of increasing revenue by this magnitude, such as adding 3p to the basic rate of income tax, would almost certainly be even more unpopular with voters.
But there is a catch. While the VAT rise may be a politically expedient quick fix for the public finances, it will do long-term economic damage to households and firms.
There will certainly be a negative effect on work incentives – which is particularly worrying given high levels of unemployment. Higher VAT means people can buy less with every extra pound they earn and given that most of what people earn is spent, this has much the same effect as an increase in income tax – it reduces real, take-home pay. If employees demand wage increases to compensate, then the result will be more unemployment. The current economic climate makes pay rises less likely, however, meaning many workers will see their living standards decline.