ChainWhat it assumes · how to break it
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The government raises the standard rate of VAT, for example from 20% to 22%.
1
As a result, the prices of most goods and services rise by roughly the same percentage for every household.
indirect tax
indirect tax
Assumes: Firms pass the tax on.
But: Where firms absorb part of the tax, the price rise is smaller.
2
This means lower-income households, who spend almost all of their income, pay a larger share of their income in VAT.
regressive tax · average propensity to consume
regressive tax · average propensity to consume
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Assumes: Poorer households spend most of their income on standard-rated goods.
Assumes: Poorer households spend most of their income on standard-rated goods.
But: Food, children's clothes and domestic energy are zero or reduced-rated, and these make up a large share of poorer households' budgets.
3
At the same time, higher-income households save more of their income, so VAT takes a smaller share of it.
saving ratio
saving ratio
Assumes: The tax is measured against current income.
But: Measured against lifetime spending, VAT is close to proportional, because savings are spent eventually.
4
Consequently, post-tax income falls proportionally more for poorer households.
post-tax income
post-tax income
Assumes: Benefits do not rise to compensate.
But: If benefits are uprated with inflation, poorer households recover part of the loss the following year.
End
Inequality in post-tax income widens.
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Questions this answers
- Explain why VAT is often described as a regressive tax.
- Assess the impact of raising indirect taxes on the distribution of income.
- Discuss the advantages and disadvantages of indirect taxes.
Diagram
Lorenz curve for post-tax income: the curve moves further from the line of equality.
Reverse and related
VAT cut → proportionally larger gain for poorer households.