By Diego Zuluaga
The Leave campaign carried the day in the EU referendum by promising to “take back control.” On an individual level, this is unambiguously an appealing prospect – who wouldn’t want to be the master of one’s own destiny? But when it comes to issues of public policy, the motto has as its corollary a troubling question: control to whom, of what, and for what?
In the case of Brexit, taking back control means that more decisions are made democratically, meaning that majorities impose their will on dissenting minorities. If most of the public were altruistic, well-informed and prescient, then democratic decision-making might be appropriate on as wide a range of issues as some Leavers advocate. But in most circumstances, at least one of the necessary conditions – favourable incentives, information and foresight – is missing. In those situations, democratic control means a greater likelihood of curtailing the efficient operation of markets; enacting policies which benefit majorities and special interest groups at the expense of the less well-organised and influential; and the erosion of the rule of law.
VAT policy is a case in point. Value-added tax is a type of consumption tax levied from producers at each stage of production, and ultimately paid by consumers of the final outputs. EU membership requires member countries to levy such a tax, and it imposes a floor on the standard rate of VAT. The EU also limits the scope of exemptions for particular goods deemed worthy of a tax subsidy, and it requires transnational agreement to alter those rules. This means, of course, that the UK qua EU member cannot unilaterally decide to breach those rules.
Brexit eliminates those strictures, leaving the UK free to introduce VAT breaks on a wider set of goods and services. What is more, post-Brexit exemptions may be more narrowly defined, against the mostly general definitions in the EU’s existing list of exempt goods, which presumably aim at preventing the use of narrow descriptions to protect favoured sectors and domestic industries. Consider, for instance, the relative effects on consumption from exempting ales from VAT but applying the full rate to German and Italian lagers. (The UK’s system of alcohol taxation is complex enough as it is.)
Pro-Brexit commentators have for some time been fomenting this sort of discriminating attitude, whereby favoured goods – notably tampons – would be freed from value-added tax. And the general public appear to be largely on their side. Alas, as with an increasing number of questions of economic policy, the majority of the public is wrong.
To be considered desirable, a tax must meet two tests: efficiency and equity. The efficiency test asks whether the tax raises revenue in the least distortive way – do people behave more or less the same as they would without the tax? The equity test concerns whether the burden of the tax is distributed fairly among taxpayers. Of course, fairness is a subjective concept and we often disagree precisely on what is fair, but in discussions of tax policy equity is generally taken to mean a proportional distribution of the burden among income brackets: the rich should generally pay more tax than the poor, and at the very least the poor should never pay more as a share of their income.
Does a tampon exemption meet the above criteria? Let’s start with the efficiency test. Assume a simplified VAT system in which all goods are taxed at a general rate, and it is proposed that tampons be exempted. Provided that we wish to raise the same revenue with and without the tax break, a tampon exemption means the general rate applied on all other goods will have to increase. The effect is to raise the retail price paid by consumers for all other goods, which will reduce demand for them.
This means that there are willing buyers and sellers who, without the tax hike, would have beneficially exchanged money for goods and no longer do. It’s what economists call the deadweight loss from taxation. The size of the loss increases with the tax rate at accelerating speed, meaning that the deadweight loss from a higher rate on all goods other than tampons will not be fully offset by the exemption on tampons. And this is assuming that all consumers are identical – all buying tampons and other goods in similar quantities – which is evidently not the case in the real world.
How about the equity test? There is no reason to believe that tampon use increases with income, although – as is the case with most other goods – expenditure may well increase with income as better-off women buy more expensive brands. But bear in mind that the chief argument for a tampon tax break focuses on affordability: tampons shouldn’t be out of anyone’s reach. Yet, the proposed tax break is undiscriminating as far as income is concerned: all women get it, and what is more, the greater one’s tampon expenditure, the greater the benefit from the VAT break because it is a proportional tax. So, the tampon exemption may not be inequitable per se, but it is a rather crude way of making this product more affordable to those of limited means.
A more surgical approach would be to establish how much an individual – or a household – would need to afford all basic necessities, and to give them a cash sum equal to the difference between that amount and what they currently earn. Milton Friedman first proposed such a negative income tax as a way to raise the welfare of the poor without the bureaucracy, paternalism and inefficiency of existing policies of price regulation and tax subsidy.
As things stand, however, it looks like one of the side-effects of post-Brexit democratic control will be the enactment of silly and counterproductive policy trinkets. Talk about the freedom to err.
Diego Zuluaga is Financial Services Research Fellow at the Institute of Economic Affairs.