VAT reform prize winning proposal

1. Introduction

Since its introduction in 1973, VAT has grown to become one of the UK’s most important taxes. Total VAT receipts in the financial year 2023-24 increased by 6% to £169 billion¹, comprising 20% of the total taxes collected by HMRC. In principle, the VAT system is simple to administer, yet many goods and services are zero-rated, subject to a reduced rate, or exempt in the UK. Within these categories, further distinctions arise to determine what exactly qualifies for which rate, which has led to the system becoming complex and increasing business and administration costs. These reduced, zero-rate and exemptions have been estimated to represent £97 billion of forgone revenue in 2022–23².

2. Problems with the UK VAT system

The inherent regressivity of VAT is often used to justify the application of reduced rates or exemptions for certain essential or merit goods, whereas goods and services such as financial services that are perceived as difficult to tax are exempt from VAT. However, a growing body of studies cast doubts on the role of such base-narrowing measures in meeting social and distributional goals, whilst experiences in some countries show the possibility of taxing a wider range of financial services. The associated administrative and compliance costs of a multiple-rate VAT structure as well as the economic distortions arising from application of different rates and exemptions call for an urgent need for reform.

2.1. The equity delusion

To achieve the envisaged social or distributional goals of reduced rates and exemptions, the decrease in tax must be passed on to consumers through reductions in price. While studies show heterogeneous responses to VAT changes, there is growing evidence that pass-through for tax decrease is generally incomplete. One empirical study on the extent of pass-through for several types of VAT changes shows that changes in standard rates are more likely to be passed on to consumers, whilst the pass-through for reduced rates and base-narrowing reclassifications is generally lower³. Not only do consumers not benefit fully from reduced rates, a study shows that the retailers are the primary beneficiaries⁴.

Even if rate reduction does lead to price adjustment, it remains uncertain if the desired social and distributional objectives can be fulfilled. While the lower income households may consume more in proportion to their income, the higher income households’ consumption is higher in absolute terms⁵. Any reduced rates or exemptions are therefore likely to benefit the higher income households more⁶. Where reduced rates apply to services that are provided by both private and public sectors, the higher income households are likely to benefit more from the rate reduction, since they tend to choose the private services⁷. Similarly, the rich are more likely to consume merit goods such as books and cultural events more than the poor⁸.

Reduced rates and exemptions, though seemingly intuitive in enhancing vertical equity, may not always do the job well. Therein lies the equity delusion many people have subscribed to. Keeping status quo and the misconceived sense of equity can be a pragmatic option, but not if it comes at substantial costs.

2.2. The inherent costs

Maintaining a multiple-rate VAT regime with wide exemptions for essential and merit goods can be costly. The first element to consider would be the tax expenditure arising from the exclusions from the VAT base. One measure of the broadness of the VAT base is the VAT Revenue Ratio (VRR), which represents the actual VAT collection in a country as a proportion of the revenue that would be raised if the standard VAT rate were applied to all consumptions. The VRR in UK for 2020 is 0.44, which falls below the OECD average of 0.56, suggesting that an estimated 56% of theoretical potential VAT revenue is not collected⁹.

Other than revenue loss, high administrative and compliance costs arising from definitional and interpretation issues are commonly associated with the application of multiple rates and exemptions. The difficulties with determining the correct treatment for different products inevitably lead to high level of litigations. Reduced rates and exemptions also create distortions to competition, since competing products may be treated differently for VAT purposes¹⁰. This may in turn incentivise suppliers to alter their products in order to benefit from the reduced rate or exemption, and inadvertently subsidize inefficient production¹¹. Other than distortions to competition, exemptions also give rise to tax cascading and create bias to self-supply and away from outsourcing¹².

The uncertainty of reduced rates and exemption in achieving social and distributional goals, coupled with the inherent costs of maintaining such a VAT structure, raise the question of whether a broader single-rate modern VAT regime operating in other jurisdictions such as Singapore and New Zealand may serve UK better.

3. Comparative studies: Singapore and New Zealand

3.1. A broad-based system paired with social transfers

In comparison to the UK, Singapore’s single-rate VAT system (where VAT is called GST) applies a flat 9% to most goods and services. In line with the destination principle, zero-rating applies to the export of goods and services. Exemption applies to only four categories of supplies – certain financial services, residential properties, digital payment tokens and investment precious metals.

Instead of applying exclusions to the tax base, the VAT charged by public healthcare and education providers is absorbed by the Singapore Government. In 2012, a permanent GST Voucher Scheme (GSTV)¹³ was created which directly links some of the country’s social transfers to the tax. The GSTV has four components:

• GSTV – Cash provides lower-income Singaporeans with cash and is paid every year;
• GSTV – MediSave¹⁴ provides senior Singaporeans aged 65 and above with a top-up to their national medical savings account and is paid every year;
• GSTV – U-Save provides rebates to lower- and middle-income households living in public housing to offset their utilities bills every quarter; and
• GSTV – S&CC Rebate offsets the maintenance fees of eligible Singaporean households living in public housing every quarter.

Eligibility for each component and the amount of benefits distributed depends on factors like annual income, property value, and the size of the public housing unit. The GSTV is disbursed automatically to eligible Singaporeans and households on a periodic basis.

From 2018 to 2020, the permanent GSTV scheme offset an average of 84% of the annual VAT payable by the bottom 20% of Singaporean households, on a per household member basis¹⁵. This excludes benefits to the lower-income through other welfare schemes and subsidies. For the middle-income, benefits are enjoyed through the U-Save and S&CC Rebate components as over 80% of Singapore’s resident population resides in public housing¹⁶.

New Zealand, which pioneered the modern VAT system by addressing the regressivity of the tax through social transfers rather than exclusions, continues to operate a single-rate broad-based VAT regime today.

3.2. Mitigating distortions from exempting financial services

In most countries including the UK, financial services are exempt from VAT due to difficulties in calculating the value-add of the supply. The exemption of financial services results in several problems mentioned at paragraph 2.2. In addition, financial institutions must perform input tax attribution and compute VAT recovery, and often incur substantial costs to comply.

Other than the complexities in valuation, financial services are not fundamentally different from any other taxable services and should likewise be subject to VAT. But as it would require further studies to determine an appropriate VAT taxation model for financial services, we discuss three ‘quick-wins’ that can mitigate the distortions from exempting financial services, referencing the Singapore and New Zealand VAT systems. Firstly, the UK can look at taxing ‘easy to value’ financial services – specifically, fee-based services. The UK exempts various fee-based financial intermediary services. However, since there is an explicit fee for many of these services, VAT can be levied on the value of the fees charged. This approach to tax most fee-based financial intermediation services is adopted by Singapore¹⁷ to limit the scope of exemption to financial services where valuation is truly complex.

Next, the UK can consider zero-rating of financial services supplied to VAT-registered business customers (“B2B supplies”). This would address the over-taxation of business customers and potential tax cascading. To mitigate the revenue loss compared to exemption, zero-rating can be limited to business customers that make predominantly taxable supplies, since they would be able to claim most or all of any VAT charged on the financial services. New Zealand introduced this mechanism in 2003 to mitigate the problems from exempting financial services¹⁸.

Lastly, a prescribed fixed recovery rate could be introduced in lieu of the requirement to perform input tax attribution and compute VAT recovery by leveraging on industrial income statistics. Singapore leverages on industrial-average statistics of banks’ taxable and exempt income to compute and prescribe an annual fixed rate for banks. While banks that prefer to perform attribution and compute their own VAT recovery are also allowed to do so, the vast majority prefer to adopt the fixed rate for its simplicity and perceived equality, since most banks will apply the same rate. While the accuracy of input tax claims is less precise, a fixed rate significantly simplifies administration and compliance for tax authorities and businesses. And as industrial-average income statistics are used, revenue loss is mitigated as the higher input tax recovery outcome of one bank would be somewhat offset by the lower recovery of another.

4. Reform design and public support

New Zealand and Singapore have shown the way of achieving social and distributional goals through a broad-based, single rate VAT system, coupled with targeted social transfers. The pertinent questions are whether similar policy can be transplanted to the UK, and if so, the form the reform package would take on, and how public support can be solicited.

Any reform to broaden the VAT base should be bundled with measures to improve both progressivity and efficiency of the overall tax system, and to compensate the losers from the VAT rate unification, using the additional revenue raised to fund the measures¹⁹. To improve progressivity, the measures can take the form of cuts in VAT standard rate, income tax rates for lower income bands, or targeted social transfers. The GSTV scheme in Singapore is a notable case study on how regressivity of GST can be addressed through a simple and efficient way. A more advanced tool to facilitate redistribution is to leverage on real-time technology and digital payment mechanism to refund VAT to eligible individuals at the point of purchase²⁰. To mitigate the impact of the reform on suppliers and customers who currently enjoy the reduced rates or exemptions, transitional measures such as staggering the rate increase or distributing vouchers to customers to buy from affected suppliers can be considered.

To solicit the public support, it is necessary to consider the political dynamics of tax reform, which can be framed as the interplay of various factors in a two-step process, comprising comprehension of the proposed tax reform as the first step, and trust in the proposed tax reform as the second step²¹. To obtain buy-in from the public, the stakeholders should be invited to co-create the policy parameters. The SHEDD model, which is an extension of the Coordinated Management of Meaning (CMM)²² theory, can serve as a guide in designing the public discourse²³. The SHEDD model consists of five phases:

1. Getting started;
2. Hearing all the voices;
3. Enriching the conversation;
4. Deliberating the options;
5. Deciding how to move forward together²⁴.

It is a bottom-up approach in seeking inputs from the public before deciding on the policy parameters.

5. Scope of research, methodology and implications

In addressing the research question of “how can the UK’s VAT system be reformed to make it fit for the challenges of the 2030s?”, the proposal will set out to examine how the VAT base can be broadened through streamlining the VAT rates and exemptions, while addressing the inherent regressivity through measures outside the VAT system.

Specifically, the objectives of the research are:

• Describe the administrative and compliance problems of the current multiple rate structure in UK.
• Conduct literature review of recent studies on the regressivity of VAT and whether the regressivity can be addressed with reduced rates or exemption.
• Undertake comparative analysis of modern VAT regimes in Singapore and New Zealand, specifically on how regressivity of VAT is addressed through targeted social transfers such as the GSTV scheme in Singapore, and how distortions from exemption of financial services can be mitigated.
• Consider how the UK VAT structure can be simplified and the design of the reform package including measures to address regressivity and to mitigate distortions from exemption of financial services.
• Formulate the strategy to solicit public support for the VAT reform.

The research would take the form of comparative analysis of VAT regimes in Singapore and New Zealand by drawing on the experiences particularly in Singapore, as well as literature review of relevant empirical studies and academic papers on the topics being covered. The research findings will be informative and relevant to policymakers in the UK seeking to reform the VAT regime, especially since insights on the Singapore’s VAT regime is limited in academic publications.