Background

The UK’s value added tax (VAT) was introduced in 1965 at the time of the UK;s ad mission into what was themn the European Economic Community (the EEC), which became the European Union (EU).

In terms of tax collected, VAT is the UK’s third largest tax, raising revenues of £162.1 billion in 2022-23 tax year, which sum represented eighteen per cent of all UK tax collected by HM Revenue & Customs[1].

How the UK’s VAT is charged

As far as the UK is concerned, VAT is fundamentally an EU tax which is operated in the UK. There are local choices on matters such as tax rates, and more freedom after Brexit, but in essence little has changed with regard to the management of this tax since Brexit took place.

Value added tax (VAT) can be applied to a supply of goods and services in the UK in one of four different ways. Three involve a charge to VAT being added to the value of the supply made at differing rates[2]:

Unsurprisingly, the standard rate of VAT is applied to most goods and services.

The reduced rate of VAT is applied to domestic energy supplies and some other supplies deemed essential e.g., sanitary products and children’s car seats.

Zero rating applies to food, children’s clothing and some other items, mainly related to charitable activities.

A VAT-registered business (which is in broad terms one making VAT-chargeable supplies of more than £85,000 a year) has to add these charges to the sums it bills its customers and pay over the sums collected to HM Revenue & Customs. It has some recompense for doing so: it is permitted to reclaim from HMRC the cost of VAT charged to it (which means that, in effect, zero-rated businesses and their customers are in receipt of a tax subsidy).

The fourth category of charge that can apply to the goods and services that a business might supply to its customers is VAT exemption. When a business supplies VAT-exempt goods and services, then there is no VAT charge added to the charge that they make. Superficially, this looks similar to supplying VAT zero-rate goods and services. It does, however, differ because a business making VAT-exempt supplies cannot reclaim the VAT charged to it in the course of its trade.

VAT exemption applies to a range of goods and services including:

• Land, although this is a complex area. Domestic rents are, for example, VAT exempt whereas commercial rents can be subject to VAT.
• Almost all insurance transactions are exempt from VAT, but many are subject to Insurance Premium Tax instead.
• Postal services provided by the Royal Mail are VAT exempt, but other equivalent services are not.
• Education and training when provided by an eligible body like a school, college or university is VAT exempt, but most that is supplied by for profit organisations e.g., professional training courses, is not.
• Most supplies of financial services are exempt from VAT but those such as bookkeeping and accountancy, debt collection, management consultancy and some investment and almost all finance and taxation advice are usually not. Banking and pension services are the main beneficiaries of this exemption.
• Health and welfare. Healthcare is a complex area for VAT. Exempt supplies include those provided by a qualifying institution like a hospital, hospice or nursing home as well as health services provided by registered doctors, dentists, opticians, pharmacists and other health professionals.
• Investment gold is exempt from VAT.
• Some sports activities are exempt, but like education this exemption largely applies to sport and related education services supplied by certain eligible bodies.
• Gaming, including betting and gaming, bingo, and lotteries are normally exempt from VAT, although the rules are complex.
• Some admission charges to public and other bodies are exempt subject to specific conditions.
• Qualifying events held by charities are VAT exempt.
• Funerals are VAT exempt, as are a range of other items of less significance.

Problems with the UK’s VAT system

There are a number of problems with VAT, of which by far the largest is that VAT is a regressive tax. A regressive tax is one where as a person's income increases the amount of that tax that they pay reduces in proportion to that income even if it increases in absolute amount, i.e. their percentage tax rate falls as their income goes up. The Institute for Fiscal Studies dispute this, because the compare VAT paid with a person’s consumption and not income, but they are technically wrong to do so[3]. By definition, since VAT is a regressive tax it is one that favours the wealthy.

This bias is exacerbated by some of the exemptions available within the VAT system. In particular, exemptions for financial services and private education strongly favour the spending patterns of the wealthiest in UK society.

If the Taxing Wealth Report 2024 was a comprehensive review of the failings of the UK tax system more radical reforms of the UK’s indirect tax system[4] might be proposed, including the possibility of creating a progressive indirect tax charge on total financial flows through a person’s or entity’s bank accounts, but there are so many immediate reforms that might benefit the UK within the existing system that more radical reforms of this sort are not being presented in this report.

As a result, just two reforms to the UK’s VAT system to make that tax more progressive are proposed. The first is to remove the VAT exemption on the supply of financial services, which it is estimated might raise £8.7 billion in tax a year, and to remove the VAT exemption from the UK’s private schools, which it is suggested might raise £1.6 billion in tax revenues a year.

Detailed proposals made

1. Abolishing the VAT exemption for financial services within the UK might raise £8.7 billion of additional tax revenue per annum.
2. Abolishing the VAT exemption for services supplied by private schools might raise £1.6 billion in tax a year

Footnotes

[1] Based on table A5 here: https://obr.uk/download/economic-and-fiscal-outlook-november-2023/?tmstv=1701349270

[2] https://www.gov.uk/vat-rates

[3] See https://www.taxresearch.org.uk/Blog/2019/05/27/the-institute-for-fiscal-studies-continues-to-spread-falsehoods-on-vat/ and associated links.

[4] I.e. taxes not directly charged on income.