Hiking VAT would have ‘serious negative impact’, economists warn Reeves

A hike to VAT would “have a serious negative impact” on the UK, leading economists have warned, as the chancellor weighs which taxes to put up at next month’s Budget to plug a £30bn shortfall.

An increase in the sales levy would have the biggest negative impact of any major tax rise, leading to a 0.9 per cent fall in GDP in the first year after the tax is applied, according to an analysis by the National Institute of Economic and Social Research (NIESR).

A higher VAT would also push up the level of inflation, interest rates and unemployment far more than other tax hikes, damaging consumer spending.

A corporation tax rise would be the second-worst damaging option, NIESR said, and would likely lead to a 0.2 per cent GDP knock.

“VAT is particularly damaging in the short term, but once the economy adjusts to the

higher prices, real GDP stabilises,” the NIESR report said.

“Corporation tax, on the other hand, has less of a short-term impact but is more persistent and starts to drag down the economy in the longer term.”

NIESR instead suggested that a hike to income tax would be the least damaging option facing Rachel Reeves.

“Although there are risks around raising income tax rates such as a negative effect on labour supply or a larger than expected reduction in aggregate consumption, it is unlikely that, even if these risks came to pass, any other option would be better,” the research said.

But the move would represent a direct contradiction to Labour’s general election manifesto, which vowed not to put up taxes on working people.

NIESR Economist Ed Cornforth said: “VAT would put pressure on prices, an undesirable option given current inflation expectations, and additional business taxes would harm investment incentives, at a time when employer NICs have already dampened business confidence.

“Although it is politically unsavoury, avoiding raising income tax will force the Chancellor’s hand into worse options; tinkering around the edges simply won’t shift the dial.”

Other taxes on the menu

Reeves has made no secret of the fact that tax rises are very likely, but it is less clear what form these will take.

Think tanks such as the Institute for Government and the Resolution Foundation have urged Labour to break its manifesto commitment not to raise income tax, national insurance or VAT.

“The most likely answer is that one of them will have to go up, and then it’s about choosing the one which is the least damaging economically,” Caswell told CityAM.

The Treasury could raise money by extending freezes on thresholds rather than raising the rates of these taxes outright. Oxford Economics estimates that £10bn could be gained from an extension of freezes to income tax and NICs thresholds.

Even if Reeves sticks to her manifesto promises, there remain a range of other fundraising options, including hikes to capital gains tax or “sin” taxes such as alcohol duty.

Other potential tax rises proposed in the report include a windfall on banks (which could raise £5bn), cutting the tax-free lump-sum pension ceiling to £100,000 (£2bn) and extending NICs to Limited Liability Partnerships (£1bn).