ChainWhat it assumes · how to break it
Start
The government raises the standard rate of VAT, for example from 20% to 22%.
1
As a result, each pound spent on standard-rated goods raises more tax, and VAT is one of the government's largest sources of revenue.
tax revenue
tax revenue
Assumes: Spending holds up after prices rise.
But: Higher prices reduce quantities bought, especially of price elastic goods, which erodes part of the gain.
2
This means revenue is fairly reliable, because VAT is charged on most spending and is hard to avoid.
broad tax base
broad tax base
Assumes: Firms comply.
But: Some VAT goes uncollected through evasion and errors (the VAT gap), especially among small firms.
3
At the same time, higher prices cut real incomes and AD, so growth slows and income and corporation tax receipts grow more slowly.
multiplier
multiplier
Assumes: The fall in AD is small.
But: In a recession, raising VAT can deepen the downturn, so other tax receipts fall and benefit spending rises.
4
Consequently, the deficit narrows, though by less than the headline yield of the tax rise.
budget deficit
budget deficit
Best link to attack
Assumes: The extra revenue outweighs the lost growth.
Assumes: The extra revenue outweighs the lost growth.
But: This depends on timing: in a strong economy the deficit narrows almost by the full yield; in a weak one the gain may be small.
End
The budget deficit narrows.
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Questions this answers
- Assess whether raising VAT is the best way to reduce a budget deficit.
- Discuss the macroeconomic effects of fiscal austerity.
- Evaluate the use of indirect taxes to raise government revenue.
Diagram
No standard diagram. Figures for VAT receipts as a share of total revenue make good evidence.
Reverse and related
VAT cut → receipts fall → deficit widens.