What difference will a VAT cut make?

Pound sign

Alistair Darling has confirmed that VAT will be cut from 17.5% to 15% from 1 December in his pre-Budget report.

A 15% rate of VAT will continue for 13 months before returning to the
present level of 17.5% at the beginning of 2010 by which time the government expects the recovery to be underway.

But some economists are not convinced that slashing VAT will make much difference to households struggling to cope with the economic downturn.

Jonathan Loynes, chief European economist at Capital Economics, says it is far from clear whether the cut will be big enough to make much difference.

“If fully passed on, the cut from 17.5% to 15% - the first change in VAT since the cut in the lower rate in 1997 - will reduce the price of VAT-able goods and services by just over 2%,” he explains. “But in an environment in which retailers like Marks & Spencer and Debenhams are having to slash prices by 20% to 25% to get shoppers through the door, a 2% cut in prices may seem pretty insignificant."

The temporary cut in VAT will have no long-term benefit, says Simon Ward, economist at New Star, as it is not targeted at households likely to spend any windfall gain.

He explains: "Consumption of higher-value items will rise in the months before the lower rate is withdrawn but fall by exactly the same extent afterwards. The temporarily higher demand will be met either from imports or a rundown of stocks, with no impact on domestic production.

"The longer-term "multiplier effect" of this VAT jiggling is likely to be close to zero."

There are also concerns that retailers may not pass on the cut fully to customers, especially taking into account the cost of changing prices for a temporary period.

And, Loynes warns that even if it is passed on, households may not choose to spend the saving. “With falling house prices and rising unemployment already putting pressure on households to save more, they may decide to put it aside for an even rainier day,” he adds.

But Stephen Robertson, director general at the British Retail Consortium, says it members will be passing on the cut to customers. 

However, he warns time-pressures will make it hard for shops and customers alike.

“Shops will cope, but implementing a new VAT rate in just a week will be exceptionally difficult for customers and retailers at their busiest time of year," Robertson ads. "IT system changes, replacing shelf labels and stickering-over prices on packs will be a mammoth and costly task. Staff will inevitably be diverted away from serving customers. Small retailers will find all this particularly difficult to accommodate."

Will it make people spend? 

Malcolm Cuthbert, managing director of Killik & Co's financial planning division, says a 2.5% VAT cut is not big enough to have a real impact on most people.

"For items such as freezers, washing machines and cars, lower VAT will make a difference," he explains. "However, whether lower VAT convinces people to go out and buy these types of items remains to be seen."

Marc Welby, VAT partner at BDO Stoy Hayward, agrees that the reduction is too small to influence consumer spending.

He estimates 15% VAT will save the average customer little more than £1
per week on a £100 supermarket shopping bill because although the VAT
on crisps and fizzy drinks will come down but there’s no VAT on
zero-rated foodstuff basics such as bread, milk, meat and potatoes.

Welby adds: “A drop in the VAT rate will have no enduring benefit for
customers – it may give a small fillip in the run up to Christmas but
it won’t persuade consumers to spend more than they would otherwise
have done before - and with the increase in alcohol duty it won’t even
allow consumers to buy more Christmas cheer. The chancellor has given
with one hand and taken away with the other." 

However, Douglas McWilliams, chief executive at the Centre for Economics and Business Research (cebr), says a temporary cut in VAT would meet the government’s three objectives – it is reversible, won’t distort the economy too much and would have a desirable short-term impact of boosting the economy.


The reduction in VAT to 15% will could also reduce the fees for SIPP investors.

John Lawson, head of pensions policy at Standard Life, says: "The reduction in VAT will provide a small reduction in fees for some SIPP investors who invest in commercial property. Non-insurance SIPP providers also charge VAT on their administration fees."

This means that VAT on charges levied by SIPP providers not classed as insurers will fall by 2.5%. However, Lawson argues that SIPP customers who go via non-insurance providers still pay 15% more tax on their fees than customers of Standard Life.