As Artur Swistak and Rita de la Feria, authors of a recent International Monetary Fund (IMF) working paper (No. 2024/078: Designing a Progressive VAT) acknowledge, perhaps the greatest criticism that can be levelled at ‘the nation’s favourite tax’, is that it is regressive. In other words, it takes a higher percentage of money from those with a lower income than those with a higher income.

The traditional method

The traditional method to alleviate some of this inequity is to provide relief through exclusions from the VAT base. In the UK, a long list of reduced-rated, zero-rated and exempt items is specified in Sch 7A, Sch 8 and Sch 9, Value Added Tax Act (VATA) 1994.

In essence, the idea is to minimise the tax paid by low-income households through specific reliefs for everyday necessities or ‘essential’ supplies while levying VAT at the standard rate on everything else.

Nowhere is the difficulty with this approach better illustrated than in the current VAT regime related to food. Schedule 8, Group 1, item 1 provides relief for food of a kind used for human consumption, unless it is supplied in the course of catering. There is then a list of excepted items and exceptions to the exceptions.

Deciding whether an individual item is within the provision, the exception to the provision, or the exception to the exception is no easy matter. In addition, arguments regarding what might be considered a basic or essential food item, rather than a luxury or treat, have spawned a parade of newsworthy decisions relating to certain products including, of course, the wily Jaffa Cake.

It is therefore no surprise that the working paper reports there is extensive evidence that a regime based on exclusions carries significant costs beyond the obvious loss of revenues. Difficulties in classifying products create additional costs and can result in apparently similar items being treated differently, distorting competition. There are increased opportunities for tax planning and avoidance, and increased compliance and administrative costs.

Nevertheless, post-Brexit, and in the wake of several successful campaigns, there have been increasing calls from various interest groups for specific items to be added to the list of relieved products. Recent petitions have focused on toothpaste and toilet roll. As the authors of the report point out, however, a relief from the standard rate of VAT will only benefit lower income households if the decrease is passed on to consumers. There is now a growing body of empirical evidence that such price reductions may not be fully realised. I am aware of anecdotal evidence suggesting that the initial drop in the retail price of female hygiene products may have been followed by a drift back toward the original price before the rate change. 

More fundamentally, this approach will, inevitably, continue to favour the rich rather than the poor since those on a higher income generally spend more on food and other products, and therefore benefit more from the reliefs provided.

And yet, the authors estimate that countries forego substantial revenue, through exclusions, to attempt to make VAT more progressive under this traditional approach.

The modern approach

The modern approach, first championed in New Zealand in the 1980s, is to tax all supplies equally but provide economic justice for those on lower incomes through the introduction of a welfare compensation system. This could be achieved through a rebate or refund to individual consumers by applying cash transfers or, in some cases, through income tax credits.

This method is designed to increase the efficiency of the VAT regime and reduce inequality, presenting a fairer outcome. Although considered technically superior, it can be more challenging politically. This, alongside targeting difficulties in lower-income countries, may account for the relatively low uptake of this approach and the proliferation, instead, of hybrid structures that retain some traditional exclusions. Even in New Zealand, the political lure of exemptions could not be completely overlooked.

Political constraints

Pausing, therefore, to consider those political constraints, the authors conclude this is not simply an information issue. If it was, the provision of clear information should be sufficient to overcome any resistance from voters. There is also, however, a trust issue. Voters must believe what they are being told. While reducing rates to assist lower-income households feels intuitive, explaining that those concessions may in fact have the opposite effect is not, providing fertile ground for manipulation by special interest groups.

Even if the new information presented to them is convincing, voters have still been shown to display a status quo bias regarding tax reforms. There are no guarantees the benefits envisaged by a base-broadening reform will materialise, so there is a tendency for voters to regard two-step policies – where an existing benefit is first removed, before being replaced by a new benefit – with suspicion. Under the modern approach, the benefit of the concession is removed and at some later point replaced with the welfare transfer. Merging these two steps, by harnessing the power of emerging digital tax technologies to introduce welfare transfers – which protect lower-income households – at the same time as tax becomes due, is plainly more attractive and may help to mitigate voter resistance.

The proposal

The authors therefore propose employing a single-rate, broad-based VAT, but providing real-time compensation to lower-income households. This, they say, ensures the regressivity inherent in the tax can be addressed while minimising the political difficulties associated with a broad-based VAT.

Real-time technology has already been widely adopted across the world as an anti-fraud mechanism. It could be adapted, they argue, introducing a validation element, to be used as a distributive tool with lower-income households receiving a welfare transfer in real-time, at the time of purchase, to compensate for the VAT charged to them.

Real-time systems requiring the systematic reporting of business-to-consumer (B2C) transactions to data warehouses have already been successfully implemented in countries such as Israel, Portugal and Russia. They link cash registers in the retail sector to massive data warehouses that record every B2C transaction in real-time. In Russia and Uzbekistan, the real time system also applies to business-to-business transactions with businesses required to submit every invoice to the data warehouse. The data warehouse is then linked to a risk assessment artificial intelligence (AI) that identifies audit targets and, in the case of Uzbekistan, can generate an individual risk factor for every VAT-registered business in the country. The Portuguese system only applies to B2C transactions, but the information sent to the warehouse identifies individual taxpayers through their personal tax numbers.

Furthermore, the pandemic has already accelerated the use of new technologies by tax administrations for welfare transfers. Mobile money, which allows value to be stored on a mobile phone and sent to others in a text message, has been successfully deployed in developing countries to carry out cash transfers to low-income individuals.

In March 2020, Colombia introduced a welfare transfer programme using mobile money to compensate for a VAT base broadening reform. Despite some limitations, the programme had a positive effect on measures of household well-being. In Uruguay, a VAT compensation scheme, in place since 2022, uses a digital wallet to make payments.

The authors suggest that the early success of these targeted programmes provides encouraging signs of what can be achieved.

A progressive VAT

The progressive VAT proposed in the IMF paper has three core design elements:

• full taxation of all consumption at a single VAT rate; 
• payment of a compensation subsidy; and 
• a digital mechanism that allows payment of this subsidy in real time, at the point of purchase. 

A variety of options, in terms of payment methods and – critically – scope, are then possible, including whether the compensation should be targeted or universal and the cut-off threshold for receiving compensation.

Three alternatives are explored in the paper:

1. A simple cut-off threshold where households with income below a certain level do not bear any VAT regardless of what they consume (the true progressive VAT approach).
2. A universal subsidy where all consumers receive VAT compensation equal to the amount of VAT charged on their purchases up to a threshold amount, regardless of what they buy.
3. A regime where all consumers receive a VAT subsidy equal to a threshold amount, regardless of income and what they consume.

Modelling each of these alternatives against the current VAT systems in Mozambique and South Africa, the authors demonstrate that:

• the cut-off threshold would achieve a small degree of progressivity, compared with that achieved under the current VAT system while substantially increasing the revenue yield;
• the two other alternatives would not substantially change the revenue yield, but would achieve a higher degree of progressivity;
• the results are particularly sensitive to the choice of the threshold amount – the higher the threshold, the more costly the programme, but the higher the progressivity; and
• higher progressivity could also be achieved by granting different levels of compensation depending on income.

The preferred option would, according to the authors, consist of a simple cut-off threshold with different levels of compensation. Such an approach would have a positive impact on reducing inequality while limiting the political cost. Real-time compensation would feel like an exemption rather than a welfare payment, reducing the welfare stigma, since it would not be observable in the same way as, for example, food stamps.

Other benefits include the indexation of compensation to prices, increased compliance and the creation of an incentive against informal suppliers where no rebate would be available.

The authors acknowledge, however, that new fraud risks would have to be considered, such as the sharing of digital wallets and the incentive to under-report income to gain a VAT advantage. There is also likely to be a disincentive to cross-border shopping.

Finally, of course, these new technologies are extremely intrusive. The potential for cybercrime attacks and the possible misuse of collected data, particularly by autocratic regimes, cannot be ignored. 

Watching brief

Thanks to digital technologies, the authors conclude, it is now possible to design consumption taxes, including VAT, that are de facto progressive, in a relatively straightforward way, without compromising efficiency or neutrality.

HMRC has, to date, adopted a watching brief on the implementation elsewhere of many of the real-time technologies discussed in this paper. For example, there is no indication that it is looking to address the lack of a unique tax identifier (as called for by ICAEW’s Tax Faculty). There is also strong opposition in the UK from civil liberty groups to the introduction of ID cards that may be a prerequisite to the introduction of such a progressive VAT regime. Clearly, making significant changes to the UK’s established VAT regime would be far from an easy task. However, the efficiency savings, compliance improvements and more equitable distribution demonstrated in the paper provide a compelling case for consideration and ample food for thought. 

Angela Bedi, Senior Technical Writer, Croner-i Ltd.