DEBATE: Should we cut VAT on energy bills?

Andy Mayer and Professor Philip Booth

January 10, 2022

Andy Mayer, COO and environment, energy and infrastructure analyst at the Institute of Economic Affairs, argues YES

Reducing the rate of VAT on domestic energy bills from 5 per cent to zero is a good idea.

No, it will not solve the underlying issues, including the government’s utter failure to plan for our continued reliance on gas. Nor is it even that generous, making perhaps a £60-£100 difference to each household. But it is progressive: energy makes up a greater share of the expenditure of poorer households, plus it is politically possible, with support from left and right.

This is not to say it is ideal. Libertarians prefer low taxes and, if we are obliged to have them, simple ones. In 2010, Reform proposed putting all goods and services on the standard rate but they were met with hostility given it would make many ‘essentials’, including food and children’s clothing, more expensive. Removing ‘zero-rating’ is also a non-starter as some things, for example charitable donations, will always be exempt from VAT.

Some see the ‘reduced’ rates (whether 5 per cent or zero) as a ‘subsidy’ on fossil fuels, and contrary to Net Zero plans. But VAT isn’t a good substitute for a carbon tax. Gas and renewables now provide roughly equal shares (at 40 per cent of generation), and while gas dominates heating (at 85 per cent), this is due to the inadequacy of alternatives, not VAT.

Domestic demand is inelastic – we don’t turn the boiler up to 25° and leave the lights on when prices fall – and so the impact of VAT rates on energy use is contestable. The real climate incentives problem is the host of extraction taxes, regulations, and charges hidden in bills. These are the serious simplification challenge, not VAT.

Environmental economics requires an understanding of trade-offs. VAT on energy bills are a weak environmental signal and strong cost of living measure. Lower energy prices benefit us all, and while the long game is supply side reform enabling a secure affordable low carbon transition through markets, zero-rating energy VAT or scrapping the reduced rate entirely would help right now.

Professor Philip Booth,  Senior Academic Fellow at the Institute of Economic Affairs, argues NO

The UK has a very complex tax system. One aspect of that complexity is multiple rates of VAT. Charging VAT at only 5 per cent on domestic energy bills represents a subsidy on carbon emitting fuels when other damaging policies are being used to reduce emissions. This is very bad policy.

Why is this tax concession a subsidy? VAT is intended to be a general tax on consumption. An exemption from VAT for an energy source reduces its relative price compared with that of other goods in the same way that a subsidy would. In general, therefore, tax exemptions, or tax expenditures, are regarded by economists in the same way as subsidies.

In 1993, the Conservative government proposed charging VAT at the full rate, then 17.5 per cent, on domestic fuel. A rate of 8 per cent was to be charged from April 1994 and 17.5 per cent from 1995. In December 1994, the government lost a vote in the House of Commons and the rate was held at 8 per cent.

In the following election, in 1997, the Labour Party had relatively few specific promises, but one of them was to lower the rate of VAT on domestic fuel to 5 per cent (the lowest rate allowed by EU rules). Interestingly, in the 1997 Labour Party manifesto, the paragraph immediately following the proposal to reduce VAT on domestic fuel, stated, with no sense of irony:

Taxation is not neutral in the way it raises revenue. How and what governments tax sends clear signals about the economic activities they believe should be encouraged or discouraged, and the values they wish to entrench in society. Just as, for example, work should be encouraged through the tax system, environmental pollution should be discouraged.

Putting aside the fact that reducing VAT would be an expensive way of making little impact on living costs, subsidising things and then finding ways to discourage their consumption, as happens with domestic energy, is just policy madness. The IEA has long promoted neutral and flat taxes. The government should increase, not reduce, VAT on domestic energy use.

Author

  • Andy Mayer is Chief Operating Officer and environment, energy and infrastructure analyst at the Institute of Economic Affairs. Professor Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham.

Written by Andy Mayer and Professor Philip Booth

Andy Mayer is Chief Operating Officer and environment, energy and infrastructure analyst at the Institute of Economic Affairs. Professor Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham.

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