Back to base on VAT: Peter Torday reports on the Chancellor's revenue-raising options for balancing the budget

THE prospect of a pounds 50bn public sector borrowing requirement has placed the issue of tax increases firmly on the political agenda. It is not a question of whether, but when. Given the Tories' aversion to higher direct taxes (on incomes) the burden is expected to fall on indirect (spending) taxes, chiefly VAT.

Few inside or outside the Government believe that the mushrooming PSBR will be fully reversed as recovery sets in. The respected Organisation for Economic Co-operation and Development, for instance, estimates that Britain's structural budget deficit - that portion of the shortfall not directly attributable to the impact of recession - amounts to perhaps pounds 15bn.

Given the scale of the problem it seems that the Treasury will have little alternative but to widen the base of VAT, which covers just 60 per cent of consumer spending, one of the narrowest VAT bases in the European Community.

Although John Major declared a year ago that there was no need and there were no plans to widen the VAT base, no other potential source of indirect taxation would deliver the revenues the Treasury now believes it needs.

The VAT-free base is divided up into VAT-exempt categories of spending and goods and services that are zero-rated. (Companies which suffer VAT can claim back from the Customs and Excise VAT that they themselves incur on their purchases. Companies producing exempt goods cannot reclaim VAT they pay; companies producing zero-rated goods can).

Zero-rated goods offer by far the greatest potential source of revenue and are the most practical target. They include food, domestic fuel and power, construction of new dwellings, passenger transport, books, newspapers and magazines, children's clothing, water and sewerage services and prescription drugs.

In total, the Treasury believes that the extension of VAT to these goods would raise pounds 17.8bn, compared with the present VAT yield of pounds 38bn.

The list itself shows how politically difficult any extension might be. Moreover, there are practical obstacles. The Treasury's estimates of the additional revenue may be optimistic. The Institute of Fiscal Studies believes that if all zero-rated goods and services were taxed at the 17.5 per cent standard rate, the Treasury would gain some pounds 11bn, partly because the Treasury figures do not take into account the impact on demand of such an unprecedented expansion of the VAT base and partly because it assumes uninterrupted spending growth. In Tax Reform for the Fourth Term, published last autumn, the IFS also argues that because many of these items include essential expenditure for poor families, the imposition of VAT would have to be offset by higher benefit spending, or higher income tax allowances, to mitigate the regressive nature of widening the VAT base.

Unfortunately, that is not an option open to the cash-starved Treasury. Indeed the long-term Conservative goal is more likely to be an assault on benefits paid equally to everyone rather than those in need. It seems more probable, therefore, that the Government will opt for a limited extension of the base, concentrating on the high revenue-yielding areas of spending such as food and energy.

Imposing VAT on new houses would crucify an already deeply damaged building industry, and raises the problem of whether old houses should be taxed too. We impose VAT on new washing machines, but not on old ones. As Paul Baker of the IFS points out, taxation of housing is thus difficult because of its durable nature. One option would be to put VAT on the notional rent that owners receive, but this is also an administrative nightmare.

Taxing passenger transport is also complicated by government hopes for the privatisation of British Rail. Applying VAT to water may have to await the introduction of metering throughout the country. Children's clothing and drugs have the same disadvantages as food and energy, with the added drawback that they would yield low amounts of tax at the cost of making any Chancellor look like Scrooge.

But one strong candidate for VAT is the newspapers, books and magazines category, which would raise pounds 1bn in a full year and which Nigel Lawson unsuccessfully tried to introduce in 1984. The political argument against such an extension is that it might unite the high-minded classes who believe that there should not be a tax on reading with powerful and Tory-supporting press proprietors like Rupert Murdoch and Lord Rothermere.

Whether Norman Lamont and the Treasury will propose a high- yielding tax this March on domestic energy or food (generating at most some pounds 9.5bn) seems more uncertain, however. The Prime Minister, backed by some right- wing ministers, thought to include Michael Portillo, Chief Secretary to the Treasury, has hinted that tax increases in March might derail the slight signs of recovery that have begun to appear. Mr Lamont and the senior Treasury officials who are pressing for higher taxes may therefore fail on this occasion.

But the Treasury will have another opportunity in December when, under a recent reform by the Chancellor, public spending and taxation measures will be brought together in a single new Budget statement. By then, it is hoped, the recovery will be sufficiently entrenched to withstand a rise in taxes.

EC rules meanwhile provide the Treasury with an opportunity to soften the blow. Community states have agreed to maintain a minimum standard rate of 15 per cent for the next four years while providing for two reduced rates, at a minimum of 5 per cent, on any of the zero-rated categories. The Treasury could thus open up the way to a significant source of tax revenue without provoking too much opposition. (The option of a higher luxury rate no longer exists after EC governments last year agreed to abolish them).

The Treasury could in theory also target exempt categories of spending. These include land, insurance and financial services, postal services, betting, education, health and welfare, sports and works of art. But many of these present obvious intrinsic difficulties. And financial services, potentially a lucrative source of revenue, are exempt from VAT under EC law.

Despite the risk of political uproar there are sound reasons for widening the VAT base. The economic case is based on the principle that a wider VAT base would generate a more efficient allocation of resources. If goods are differentiated by the absence or imposition of taxes, consumers are likely to switch their spending for tax reasons rather than for the intrinsic value of the goods or services in question. This same argument also applies against the introduction of multiple VAT rates.

More broadly, widening the base would bring Britain into line with the rest of Europe, where the average amount of consumer spending covered by VAT ranges between 70 per cent and 75 per cent.

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