ICAEW prize winners suggest how to fix VAT

In 2024, as part of its How to fix VAT campaign, ICAEW launched the VAT prize, seeking proposals for research papers on how to reform the UK VAT system. Having submitted the winning proposal and collected the cash prize of £5,000, Cheryl Ong, Sze Teen Wong, and Anna Poh, have since presented their findings at a recent ICAEW conference and published a research paper. ICAEW’s Tax Faculty picks out some of the key points.

The problem with UK VAT

The UK has a multiple rate VAT structure under which goods and services may be:

• taxed at the standard rate of 20%;
• taxed at the reduced rate of 5%;
• taxed at the zero rate of 0%; or 
• exempt altogether.

The intended purpose of this rate structure is to make VAT less regressive. In simple terms, a tax is regressive where lower-income households spend a larger portion of their income on paying tax than higher-income households. The UK’s VAT system is designed so that essential items are free from VAT or subject to VAT at a lower rate.   

However, for this to work in practice, the tax savings must be passed on in price. According to the research paper’s authors, this is not the case: there is “overwhelming evidence that reduction in VAT rate is generally not fully passed on to consumers”. Further, even if rate reduction did lead to price adjustment, the authors believe reduced rates and exemptions are more likely to benefit higher income households as their consumption is higher in absolute terms.  

In addition to not working as intended, multiple rates and exemptions mean increased costs. First, there is the lost revenue for the government. It is estimated in the research paper that the UK collects only 49% of the VAT that would be paid if all goods are services were subject to the standard rate, costing it an estimated £97bn each year. Second, working out the VAT treatment of a supply can be complicated, giving rise to high administrative and compliance costs for the government and businesses.   

Lessons from overseas

Having identified the problem, the paper’s authors believe that the answer may be found overseas, in the modern broad-based, single-rate VAT regimes in New Zealand and Singapore. Based in Singapore, the authors are able to provide unique insight into the workings of Singapore’s Goods and Services Tax (GST) in particular.  

Singapore’s single-rate GST system applies a flat rate of 9% to most goods and services, making it simple to understand and apply, and works alongside the GST Voucher (GSTV) scheme to ensure that lower- and middle-income households receive appropriate GST offsets. The GSTV scheme has the following four components, with eligibility and reward determined by a range of factors, including annual income and property value:   

• GSTV – Cash. Cash is paid to lower-income Singaporeans each year.
• GSTV – MediSave. Singaporeans aged 65 and above receive an annual top-up to their national medical savings account. 
• GSTV – U-Save. Rebates are applied to the utility bills of lower- and middle-income households living in public housing each quarter; and
• GSTV – Service and Conservancy Charges rebate. An offset against the maintenance fees of eligible Singaporean households living in public housing each quarter.   

For the paper’s authors, “both New Zealand and Singapore demonstrate how a single-rate VAT system with limited exclusions can be achieved through careful policy design and comprehensive social benefits”.  

A plan for reforming UK VAT

Assuming that the goal is to solve the UK’s VAT issues without increasing or reducing net VAT revenues, the answer could be to broaden the UK’s VAT base by withdrawing exemptions and lower rates, and to use the additional VAT revenue raised to compensate lower-income households and/or middle-income households directly.  

The research paper estimates that a broad-based VAT rate of 18% would generate additional VAT revenue of £26.1bn. This could be used to fully offset the total annual VAT bills for households in the lowest four income deciles, or to cover the additional VAT payable by households up to and including the 9th income decile (plus generating a surplus of approximately £1bn).  

This is just one example, and the authors say that the VAT rate and the way in which the additional revenue is distributed could be “calibrated to meet the broader social and distributional goals of the government”. The VAT rate could be reduced as low as 15% without a drop in VAT revenues.  

The authors acknowledge that this would represent a significant change and that the government may need to take action to reduce the impact on affected suppliers, workers and consumers. For example, suppliers of goods and services that are reduced-rated currently would need to consider whether to raise prices or absorb the additional cost, perhaps cutting jobs to protect profits. Transitional measures, such as phasing in the changes over a number of years, could be put in place to soften the blow. 

The authors say that the call for reform is “clear and strong”. Although the journey to change may be “arduous”, it is not impossible if public support can be won and if stakeholders are consulted on and involved in the design of the new VAT regime. The authors believe this is a journey worth taking as “comprehensive VAT reform, properly designed and implemented, can enhance both efficiency and equity in the UK tax system”.     

Financial services

The paper looks separately at the challenging issue of financial services. In common with most countries, the UK exempts financial services from VAT due to difficulties in ascertaining the value-added component of the supply. The research paper notes that this gives rise to several problems, including: 

• “tax cascading issues”. As irrecoverable input tax may become embedded in the value of exempt financial services, “tax on tax” may arise when customers use the financial inputs to make taxable supplies; 
• economic distortions. Financial institutions may be incentivised to use in-sourced services rather than out-sourced services to minimise the costs of irrecoverable input tax; and
• substantial compliance costs as businesses struggle with complex input tax attribution and apportionment calculations. 

Again, the paper’s authors look to New Zealand and Singapore for inspiration, with some success. For example, in what the authors describe as a “novel move to alleviate compliance costs for banks”, Singapore uses industry-wide statistics to compute and prescribe an annual fixed input tax recovery rate for banks, with a different rate for each banking licence type. However, all options for reform would have pros and cons and the UK government would need to weigh up all the possible implications before deciding on a way forward.  

Why this research matters

Ed Saltmarsh, ICAEW Technical Manager – VAT, commented:  

“This research prize was launched to spark fresh thinking on how to fix UK VAT, and Cheryl, Sze Teen, and Anna have delivered exactly that. Their paper offers a bold yet practical vision for reform, grounded in international experience and supported by detailed modelling. While any change to the VAT system must be carefully managed, the case for simplification and improved equity is compelling.” 

“It is of course important to recognise that the UK and Singapore have very different economies, social structures, and public expectations. However, the Singaporean model does provide valuable lessons – particularly in how a broad-based, single-rate VAT can be paired with targeted support for lower-income households. The challenge for the UK would be to adapt these principles to our own context, ensuring that any reform is sensitive to the needs of UK households and businesses, and that appropriate compensatory mechanisms are in place.”

“ICAEW looks forward to continuing the conversation with policymakers, businesses, and the public on how best to take this forward.”