On why introducing increased rate of VAT on luxury products in the UK is a bad idea, and on what would be a good idea for a rate reform

With public finances consistently in the public eye, every so often we hear in the media politicians, or NGO representatives, calling for the introduction of an increased rate of VAT for luxury products. It sounds like a great idea: with revenues in short supply, it is only fair that those that can pay for luxury products, should also pay additional tax for the privilege – a proxy of sorts for those in (very) high incomes.  It sounds like feasible, sensible, tax policy, but unfortunately, it is not.  It is not feasible because such a rate would be contrary to EU law; but even if that was not the case, it would still not be sensible, as it would be likely to yield significant costs, with little or no benefits.

On why introducing increased rate of VAT on luxury products is not feasible

Within Europe differentiated rates structures date back to the introduction of VAT itself. Although evidence as regards potential negative consequences of applying multiple rates was largely unavailable at that time, difficulties have been apparent for some decades. In light of this reality, since the late 1980s, there have been several attempts to amend European rates structures under the political guidance of the European Commission. Whilst these attempts have been on many aspects unsuccessful, there has been one considerable achievement: since the early 1990s the application of increased rates of VAT to so-called luxury products has been banned.

Under the current European VAT rules (see Articles 96 et seq of the Council Directive 2009/47/EC of 5 May 2009), Member States may apply a standard rate and up to two reduced rates in theory (two more in practice), subject to a few basic rules, in particular:

• the standard rate cannot be lower than 15%;
• reduced rates can only apply to specific goods and services listed in the Directive; and
• reduced rates cannot be lower than 5%, although some Member States, such as the UK, have been granted an authorisation to derogate from this rule, applying a 0%.

Whilst Member States have significant freedom to choose their own rates structures under these basic rules, it is clear that the introduction of a rate higher than the standard rate would be contrary to the VAT Directive.  Should the UK introduce such a rate for luxury products, therefore, it would be in violation of EU law, and thus susceptible of being challenged by the European Commission under an infringement procedure.

On why introducing increased rate of VAT on luxury products is not sensible

Even if application of an increase rate of VAT to luxury products was permissible under EU law, would it be sensible tax policy? The case for differential tax rates under optimum commodity taxation has been consistently made since the elaboration in the 1920s of the inverse elasticity rule.  The dynamics of this rule, however, are often misunderstood, since it suggests that economic efficiency is maximised by taxing consumption goods at rates that are inversely proportional to their price elasticity.  So under this rule, basic goods, such as food, which make up a larger proportion of the expenditures of low-income households, would be subject to higher rates of VAT.  This is not seriously supported by any policy maker – not only because highly impractical, but also because of its distributional effects.

What is often defended, therefore, is rather the opposite, namely that basic products be subject to lower rates of VAT, and that luxury items be subject to increased rates.  No economic case has been made for the optimality of such a structure, but there are two main economic reasons generally used to justify rate differentiation: vertical equity and positive externalities. The former is particularly relevant for justifying the case for luxury rates.  Essentially it is based on the idea that applying reduced rates to key products such as food, energy, healthcare, education, etc, would limit the impact of the tax on low-income households; and applying increased rates to luxury products would effectively have a redistributive effect, collecting more tax from high-income households, used to subsidise public services for lower-income households.

But what are the benefits, and what are the costs of applying such increased rate to luxury products?  For some of the benefits to be attained there is a presumption that decreases or increases in the VAT rate are reflected in consumer prices. Whilst theoretically, this should indeed be the case, empirical studies with VAT rates seem to indicate the opposite: prices are primarily based on market forces (supply and demand, price elasticities, competitiveness of markets), rather than VAT rates.  The increased revenue benefit – a main consideration in the case of luxury rates – is also dubious: whilst the amount of revenue collected will of course depend on which, and how many, products are deemed to be luxurious, and thus attract the higher rate, it is probably reasonable to assume that the amount collected would be relatively small.

On the contrary, the costs of applying such a rate are likely to be significant.  First and foremost, there is an identification / scope problem: what would be regarded as luxury products for the purposes of the tax? The narrower the scope, the less revenue collected; the broader the scope, the less likely to have a redistributive effect.  Once the scope of the new rate is eventually decided upon, however, new problems would emerge:

• definitional and interpretative problems, likely to give rise to litigation, as so often happens now in the context of reduced rates of VAT;
• increase scope for VAT avoidance and VAT fraud, namely misclassification of products either in contravention of the purpose of the law (avoidance) or of its letter (fraud);
• distortions of competition, by de facto subsidising products (subject to standard rate), in detriment of often competing products (subject to increased rate);

All of the above would unavoidably result in higher compliance costs, but crucially as well, in higher administrative costs – which given the limited revenue one may expect to collect, are likely to be higher than the revenue collected.

On what would be a feasible and sensible VAT rate structure for the UK

In this context, would it be possible to have significantly improved VAT rate structure in the UK, which is both feasible in terms of EU law, and sensible tax policy?  The answer is yes. Taking into consideration both budgetary, as well as legal limitations, four criteria are proposed that would lead to a better, more efficient, more neutral, UK VAT rate structure, essentially by broadening the base of the tax, whilst protecting lower income households and key sectors of the economy. The criteria proposed are based on my experience as VAT Policy Adviser to the Portuguese Government after the troika bail-out (2011-2012).

Criterion 1: Elimination of application of reduced rates of VAT, where the rationale for its application is the creation of positive externalities and/or correction of externalities (e.g. books, environmentally friendly products, etc).

Criterion 2: Maintaining the application of reduced rates of VAT where the rationale for is application is vertical equity (e.g. food, medication).

Criterion 3: Maintaining the application of reduced rates of VAT where its elimination would have a serious impact on industries which are either labour-intensive or key for economic recovery (e.g. tourism).

Criterion 4: Rationalisation of categories of goods and services to which reduced rates of VAT apply, by eliminating distinctions within categories.

The criteria proposed for reform of the UK VAT rate structure would not result in the best VAT possible, but rather in the best VAT the UK can possible have, given budgetary and legal limitations. A broader-based VAT, which will result in increased revenue, decreased administrative and compliance costs, and less susceptibility to fraud, avoidance and planning; overall a more efficient, more neutral VAT. A rare case of significant gain, with limited pain.

Summary

1. EU law as it stands prevents the UK from introducing an increase rate of VAT for luxury products.
2. Even if not incompatible with EU law, the introduction of an increased rate of VAT for luxury products in the UK would give rise to significant legal and economic difficulties, with limited revenue benefits.
3. It is possible to reform the UK VAT structure, so as to increase revenue whilst protecting lower income households, and in the process achieve a better, more efficient, VAT rate structure.

This post is based on a paper entitled “Blueprint for Reform of VAT Rates in Europe”, forthcoming on (2015) Intertax 2.  Full paper available here.

Rita de la Feria, Professor of Tax Law, Durham University; Program Director, Oxford University Centre for Business Taxation.

Follow me on @delaferiaR