How indirect taxes can be regressive and progressive Office for National Statistics
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Summary Previous analysis by the Office for National Statistics of the redistributive effects of indirect taxes, showed they were both regressive and progressive, depending on whether the distributions of households were ranked according to their disposable income, or their expenditure. Using data from the same source (Living Costs and Food Survey) this article shows that these findings are consistent over time by providing similar analysis for the period 2001/02 to 2008/09. In the household income distribution method (where households are ranked from lowest to highest disposable income), households with lower income pay, on average, a higher proportion of their income in indirect taxes than households with higher income in this instance indirect taxes are regressive. However, when using the household expenditure distribution method (where households are ranked from lowest to highest expenditure), households with higher expenditure tend to pay a higher proportion of their income in indirect taxes than households with lower expenditure this is progressive. It is important to remember, when comparing the results between the two methods that the households which make up the quintile groups in the income distribution do not necessarily sit in the same quintiles as those in the expenditure distribution. The highest income households (the top quintile group in the income distribution) are therefore not necessarily also the highest spending households (the top quintile in the expenditure distribution). Similarly the lowest income households (those in the bottom quintile of the income distribution) are not always the same households as the lowest spending households (the bottom quintile of the expenditure distribution). Context In 2008/09 UK households paid on average 4,741 per year in indirect taxes (taxes that are paid on items of expenditure, such as VAT see Background Notes for a full definition) which represented 16.7 per cent of the average household disposable income (Figure 1). This was a slight fall from 2001/02 1 when the figure stood at 18.9 per cent. However, between 2001/02 and 2007/08 indirect taxes as a proportion of disposable income were relatively stable, falling by only 1.2 percentage points over the six year period. It was in the 12 months to 2008/09 that there was a more pronounced fall of 0.9 percentage points, reflecting changes to the VAT rate (which are discussed further below). 1 During the transition between the Family Expenditure Survey and the Expenditure and Food Survey small changes in interview methodology resulted in increases in the estimates for average household income. This analysis therefore starts in 2001/02. For more information see the 2002/03 Expenditure and Food Survey Technical Manual. Office for National Statistics 1
Figure 1 Household indirect taxes as a proportion of disposable income of all households United Kingdom Percentages 20 18 16 14 12 10 8 6 4 2 0 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 Source: Living Costs and Food Survey, Office for National Statistics Table 1 shows the percentage change in average household disposable income, expenditure and indirect taxes in the UK over the period and illustrates the changes in these headline measures between 2001/02 to 2007/08 compared with the 12 months to 2008/09. Table 1 Percentage change in average household disposable income, expenditure and indirect taxes of all households, 2001/02 to 2008/09 United Kingdom Percentages Years 2001/02 to 2007/08 2007/08 to 2008/09 Total change Disposable income 7.6-0.9 6.6 Expenditure 1.7-0.4 1.3 Indirect taxes 0.6-6.1-5.6 Source: Living Costs and Food Survey, Office for National Statistics Between 2001/02 and 2008/09 average household disposable income increased by 6.6 per cent, while average household indirect taxes decreased by 5.6 per cent over the same period. It is important to note, though, that between 2001/02 and 2007/08 average household indirect taxes increased by 0.6 per cent therefore the sharp decline in indirect taxes can largely be attributed to the 12 months to 2008/09 and the changes to the VAT rate. Office for National Statistics 2
Indirect taxes Indirect taxes and the income distribution When households were ranked according to their equivalised disposable income the effects of indirect taxes were regressive throughout the period 2001/02 to 2008/09 when expressed as a percentage of disposable income (Figure 2). Figure 2 Household indirect taxes as a proportion of disposable income by quintile (income distribution) United Kingdom Percentages 35 30 25 20 15 Bottom 2nd 3rd 4th Top 10 5 0 2001/02 2003/04 2005/06 2007/08 2008/09 Source: Living Costs and Food Survey, Office for National Statistics In 2001/02, households in the bottom income quintile group paid 34.4 per cent of their disposable income in indirect taxes, compared with 13.9 per cent for households in the top income quintile, a ratio of 2.5 to 1. In 2007/08, households in the bottom income quintile group paid 31.3 per cent of their disposable income in indirect taxes, compared with 13.3 per cent for households in the top income quintile, a ratio of 2.4 to 1. In 2008/09, households in the bottom income quintile group paid 28.2 per cent of their disposable income in indirect taxes, compared with 12.8 per cent for households in the top income quintile, a ratio of 2.2 to 1. Office for National Statistics 3
The fall in the ratio over the period 2001/02 to 2008/09 from 2.5 to 2.2 was because the proportion of disposable income paid in indirect taxes for the bottom income quintile fell faster than that of the top income quintile. However, for both quintiles, around half the total falls over the period occurred between 2007/08 and 2008/09. Therefore when measuring indirect taxes as a proportion of disposable income using the income distribution, indirect taxes were slightly less regressive in 2008/09 than they were in 2001/02. Indirect taxes and the expenditure distribution However, when households were ranked according to their equivalised expenditure the effects of indirect taxes were progressive throughout the period 2001/02 to 2008/09 when expressed as a percentage of disposable income (Figure 3). Households in the top expenditure quintile paid almost five times as much indirect tax (in cash terms) as households in the bottom expenditure quintile in 2008/09. In the same year the households in the top expenditure quintile received over three times as much disposable income as those in the bottom quintile and spent over six times as much as those in the bottom. Figure 3 Household indirect taxes as a proportion of disposable income by quintile (expenditure distribution) United Kingdom Percentages 35 30 25 20 15 Bottom 2nd 3rd 4th Top 10 5 0 2001/02 2003/04 2005/06 2007/08 2008/09 Source: Living Costs and Food Survey, Office for National Statistics Office for National Statistics 4
Households in the top expenditure quintile therefore paid a higher proportion of their disposable income in indirect taxes, than households in the bottom quintile. In 2001/02, households in the top expenditure quintile paid 19.5 per cent of their disposable income in indirect taxes, compared with 14.5 per cent for households in the bottom quintile, a ratio of 1.3 to 1. In 2007/08, households in the top expenditure quintile paid 19.1 per cent of their disposable income in indirect taxes, compared with 12.1 per cent for households in the bottom quintile, a ratio of 1.6 to 1. In 2008/09, households in the top expenditure quintile paid 18.4 per cent of their disposable income in indirect taxes, compared with 12.1 per cent for households in the bottom quintile, a ratio of 1.5 to 1. Using the expenditure distribution there was a slight increase in the ratios from 1.3 to 1.5 over the period 2001/02 to 2008/09. This is because the proportion of disposable income paid in direct taxes for the bottom expenditure quintile fell more than the top expenditure quintile. However, as can be seen in Figure 3, all the fall in indirect taxes as a proportion of disposable income for the bottom expenditure quintile came in the period 2001/02 to 2007/08 (a fall of 2.4 percentage points) whereas in the 12 months to 2008/09 there was no change. For the top expenditure quintile, although there was a smaller decline in the period 2001/02 to 2007/08 than households in the bottom quintile, in the 12 months to 2008/09 this decline continued (0.7 percentage points). Therefore when measuring indirect taxes as a proportion of disposable income using the expenditure distribution, indirect taxes were slightly more progressive in 2008/09 than they were in 2001/02. As noted earlier it is important to remember, when comparing the results between the two methods that the households which make up the quintile groups in the income distribution do not necessarily sit in the same quintiles as those in the expenditure distribution. This is illustrated in Figure 4 which shows the disposable income and expenditure of households by quintile when ranked by the income distribution (the disposable income and expenditure of those households which make up the quintiles in Figure 2). The figure shows that in 2008/09 average household disposable income among households in the bottom income quintile was 10,130 while the same household s expenditure was 13,285. Office for National Statistics 5
However, further up this quintile distribution, disposable income was higher than expenditure. Similar results were provided in previous ONS research as well as analysis by the Institute for Fiscal Studies (2006). The ONS research considered how high expenditure households (where expenditure was greater than twice the level of their disposable income) funded their expenditure. Using 2007/08 data from the LCF it was found that, among these households, 53 per cent chose at least one of the eight possible options from the survey. Savings were the most common resource indicated used for sustaining expenditure (32 per cent), followed by overdraft (19 per cent) and credit/store card debt (15 per cent). Loans from other sources and loans from friends/relatives were next, chosen in 12 per cent and 11 per cent of the cases, respectively. Figure 4 Household disposable income and expenditure by quintile group, 2008/09 United Kingdom Average per household ( per year) 60000 50000 Expenditure Disposable income 40000 30000 20000 10000 0 Bottom 2nd 3rd 4th Top Quintile group 1 1 Households have been ranked by equivalised disposable income Source: Living Costs and Food Survey, Office for National Statistics This implies that those households at the bottom of the income distribution sustained their expenditure with resources that were additional to their income, such as making use of savings, using credit/overdrafts or borrowing. It might also reflect the fact that some of these households were only temporarily at the bottom of the income distribution (maybe as a result of recent unemployment), while maintaining their expenditure at a constant level. Office for National Statistics 6
VAT The largest element of average indirect taxes paid by all households in the UK is VAT. From 1st December 2008 the Government dropped the standard rate of VAT from 17.5 per cent to 15.0 per cent. Despite this change only contributing to the last 4 months of data for 2008/09, the level of VAT paid by households in this 12 month period fell from an average of 2,107 2 per household in 2007/08 to 1,997 in 2008/09. As VAT forms such an important part of household indirect taxes (approximately 40 per cent), when it is considered as a proportion of disposable income by the two distributions, it shows a similar pattern to those in Figures 2 and 3. VAT and the income distribution When using the income distribution, VAT is regressive, so households with lower income paid a higher proportion of their disposable income on VAT than households in the top income quintile. In 2001/02, households in the bottom income quintile group paid 13.0 per cent of their disposable income in VAT, compared with 6.1 per cent for households in the top income quintile, a ratio of 2.1 to 1. In 2007/08, households in the bottom income quintile group paid 12.1 per cent of their disposable income in VAT, compared with 5.9 per cent for households in the top income quintile, a ratio of 2.1 to 1. In 2008/09, households in the bottom income quintile group paid 10.8 per cent of their disposable income in VAT, compared with 5.8 per cent for households in the top income quintile, a ratio of 1.9 to 1. VAT and the expenditure distribution When the expenditure distribution is used, VAT is progressive, so households with higher expenditure paid a higher proportion of their disposable income in VAT than households with lower expenditure. 2 Data have been adjusted to 2008/09 prices using the implied household final consumption expenditure deflator. Office for National Statistics 7
In 2001/02, households in the top expenditure quintile paid 8.9 per cent of their disposable income in VAT, compared with 4.7 per cent for households in the bottom quintile, a ratio of 1.9 to 1. In 2007/08, households in the top expenditure quintile paid 8.8 per cent of their disposable income in VAT, compared with 4.1 per cent for households in the bottom quintile, a ratio of 2.1 to 1. In 2008/09, households in the top expenditure quintile paid 8.7 per cent of their disposable income in VAT, compared with 4.1 per cent for households in the bottom quintile, a ratio of 2.1 to 1. Indirect taxes can therefore be considered regressive under the income distribution method and progressive under the expenditure distribution method. This is because households at the bottom of the income distribution have, on average, higher expenditure than disposable income, as can be seen in Figure 4. Therefore these households use resources other than just income to finance their spending. Given that indirect taxes are levied on expenditure, rather than on income, referring to the income distribution emphasises the effects of indirect taxes on low-income households. The expenditure distribution method however reduces the burden of indirect taxes on the lower part of the distribution, as households are ranked according to their spending rather than on their income. There is also evidence which suggests that indirect taxes may have become less regressive between 2001/02 and 2008/09 when using the income distribution and slightly more progressive over the same period using the expenditure distribution. Office for National Statistics 8
Background Notes Distributions In this analysis households are ranked according to their equivalised disposable income or their equivalised expenditure (less council tax). Equivalisation Equivalisation is used in producing the two household distributions used in this analysis as it takes account of different household size and composition in survey samples. The equivalence scale used is the McClements scale. Indirect taxes Indirect taxes include VAT; duties on alcoholic drinks, tobacco, petrol, oil, betting; customs (import) duties; motor vehicle duties; air passenger duties; insurance premium tax; driving licenses; television licenses; stamp duties; Camelot - payments to National Lottery Distribution Fund, and estimated Intermediate taxes. Quintiles After households have been ranked according to their equivalised disposable income or equivalised expenditure they are then grouped into groups of equal size thus groups containing 20 per cent of households are referred to as quintile groups. As noted, in the two methods in this analysis the same households are ranked by two separate distributions equivalised disposable income and equivalised expenditure and split into quintile groups. The table below shows the proportion of UK households belonging to each of the possible combinations of quintiles within these two distributions. Further investigation into the characteristics of households within each of these subgroups is planned by ONS for 2011. Percentage of households in income and expenditure quintile groups, 1 2008/09 United Kingdom Quintile groups of households ranked by equivalised INCOME Quintile groups of households ranked by equivalised EXPENDITURE Percentages Bottom 2nd 3rd 4th Top Total Bottom 9 5 3 2 1 20 2nd 6 6 4 2 1 20 3rd 3 5 6 4 2 20 4th 1 3 5 7 5 20 Top 0 1 2 5 11 20 Total 20 20 20 20 20 100 1 The table shows that 9 per cent of households were in the bottom expenditure quintile and the bottom income quintile, 5 per cent of households were in the second expenditure quintile and the bottom income quintile, and so on. Source: Living Costs and Food Survey, Office for National Statistics Office for National Statistics 9
References Brewer, M. Goodman, A. Leicester, A. (2006) Household spending in Britain what can it teach us about poverty? An Institute for Fiscal Studies publication for the Joseph Rowntree Foundation. Carrera, S. (2010) 'An expenditure-based analysis of the redistribution of household income' Economic & Labour Market Review, vol 4, No. 3, March, Office for National Statistics. Office for National Statistics 10