The VAT Increase – What does it mean and how can models help? On Tuesday this week (4th January), the VAT rate in the UK rose from 17.5% to 20%, causing many to debate its impact for three groups; the government, retailers and consumers. Figure It Out decided to take a look behind the numbers quoted in the news this week and investigate what the increase is likely to mean for each group and how they have used or could use modelling to help them through the change. What it means for the Government The Government has said that the 2.5% rise in VAT will raise more than £13bn a year for the UK economy during this government. Considering the budget deficit stood at approximately £155bn at the end of 2010, the VAT contribution would have tackled over one-third of the deficit by the next general election in 2015. There will be some negative knock on effects from an increase in VAT – otherwise there would be no debate – and the government will have drawn on a wealth of expertise to decide whether to raise VAT, especially when deciding what the new rate should be. The UK Government Operational Research Service supports strategic government decisions, such as the VAT rise, by using their modelling and analysis skills to forecast the effect of fiscal (and other) decisions on the economy. In order to predict the effect of a 2.5% rise in VAT and estimate how much revenue it will provide, it is not as easy as applying the new rate to current spending levels. An increase in VAT could sufficiently depress spending levels so as to negate the primary purpose of boosting treasury coffers to mitigate cuts elsewhere! A (much simplified) system dynamics model can illustrate that, although an increase in the VAT rate increases government revenue, it leads to a decrease in consumer spending, thus having a contradictory negative effect on revenue (note: the signs above the arrows in these diagrams show the correlation between linked variables). We can see that finding a balance in the VAT rate in seeking the optimum revenue level influences the VAT policy decision to further adjust the rate. The Government OR Service will have modelled more complex sets of data on retailer and consumer behaviour in order to make its prediction. For example, if many retailers were to absorb the increase, this may help to keep spending buoyant but would certainly affect the financial performance of retailers and hence their long term stability. What it means for retailers While the VAT rise should be good for the Exchequer, the Centre for Retail Research has predicted that retail sales will fall by up to £2.2bn in Q1 2011 compared to the previous year. This may appear to be huge but, as with most statistics, once you dig a bit deeper, you find that the headline doesn’t tell the full story. This figure compares Q1 2011 with Q1 2010, so the general decline in retail spending during the recession plays a big part in this fall. So, although this figure is being quoted as occurring ‘in the wake of the VAT rise’, it is certainly not entirely caused by it. That said, it is inevitable that retailers now face some tough decisions about how much of the increase to pass on to consumers, which prices to increase and when to implement the changes. Some retailers, for example, are implementing a ‘VAT freeze’ for a few months, in the hope that consumers won’t notice the increase if prices rise gradually. In fact, fewer than 1 in 5 retailers will pass on the increase straight away but 95% will do so within 3 months. There are also some added costs for retailers that consumers will not see – for example, even though VAT does not apply to most food products, the cost of transporting the food for retailers will increase with the rise in the cost of petrol (to which VAT does apply). At Capgemini, we have worked with a number of retailers to produce similar pricing models. Retailers can use the wealth of customer data they now have, along with cost and revenue data and some forecasting of future behaviour (household income, typical ‘basket’, spending patterns etc), to minimise the effect on profit whilst retaining their customers. What it means for consumers The VAT increase is predicted to result in an average increased spend of £212 per person per year in the UK. There has been lively debate between the government and the opposition party this week, with opinions from economists and journalists, about whether the rise in VAT is ‘progressive’ or not, i.e. whether or not it places the biggest burden on those most able to pay. The Government has asserted that it is progressive, as those with higher incomes spend more and will therefore pay more VAT. Labour claims, however, that as low earners have to spend a much bigger share of their income than high earners in order to meet their basic needs, the tax will actually hit them harder. While this debate goes on, each individual is faced with reviewing their own budget and spending patterns in order to make future decisions so that they can adjust to the VAT increase. By using comparison websites, consumers can research prices online for their essential products to get the best post-increase prices. They can also make some simple calculations to figure out what luxuries they can still afford, given that most luxury items are subject to VAT. The effects of the VAT increase on us all will become apparent over the next few years. Models can support organisations and individuals in making the most informed decisions under uncertainty and go a long way to mitigate the unpredictability in the economy. .