VAT increase may yet deliver on targets

Whatever the financial impact of indirect tax increases, psychologically it always helps if you feel you have a choice as to whether you incur a tax or not. How real that choice is when essentials such as clothes, petrol or diesel for the car are considered is debatable. In fact 49% of all goods and services traded in Ireland are covered by the standard rate of VAT. Nevertheless it still just feels better when you open your pay packet and it has not been depleted again. And while the Government has come in for some criticism, there is actually a reasonable chance that the VAT increase will be successful in raising the revenue targeted by the Government while not unduly impacting on the average consumer.

Ireland in line with EU on rates
From an international perspective Ireland, with a 23% standard rate of VAT, is surprisingly not that far out of line with the average standard VAT rate of 20.7% across the EU and with its extensive zero rating of essentials, such as food and medicine, the State actually compares favourably with most EU members on the general VAT burden.

Following the increase, the Irish VAT rate will be the third highest in the EU after Sweden, Denmark and Hungary which each have rates of 25%, followed by Romania with 24%. Ireland will share the third highest rate with Poland, Finland, Greece, Portugal and Italy.

In increasing its standard rate of VAT, Ireland is following suit with the UK which recently increased its rate to 20% from 17.5%. Interestingly while the UK dropped its standard VAT rate by 2.5% when the financial crisis hit in 2008 to stimulate spending, it has now effectively increased it again by 5% over the course of the crisis. Looking to the other debt burdened economies Greece has increased its rate from 19% to 23%, by the end of this year Portugal will have gone from 20% to 23%, Spain has increased its rate from 16% to 18%, while in Italy it is proposed to increase its VAT rate from 20% to 23% by the end of next year. The prevailing wisdom across Europe just now is that increasing indirect taxes is preferable to increasing direct taxes when it comes to the impact on consumer confidence and on balance I believe this is a correct assessment.

For those complaining about the increased VAT rate at 23%, and too young to remember, a glance back at the rates which were in force in the last recession provides some context. In 1983, the “low” rate of VAT was actually 23% and the standard rate was 35%. Looking further back to the 1970s there were VAT rates as high as 40% on electrical goods.

As far as the current increase is concerned it is likely that many retail businesses will absorb the costs of the increase rather than try to pass it on. The rate increase represents only €20 on a spend of €1,000 so its effect on the average weekly household spend is unlikely to be noticeable to all but the most hard pressed. Take an average shopping basket and the effects are even lower because of the zero rate of VAT attaching to most essential food items. Even if half of the shopping was liable to VAT at the standard rate, which is probably an over-estimation, given that the majority of it will be spent on food the change in VAT rate will add only €2 to a shopping bill of €200 if it is actually passed on in full by the retailer.

There is therefore a reasonable chance that the Government will succeed in collecting the additional VAT revenues in excess of €600m which it has targeted from this VAT increase. Combined with the sense of relief many taxpayers will have with incurring no reduction in take home pay, the overall tax take could even exceed this target. All of this is, of course, subject to the giant elephant in the room - which is finding some sort of solution to the Euro crisis. Far from VAT increases, the Euro crisis is the single biggest issue for business and consumer confidence alike. Until this is resolved uncertainty will reign, the banks will be unable to function properly and saving and lack of investment rather than spending will persist as a severe damper on the economy.

A more surprising aspect of the Minister’s statement perhaps was that the Government would not increase the standard VAT rate during the life of this government. While this was probably intended to give comfort and visibility to hard pressed households it obviously rules out a significant source of additional revenue for the Government and will, as a consequence, reduce the scope available to the Government to steer away from direct taxes such as income taxes.

How are exports affected?
The one bright star in the economy, at present, is the level of exports from the country. The good news is that apart from service businesses exporting to private consumers and service businesses that cannot recover all of their input tax, such as those supplying financial services, there will be minimal impact on exports arising from the VAT rate change. For the two specific categories of business just mentioned the rate change will go straight onto the price of services or reduce the businesses margin by €20 per €1,000 in sales or costs respectively. For businesses selling services to consumers abroad, on the internet for example, the increase in VAT rate may make Ireland less attractive as a location from which to deliver these services in the short term. However, changes to the VAT rules due in 2015 will eliminate this disadvantage because from then on the VAT will be paid at the rate and to the Government of the Member State in which the consumer is located.

Summary
On balance, and given its limited options, the increase in the VAT is probably the right move for the Government and is likely to deliver the targeted revenues. If the Euro crisis could be resolved there could be a major bounce in confidence for consumers and business which might result in an even greater return for the exchequer from this measure. This would provide breathing space for the Government on income tax and other direct charges while we wait for fairer economic weather which might provide growth in the economy.

This article first appeared in the Sunday Business Post on Sunday January 1 2012.