Taxing the many products and services that are at present zero- rated could raise almost pounds 18bn a year. It would go a considerable way to plugging the hole, but would start a firestorm of controversy.
Even so it is a solution that has its advocates, principally those who argue it is a more efficient way of boosting revenues than raising direct taxes, since it does not undermine incentives to work and save.
Moreover, Britain has fought to retain, under European Community rules, a system of zero-rating for a broad range of expenditure (see table). It imposes VAT on a smaller proportion of consumer spending than any other member country apart from Ireland.
In March, Norman Lamont, then Chancellor, began to bridge the gap between Britain and the rest of the EC by levying VAT on domestic fuel and power.
That decision has prompted protests from the old and the poor alike, on a scale not seen since the uproar over the poll tax. Yet, once implemented, the UK will be taxing only about 60 per cent of consumer spending, far less than almost every other country in Continental Europe.
But there are downsides to this solution. VAT on domestic energy will raise some pounds 2.6bn a year by 1995-6, but the price is not only lost popularity. The uproar has prompted the Chancellor to promise a compensation package for low- income groups that the Institute of Fiscal Studies estimates would cost some pounds 900m.
Extending the VAT base would also put upward pressure on prices, a delicate decision in view of this week's inflation rise to 1.8 per cent.
In theory, the Treasury could raise pounds 17.6bn by levying standard- rate VAT on all zero-rated consumer spending. But the IFS believes the final yield might amount to only pounds 11bn, because Treasury figures take into account neither the impact on demand, nor the need to offset the effect of taxing essential spending with increased benefits for the poor.
A further pounds 7.4bn could come from removing the exempt status of a wide range of services. But many of these are public services, while others present serious administrative problems in tax collection. So in practice, Kenneth Clarke, the Chancellor, has only a limited number of options.
His main targets are thought to be newspapers, magazines and books, which the Treasury has long wanted to subject to VAT. This would raise pounds 1.1bn. But a high-profile campaign, 'Hands off Reading', has already sounded the alarm, both on the economic effects and the potentially negative impact on learning and literacy.
A coalition of newspapers, magazine and book publishers, readers and librarians has commissioned some independent research into the impact and this is likely to give Mr Clarke pause for thought.
A Price Waterhouse study expects regional and national newspapers to shed 2,500 jobs and predicts 20 per cent of regional titles could fold. It says some national titles could also be threatened. Another survey, by BDO Binder Hamlyn for the Periodicals Publishers Association, warns that 4,200 jobs could be lost as some 1,700 magazines go to the wall.
The National Books Committee says that applying VAT to books would reduce sales by 5 per cent, while raising perhaps only pounds 270m revenue annually.
'No one really knows how much it would raise,' said Tim Hely Hutchinson, chief executive of the book publisher Hodder Headline. 'But we think it could be as little as pounds 100m at the end of the day. We don't think that's worth it, given the extra administrative costs it is going to mean.'
Alternatively, the Chancellor could turn to international passenger transport, chiefly air fares, which might generate a more substantial sum - possible as much as pounds 1bn.
Although British Airways has run a strong campaign against the idea, warning it could lose 500,000 passengers, this target might carry the lowest political cost.
It would be far more controversial to extend VAT to domestic passenger transport. This could yield pounds 1.15bn at the full rate of 17.5 per cent, but would probably trigger a political storm, given that fares are set to rise anyway. The prospect of rail privatisation also raises the possibility of further increases in future. Such a tax would also provoke the green lobby, which would argue that it would drive people off public transport and into cars.
The Chancellor has few other options. Full-rate VAT on children's clothes would raise pounds 600m but might be construed as running counter to John Major's 'family values' theme. VAT on water and sewerage would yield pounds 800m. But charges are rising in any case owing to large-scale capital investment plans by the water companies.
Then there is the VAT 'exempt' area. Here, unlike with zero rating, companies cannot reclaim VAT they pay. This sort of spending is usually excluded from VAT either because it is difficult to administer or because the Government is the supplier of the product.
This sector offers few realistic opportunities for raising revenue. Rent, education, health and postal services seem politically off-limits. Betting and gaming are already subject to hefty duties which raise pounds 1.1bn, although exempt from VAT. And experience elsewhere in the EC has shown the difficulty of levying VAT on financial services and insurance - a potentially rich source of revenue that would raise an estimated pounds 3.3bn.
Extending the VAT base would also throw up additional headaches for Mr Clarke - principally inflation. The Central Statistical Office estimates that levying VAT on, say, newspapers, books and magazines at the full standard rate would add about 0.25 points to the retail price index. VAT on international passenger transport adds 0.52 points, because of the heavy weighting on foreign holidays. Domestic transport adds 0.35 points while the (unlikely) option of levying a reduced rate of 8 per cent on food adds a full point to the index.
The Chancellor could also raise the standard rate by 1 per cent and leave the base unchanged. This would yield a hefty pounds 2.53bn in a full year but add about half a point to the RPI.
All in all, Mr Clarke might find it easier to look to direct taxes after all. Personal allowances cost the Treasury a whopping pounds 24.9bn a year and new restrictions, hitting high earners, might have a much lower political cost.
THE VAT BILL
Food pounds 7.2bn
Construction of new dwellings pounds 1.8bn
Domestic fuel and power pounds 2.6bn
Domestic passenger transport pounds 1.15bn
International passenger transport pounds 1bn
Books, newspapers and magazines pounds 1.1bn
Children's clothing pounds 600m
Water and sewage services pounds 800m
Drugs and medicines on prescription pounds 500m
Supplies to charities pounds 200m
Ships and aircraft above a certain size pounds 500m
Vehicles and other supplies to disabled pounds 150m
Potential revenue gained from levying VAT at 17.5 per cent on expenditure currently zero-rated
Source: HM Treasury
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