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An immediate trimming of the rate of VAT has been recommended by the Centre for Economics and Business Research (CEBR) as means of strengthening the weak economy.
A new report from the think-tank suggests that the standard rate should be reduced to 12.5% 'at least until the end of 2009'.
Such a measure, says the document, would cost £24 billion gross - but the net cost would be much less and possibly nothing if the impact on fiscal confidence is sufficient to stop the recession from intensifying.
In theory, a cut of 5% would conflict with the VAT directive of the EU, which sets a lower limit of 15% on the standard rate. The CEBR report, however, points to para 59, which allows member states 'within certain limits and subject to certain conditions' to derogate from the directive.
VAT expert Neil Warren predicted that such a measure would create a minefield of problems.
'The aim is to try to reduce prices and encourage consumer spending — but what if retailers refuse to pass it on? Would they, for instance, reduce a £1 item to 96p to share the VAT reduction — and would such a small adjustment encourage consumers to spend more?'
Mr Warren added then highlighted another problem: a large proportion of VAT paid by one business is reclaimed by another as input tax, so the end result could be a VAT windfall for retailers but nothing for other businesses further down the supply chain.
'To give a simple example, all of the VAT paid by a manufacturer on his material costs is reclaimed as input tax, and any VAT he charges to his customers when he sells his goods will be reclaimed by them as well.
'It is only when goods are sold to members of the public or certain businesses that cannot reclaim VAT that a saving takes place.'
It is ironic, remarked Neil, that a VAT rate cut would benefit banks and financial institutions, which largely caused the credit crunch in the first place. They are unable to reclaim as input tax most of the VAT they pay on their costs, so a VAT saving would reduce the cost of their overheads.
The next movement in the standard rate should be upwards not downwards, said Neil, who has worked in VAT for 25 years.
'Movements have only been one way as modern economies recognise the benefits of taxing spending rather than incomes to encourage choice,' he noted.
'The great thing about VAT is that people don't realise they are paying it in many cases.
'I think that an increase in the rate of VAT to 20% should be the next move, possibly after the next General Election. It is about the only tax that the Government has not yet made a mess of in terms of policy, so it still has potential to raise more revenue in the future.'
