After months of stasis under a caretaker prime minister, the UK finally has a new one, Liz Truss, and with her, a new chancellor of the exchequer in the form of Kwasi Kwarteng. For better or worse, this administration has promised to deliver sweeping reforms to UK finances. Cutting taxes to the tune of over £30 billion ($34 billion) was one of Truss’s flagship policies in the hard-fought leadership contest.
Given rising inflation and sky-high energy costs, the new cabinet must act quickly and decisively. A key measure reportedly in consideration for the upcoming “mini-budget” on Sept. 23 is a temporary cut to value-added tax.
The UK government is not alone in its plans to tinker with indirect taxation. As the entire European continent braces for a long, hard winter, many EU countries have axed VAT on energy. Some have gone a step further, with Germany renewing a cut to VAT on hospitality services into 2023, and Poland cutting VAT on food until the end of the year.
This raises some interesting questions. Why do governments tend to cut indirect taxes during times of economic hardship? How can they target these reforms for maximum efficacy? And crucially, what does this mean for businesses?
Why Are Governments Cutting VAT?
The last time the UK implemented a broad-brush cut to VAT, like the one reportedly under consideration by the Truss administration, was during the 2008 financial crisis. From November 2008 to January 2010, Chancellor Alistair Darling temporarily cut VAT by 2.5% to 15% in an effort to boost consumer spending.
Did his intervention prove effective? Not particularly. A 2010 ORC report found that four in five businesses passed the VAT cut onto consumers, but most felt it had little impact on shopper behavior.
However, this doesn’t mean that any intervention by the current government would be similarly ineffective. The situation in 2008 was very different from today’s crisis. For instance, we are experiencing almost the direct inverse in terms of energy prices—crude oil tanked to $43.44 per barrel at the turn of 2009 from $147.30 per barrel in July 2008. Plus, the previous cut of 2.5% falls short of the 5% or even 10% cut reportedly planned by Truss and Kwarteng.
How Are VAT Cuts Deployed?
When cutting indirect taxes like VAT, governments can take several routes. The first is a broad-brush approach in the form of a flat cut to VAT—applicable to all sectors. The second option is to be more targeted. For instance, we have already seen many EU countries axing VAT on skyrocketing energy bills. And some are considering further VAT cuts to keep down the costs of inflation-hit essentials like food, toiletries, cleaning products, and some clothing.
It’s also possible that governments will target specific sectors—such as hospitality, for example—to encourage spending on luxuries as consumers tighten their belts. In theory, governments will collect more VAT revenue long term if they can prevent hospitality businesses from closing. Job losses due to business closures also lead to lost income tax revenue and additional spending on unemployment benefits.
It is worth noting that cuts to VAT can have other welcome side effects, such as encouraging cross-border shopping. Commentators have speculated that a UK VAT cut would encourage shoppers from the Republic of Ireland (where VAT is 23%) to cross the border to Northern Ireland for their larger purchases, particularly in the run-up to Christmas. This would buoy economic activity in struggling Northern Ireland. The same principle would apply in continental Europe if large VAT discrepancies emerged between neighbors like Spain and Portugal or between Germany and Poland. There are reports of this already happening, with Czech shoppers going to Poland to take advantage of the VAT cut on foods.
What Does This Mean for Businesses?
Since VAT as a tax method essentially turns private businesses into tax collectors, any changes will directly impact their compliance and reporting processes. Examples of the so-called compliance burden include having to educate employees on changes, update and test systems, and correct errors. What’s more, it’s likely that UK businesses will have to move quickly to comply with any changes. Back in 2008, they were given just one week’s notice of the temporary VAT reduction.
The compliance burden is exacerbated for multinational businesses—particularly since it looks like EU jurisdictions will also implement a patchwork of temporary VAT cuts.
To prepare themselves, businesses must dedicate resources to monitoring any announcements regarding VAT. These can come thick and fast. For instance, Italy has previously given businesses just 24 hours to comply with a VAT change.
Businesses should also look at their internal VAT compliance and reporting processes. Can these be streamlined, outsourced, or automated? Do they have adequate in-house expertise across all relevant markets, or should they look to external partners for support? Short of having a crystal ball, engaging in proactive preparation is the best way to avoid getting caught out by any upcoming changes to VAT.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.