VAT policy and sustainability

All this means there is a big decade ahead for the UK’s VAT system and an opportunity to help shape the way forward. One of the key developments is likely to be the opportunity for UK VAT policy to be used to help drive the environmental and sustainability agenda.

The UK government has a commitment to bring all greenhouse gas emissions to net zero by 2050 and as world leaders convened from 1 November for the UN Climate Change conference (COP26) it is clear that climate protection is at the forefront of world leader’s minds.

With the UK now outside EU law for the purposes of developing tax legislation, the country has new flexibility to use VAT as a lever to influence environmental change with an increased focus on sustainability.

Can VAT be used to change behaviour?

Ultimately VAT is a tax on consumption. Therefore, it is logical to assume that VAT has the potential to influence consumer behaviour and align incentives with global sustainability goals.

From a VAT perspective there has been limited change in policy across the EU regarding sustainability.  This is partly because the EU VAT infrastructure does not allow much room for radical diversion by individual member states to pursue their own policies.

The UK’s withdrawal from the EU on 31 January 2020 presents the UK with the legal freedom to introduce its own approaches to changing historic UK VAT legislation. This flexibility has already influenced social policy and, for instance, facilitated the successful abolition of VAT on women’s sanitary products, the so called ‘tampon tax’, which was not possible while the UK was aligned with the European VAT Directive. 

Given the weight of political will towards producing a better sustainable environment at COP26, could this flexibility give the UK government a unique opportunity to use VAT to influence sustainable actions?

What practical measures could be implemented?

The use of VAT to stimulate sectors of the economy and meet policy goals is not a new concept. By zero rating the sale of electric vehicles (EVs) in 2001 and eliminating import duties, the Norwegian government was able to push EVs sales to a 77.5% market share in 2021.

As achieving purchase price parity is widely considered the key benchmark to bringing down barriers to buying a new EV, could it be possible to artificially tip purchasing price parity in favour of the EV by reducing or abolishing VAT on EVs in the UK, giving rise to world leading consumption of this more sustainable mode of transport?

Could VAT penalise polluting behaviour?

A formidable barrier to deploying wide-spread zero-rating for sustainable practices is that VAT and other indirect taxes make up 29% of UK government revenue. It would simply not be feasible to forgo significant sources of this revenue without seeking compensatory alternatives.

In the same way, certain goods are set aside for reduced VAT rates; in future we may see business activities with significant environmental impacts primed for a higher ‘pollution penalty’ rate of tax.

As an example, the EU has previously considered the adoption of Damage and Value-Added tax (DaVAT). This concept proposed a shift from VAT to DaVAT, whereby goods and services are allocated different tariff rates according to their environmental impact assessed over their life cycle.

However, a major caveat of this approach for UK tax policy is its complexity and potential administrative burden. For instance, would UK businesses be willing and able to undertake complex procedures for a greener future?

What other indirect tax policy options could/will be used?

Although VAT is undoubtedly an important driver of change, the greatest results are often gleaned from a collaborative approach utilising indirect and other sustainability taxes in tandem to spread the burden of compliance between consumers and businesses. 

To target manufacturers, a plastic packaging tax (PPT) will be introduced for large businesses, taking effect on 1 April 2022. PPT will be levied on finished packaging predominantly containing plastic made up of less than 30% recycled plastic.

The Environmental Audit Committee has also recently suggested a review of carbon border adjustment mechanisms (CBAM). CBAM broadly places an extra charge on goods manufactured in countries with less stringent emissions policies, cracking down on carbon leakage and the sustainability of imported goods. Such a divisive mechanism places the onus of sustainability firmly in the hands of high emission exporters trading with the UK.

These alternate environmental taxes aim to encourage both UK and international businesses to opt for more sustainable development strategies by penalising poor environmental practices and incentivising sustainable behaviours. The difficulty will arise in selecting which sectors will be affected by these regimes, and how international trade relationships and manufacturers will adapt.

What next?

Regardless of the method of implementation, it will be essential for any sustainability driven reform of the UK tax system to send a clear message to consumers and be simple to adhere to for business. At the same time, governments will no doubt be conscious that they must balance encouraging sustainable behaviour with the maintenance of tax revenues.

With the commencement of COP26 and the policies that may arise as a result, this moving landscape will likely develop over the coming weeks. EY believes that VAT has the potential to be included in upcoming policies as an impactful lever to encourage change to consumer behaviour.