Here is a revision video on shaping an answer to a 25 mark essay question on the possible micro and macro economic effects of increasing VAT in the UK
Micro Point 1
One micro effect of 25% VAT would be to increase retail prices if suppliers opt to pass on VAT to consumers
A rise in VAT to 25% causes a pivotal inward shift of the supply curve and if demand is price inelastic, suppliers will then be able to raise price without a big loss of sales. This is shown in my analysis diagram.
However some firms will choose to keep their prices lower in an attempt to gain market share. This depends on how profitable they are. In an oligopoly for example, protecting market share is seen as a key objective.
Micro Point 2
Raising VAT to 25% might lead to a rise in inequality because of regressive effects on low-income families.
VAT overall tends to have a regressive effect. It takes 11% of the disposable income of households in the poorest 20 per cent of the income distribution but only 5% of the income of the richest 20 per cent of people.
However, this depends on whether there is any change to the scope of VAT. Children’s clothing and prescriptions are zero-rated and a decision for example to apply 25% VAT to private school fees might be seen as progressive.
Macro Point 1
A rise in VAT will lead to higher inflation and cause a fall in real disposable incomes – this might cause a slowdown in GDP growth and rising unemployment
Higher VAT makes things more expensive. A TV screen would increase from £649 to £676 and a pair of shoes would jump from £60 to £62.50. This will make life difficult for millions of families who are just about managing and cause a fall in confidence and spending.
This depends on whether the rise in VAT is seen as temporary or permanent and whether wages, pensions and other benefits rise in line with consumer prices.
Macro Point 2
A jump in VAT to 25% would increase tax revenue for the government and help to lower the fiscal deficit and eventually contribute to a lower level of national debt.
In the UK VAT brings in around 17% of total tax revenues each year. A rise in VAT would improve the government’s finances and allow them either to borrow less or perhaps spending more on improving public services such as the NHS or extra funding for education.
Instead of raising VAT to 25% the government might be better off widening the scope of VAT to include more items or focus instead on cutting VAT and corporation tax avoidance by businesses.
Some evaluation questions
Remember to come to a final judgement!
Some evaluation points worth considering:
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