A number of necessary goods in the UK have zero VAT and an analysis of applying a flat rate of 20% tax on such commodities should be conducted in terms of welfare. A value added tax [VAT] is a percentage tax on value added at each stage of production. However, price elasticities of demand of such commodities, which is the absolute value of the percentage change in quantity demanded to the percentage change in price (Rosen and Gayer, 2014), ought to be taken in consideration to assess improvements in efficiency and greater inequality. A Pareto improvement in welfare can occur if there is some action that can be taken to improve the utility of one individual without worsening the situation of the other. Efficiency, in this context, would refer to the loss of welfare above and beyond the tax revenues collected or the excess burden.
Imposing a VAT would cause a shift of the supply curve from S to S1, which would then change the equilibrium point of the market from (Q*, P*) to (Q1, P1). This occurs for both figures 1 and 2. However, the efficiency differences reside within a lower deadweight loss when demand for the commodity is inelastic when compared to the demand being elastic. The deadweight loss is indicated in the shaded area of the triangle. A price elastic demand for a commodity would create a bigger behavioural response to the tax as a result of a larger decrease in quantity demanded in figure 2 compared to figure 1. Consumer tax burden in figure 1, of an inelastic demand would, however be larger than the producer’s, this is the opposite in figure 2.
Linear and nonlinear commodity taxes attempt to address the progressivity and regressivity of tax policies. Figure 3 presents impacts of different tax systems on income tax paid. As commodity VAT taxes are consumption taxes, they are deemed regressive to lower income households. This is because as the propensity to consume decreases with the rise in income, lower income families spend a larger proportion of their income on necessities and consumer goods (Carlson, 1989, pp. 339). Intuitively, exempting food and necessities is one way to reduce the regressivity of the tax system. However, a study in Japan concluded that even though an exemption of VAT on such necessities under both a tax credit and subtraction method reduced the tax burden across all incomes, it did not reduce regressivity (Tamaoka, 1994). Yet, this argument is weaker when consumption is considered from a lifetime view, if people consume all their earnings at some point in their lifetime (Mirrlees, 2010, pp. 275-422).
Adam Smith’s Four Canons provide a basis into the assessment of changes to the UK taxation of commodities (Rosen and Gayer, 2014). Efficiency in this context would refer to the tax policies ability to enforce small costs of collections and avoid distortionary effects on taxpayers. Measures such as the inverse elasticity rule would regard that for efficient taxation the ratio of the tax rates applied to two commodities should be inversely proportional to their elasticities. The second canon of equity, which attempts to address rising inequality is fairness with respect to contributions. Cross price elasticities are also taken in account through Ramsey’s rule, which states that efficient taxes would be set such that the percentage reduction in the quantity purchased of each good would be the same (Atkinson, 1976).
In production efficiency, it would be optimal not to affect the prices of goods and services used in production—such that there should not be taxes on transactions between producers within a supply chain. Atkinson and Stiglitz (1976) note that it may be better to address equity concerns through the benefit and income tax system, where it exists, than through commodity taxation. This could suggest an argument for the commodity tax system to be neutral, which could avoid the inefficiencies linked with tax exempt goods. Mirrlees Review proposed several reforms to the UK tax system, one of which addressed how broadening of VAT for a flat-rate tax can be carried out in a non-regressive manner (Mirrlees, 2010, pp. 216-230). It was found that applying uniform rates to commodities would increase consumer welfare through a decreased distortion of their spending choices. Although its reform package would raise the cost of living, certain compensations through the direct tax and benefit system would be distributionally neutral and would not worsen work incentives.
A Hall-Rabushka flat tax is, in essence, a modified VAT, yet takes advantage of its administrative convenience. It would comprise businesses paying a flat rate VAT on their sales minus any purchases from any other firm and also subtracting their wage payments to employees. There would also be a family-level exemption, which would allow for some degrees of progressivity, yet raising the same amount of revenue as a standard VAT would. An important element is that capital income and corporation profits are not taxed (Rabushka, 1985). It has strong investment incentives considering consumption taxes do not put taxes on investment.
Atkinson and Stiglitz (1976) work on uniform commodity taxation suggests that upon the possibility of the government redistributing income through income taxation, and if the “utility function is weakly separable between goods and leisure”, then commodity taxes to be optimal should be uniform. Production efficiency findings by Diamond and Mirlees (1971) contribute to these findings in a way that suggests a progressive (non linear income taxation system) is enough for inequality measures and redistribution. Governments should keep the commodity market efficient. However, a reexamination of these studies presents that if the production side of an economy is taken into consideration, a Pareto improvement in welfare is still possible under nonlinear commodity taxation and a nonlinear income tax system (Naito, 1999).
Assessment of tax commodities in the UK may not only reside within its impacts on welfare in terms of its price elasticities but also in terms of efficiency. Hall Rabushka and reforms in Mirrlees Review provide some possible implementations to decrease the regressivity of current tax systems. Their findings are supported by Atkinson and Stiglitz, yet, may lack further research into the role of production efficiency in commodity taxation.
References
Atkinson, A., & Stiglitz, J. (1976). The design of tax structure: Direct versus indirect taxation. Journal of Public Economics, 6(1-2), 55-75. doi:10.1016/0047-2727(76)90041-4
Diamond, P., & Mirrlees, J. (1971). Optimal Taxation and Public Production I: Production Efficiency. The American Economic Review, 61(1), 8-27. Retrieved January 11, 2021, from http://www.jstor.org/stable/1910538
Carlson, G., & Patrick, M. (1989). ADDRESSING THE REGRESSIVITY OF A VALUE-ADDED TAX. National Tax Journal, 42(3), 339-351. Retrieved January 11, 2021, from http://www.jstor.org/stable/41788804
Naito, H. (1999). Re-examination of uniform commodity taxes under a non-linear income tax system and its implication for production efficiency. Journal of Public Economics, 71(2), 165-188. doi:10.1016/s0047-2727(98)00052-8
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Mirrlees, J. A. (2010). Value Added Tax and Excises. In Dimensions of tax design: The Mirrlees Review (pp. 275-422). Oxford: Oxford University Press. Retrieved 2021, from https://www.ifs.org.uk/mirrleesreview/dimensions/ch4.pdf
Rabushka, A., & Hall, R. E. (1985). The route to a progressive flat tax. Cato Journal, 5(2), 465-480. Retrieved 2021, from https://www.cato.org/sites/cato.org/files/serials/files/cato-journal/1985/11/cj5n2-6.pdf
Rosen, H. S., and T. Gayer. 2014. Public Finance. 10th ed. Maidenhead, UK: McGraw Hill Education.
Tamaoka, M. (1994). The Regressivity of a Value Added Tax: Tax Credit Method and Subtraction Method – A Japanese Case. Fiscal Studies, 15(2), 57-73. doi:10.1111/j.1475-5890.1994.tb00197.x