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6 January 2022

David Gauke

Tory MPs and Labour want to cut VAT on domestic fuel – they’re wrong

Cutting taxes on fuel would be inconsistent with any serious attempt to lower carbon emissions.

An unlikely alliance is forming between the Labour Party and Conservative MPs sceptical about the government’s net zero objective. The issue on which they are uniting – and where they may well succeed in forcing the government’s hand – is scrapping VAT on domestic fuel.

The case for the policy is straightforward. Come the spring, the country will face a substantial cost-of-living squeeze. Inflation is expected to be around 6 per cent and energy prices, in particular, will be rising fast. The energy price cap will have to be lifted, likely to increase household costs by £500 a year.

At the same time, tax increases, including the rise in National Insurance contributions announced in September last year to fund additional health and social care expenditure, are due to take effect, costing a typical household £600 a year.

If the cost of living is increasing because of rising taxes and rising energy prices, the argument goes, an obvious response would be to cut taxes on household energy bills and scrap the 5 per cent VAT on domestic fuel – at least temporarily. This would save a typical household £90 per year. The cost to the Exchequer is not negligible (it would have cost £1.7bn last year) but should not result in the Chancellor breaking his fiscal rules (particularly if it’s only “temporary”).  

The spring, of course, is also politically important because it is the run-up to the May local elections which, if they go badly for the Conservatives, might trigger an attempt by Conservative MPs to remove Boris Johnson as party leader and Prime Minister. It would be no surprise if Johnson gave MPs what they want.  

In this event, Labour will claim victory, as will Conservative backbenchers. The government will boast that it is doing all it can to be on the side of hard-pressed energy consumers while also pointing to a benefit of Brexit (we could not reduce VAT on domestic fuel below 5 per cent as a member of the EU). This would be a more substantial policy than putting a crown stamp on a pint glass.

It is hard to see who will oppose the policy. So let me do so.

There are three objections to cutting VAT on domestic fuel in terms of policy coherence.

First, if we are worried about the poorest not being able to pay for their fuel bills, there are much better targeted policies than cutting VAT for everyone. For example, we could give the poor more money by increasing the generosity of Universal Credit and pension credit. Cutting VAT will mean that, in cash terms, those households with large houses will usually benefit the most.

Second, such a policy would be inconsistent with any serious attempt to lower carbon emissions.  

Those pushing for a VAT cut from the Conservative benches are generally sceptical about the government’s net zero requirement. Their argument is that the net zero target is an elitist project with little democratic legitimacy that will impose costs on the British public. From previous experience, they believe that there is a rich political seam to mine here.

At one level, they have a point. Governments and opposition parties rarely acknowledge that net zero will come with costs. This will, at some point, result in a backlash and that backlash may be imminent.

If we are serious about reducing carbon emissions, however, we should put a price on carbon. This would encourage consumers to reduce their carbon emissions and encourage investors to invest in low-carbon alternatives.  

One does not have to be a hardcore climate pessimist to believe this is a sensible approach. Even Bjørn Lomborg, who argues in his 2020 book False Alarm that the risks of climate change are generally overstated, believes that a carbon tax is necessary.  

To work properly, a carbon tax should be consistent across various forms of activity. The problem here is that domestic fuel is, compared with other forms of carbon-emitting activities such as manufacturing and driving, already under-taxed. As the Institute for Fiscal Studies says, domestic fuel – even with a 5 per cent rate of VAT – is “effectively subsidised”. Abolishing VAT would increase that subsidy and make our approach to carbon taxes even less coherent. (So much, by the way, for Labour’s climate change credentials if they are outflanked by Lomborg.)

Third, cutting VAT on domestic fuel would open up a debate on VAT rates that will only result in one of our more efficient and better-designed taxes becoming much more complicated.  

I pity future tax ministers who will face a long queue of industry bodies arguing that the answer to any particular problem requires a reduced or zero rate of VAT for their particular sector. Once upon a time, ministers could happily dismiss most of these calls by pointing out that their hands were tied by EU rules. This is no longer the case, and a cut in VAT on domestic fuel will make it harder to resist the lobbying.

VAT works best when it is broad-based. In future, the VAT tax base will face constant pressure to be narrowed with a multiplicity of rates. Our tax system will become yet more complex.

There may well be a happy cross-party consensus in cutting VAT on domestic fuel in the spring. The political logic may be irresistible. But, as a rational and coherent policy response to rising energy prices, it would be a mistake.

[See also: Politicians must tell the truth: we all need to use less energy for the climate]

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