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VAT cuts as a fiscal response to Covid-19

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It was reported that the UK Treasury is considering temporarily cutting VAT rates in a bid to boost consumer confidence. In doing so, it would follow in the footsteps of other European countries, such as Germany, which announced at the start of June that it would slash its standard VAT rate from 19% to 16%, and its reduced VAT rate from 7% to 5%, for 6 months from 1 July to 31 December 2020.

Such moves mark the beginning of a new phase in the fiscal response to the Covid-19 pandemic and its economic fallout. Initial measures, such as the UK’s furlough scheme, were intended to preserve jobs and keep the economy alive during lockdown. As part of the immediate package of emergency support, VAT payments for all UK businesses have been deferred for three months, from 20 March 2020 until 30 June 2020. As European countries gradually emerge from lockdown (the UK later than others), they are now moving into the second phase: enacting measures to stimulate demand and bolster economic recovery.

A temporary VAT cut is an obvious contender. Unlike changes to income tax or social security contributions, which may require a longer lead time to enable employers to update complex payroll systems, a VAT cut could be swiftly implemented and presented as a confidence-boosting headline. It should also be possible to target the hardest-hit domestic sectors, such as hospitality and tourism. For instance, the UK government may choose to follow other countries by setting a lower rate of VAT for goods and services offered by pubs, restaurants and hotels. 

The economic theory is quite straightforward. Assuming that businesses would not simply pocket the difference, a VAT cut should be reflected in the overall amounts that consumers pay for goods and services. That should have two effects. First, it would increase households’ spending power. Second, as long as the time-limited nature of the cut is clearly signalled, it should encourage consumers to bring forward spending, rather than postponing it.

Does this sound familiar? It should. In December 2008, in response to the global financial crisis, the UK VAT rate was dropped from 17.5% to 15% for 13 months. Subsequent studies prompted critics to observe that, while the cut led to a small increase in spending, that increase was temporary and came at significant cost to the public purse. Arguably, therefore, the policy did not offer good value for money.

But old habits die hard. It is comforting to turn to the tried and tested in response to events that are (perhaps hyperbolically) termed ‘unprecedented’. Thus, governments and central banks around the world have resorted to well-rehearsed fiscal and monetary stimulus in response to the Covid-19 crisis, albeit on a much grander scale than ever before. 

As lawyers, we learn both to value and to question precedents. It remains to be seen how well the last decade’s monetary and fiscal playbook will work this time around.

Tom Gilliver, Slaughter and May (