The End of Tax-Free Shopping in the United Kingdom

The VAT Retail Export Scheme

From the 1st of January 2021, international shoppers are no longer able to claim a VAT refund from purchases made in the United Kingdom that they take with them on leaving. The previous VAT Retail Export Scheme allowed foreign customers to receive a partial VAT refund on goods which are to be exported outside of the UK/EU. HM Treasury has argued that as well as the loss in VAT receipts, the scheme has been expensive to administer and has favoured London over provincial businesses. They suggest that the move will save £400m by 2024, adding that keeping the scheme in place would cost the taxpayer an extra £900m as Brexit would force the UK to extend the offer to EU nationals, who are currently excluded.

There has been recent controversy over the decision to cancel this scheme, partly on the grounds that London will lose its competitive advantage compared to other major tourist capitals. In addition there will be a substantial net loss of tax revenue; and a detrimental impact on London jobs and businesses as a result. Many MPs and CEOs of leading retailers including Harrods and Selfridges plus industry bodies including The Walpole Group and The New West End Company have written to the Chancellor questioning the decision. They claimed ministers have overestimated the cost of extending the schemes to EU visitors by “at least 300 per cent” and underestimated the number of current users of the scheme by “at least 400 per cent”. Looking to the near future of the post-pandemic economy, what would have been the best decision for the Government to have taken?

Impact Assessment

The effect of making overseas visitors pay the full VAT on their purchases in the UK is essentially the same as increasing prices. This results in two tiers of consequences, primary and secondary. The former concerns how much more revenue the Treasury receives from retaining the VAT on the relevant goods. The latter is the knockon effect of the loss of tax revenue from hospitality and travel due to the decline in visitor numbers. The factors which contribute to the new market equilibrium are examined from the supply(producers) and demand(consumers) points of view.

The Primary Impact

There are four possible direct consequences which may arise from the withdrawal of the scheme, which are in brief:

• Companies may decide to absorb the VAT in order to maintain competitive prices.
• Customers may be able to negotiate larger discounts with companies as a result of high gross margins on most of the goods purchased .
• Customers may be inclined to ship purchased products home rather than bringing it with them,
  meaning that they do not have to pay VAT.
• Customers may choose not to buy at the higher price or buy elsewhere.

The VAT refund scheme is considered by key luxury brands to be critical in attracting high spending visitors to the UK. Therefore, it is possible that the extra tax charge associated with purchasing these high-value products such as fashion or jewellery may put retailers at a disadvantage when it comes to persuading consumers to buy. Within the luxury goods market, most items are sold at high margins. Since products are sold in comparatively low quantities, they must make higher profits on each product sold. Therefore, producers may ‘absorb’ the extra 20% tax rather than pass the costs off to consumers and suffer huge drops in demand, thus keeping the price the same but taking a reduction in profit. This may be compensated for by a greater volume of sales or by increasing prices in other markets, especially those with currencies relatively strong compared to the pound.

Another possibility of the effects that arise from the VAT scheme removal, is that companies, especially those within the designer and luxury market, will extend further discounts to customers. Offering a discount is a popular selling strategy in this sector so there is an option for companies to extend further discounts to their customers to compensate for the VAT. This achieves the same effect as absorbing the VAT into their price except is just a different marketing strategy. These two possible consequences should result in a similar demand rates for products, but there will be a visible decline in margins for companies and VAT receipts for the Treasury on the lower retail selling price charged.

An exception to the rule is that clients can still claim a refund on products which are shipped home, although customers will generally prefer the “instant gratification” of immediate access to their purchases. However, this will allow some UK companies, most likely those that deal with large products such as cars, to maintain international price competitiveness.

The final option happens when none of the above are plausible. The law of supply and demand states that there is an equilibrium at which the two factors will balance. In this scenario, the added tax will effectively shift the supply curve of luxury goods to the left, meaning the quantity of the product decreases. Specific to London, Paris is the main European competitor for luxury and designer shopping. If international tourists decide to visit Paris where a TVA (VAT) refund scheme still operates, instead of London there will be profound economic consequences.

Economic Impacts

According to the Centre for Economics and Business Research, 128,000 jobs would be put under threat and a fall of over £6 billion in retail sales could result from the implementation of this tax change. The net impact on tax receipts will depend on the sales achieved and price charged. Changes in sales revenue will depend on the elasticity of demand with respect to price changes. Veblen (1899) argued that the status value of luxury items suggested that price increases could actually grow demand as items would seem more exclusive and desirable. However, in an age of transparent communication via the Internet and almost perfect competition between rival destinations (such as that in internet related industries like Amazon and E-bay), this concept would seem to no longer apply.

The equilibrium on the first example is initially at 88 units at a price of $10, yet when a $6 tax is imposed, the demand only drops to 80 units, equivalent to a price of $8. The second example shows that when the same tax is in effect there is a fall in demand from 80 to 50 units. In both cases the shaded area shows the tax revenue with the upper part being that effectively paid by the consumer and the lower by the brand. The more price inelastic demand for the good, the less effected the quantity is when there are price fluctuations. However, if the good is elastic then a small change in price will result in a larger change in quantity. In a report by International Retail, they estimate that the Gross Value Added (GVA) or in other words the output, will be reduced by £9.3 billion, resulting in a potential 138,423 jobs lost. This is because there is an estimated 31% reduction of tourists (4.96 million people), with a further reduction of £6 billion spent by these visitors. Overall, International Retail estimate that after any gains from the removal of the VAT Retail Export Scheme, total tax revenues for the government are likely to be £3.5 billion lower. Conversely, in a House of Lords debate, Lord Ed Vaizey suggested “If the scheme is kept and extended to EU visitors it could create 20,000 jobs and generate £1bn of retail sales.” The cost of supporting the additional long term unemployed also needs to be counted. Any impact assessment at this stage is bound to be speculative, but the evidence suggests that the Treasury’s modelling of tax revenue may not have taken sufficient account of all the relevant factors, especially the secondary impact on the hospitality and entertainment sectors of a decline in visitor numbers.

Is London’s future threatened?

The relative attraction of shopping destinations has traditionally been evaluated using gravity modelling, to visually demonstrate the reasons behind trade flows of different locations – largely based on economic size and physical distance between the two units. However, in the age of the Internet this has become less feasible. Moreover, whereas most purchases are made on a local basis, the luxury consumer operates within a global marketplace. Thus, a different economic theory needs to be drawn upon. Porter’s Generic Strategies examines a firm’s competitive advantage in terms of three aspects:

• The product, consumer, and service focus.
• The differentiation in terms of facilities and experience.
• The value in terms of market-pricing.

This theory can be applied to competing cities in the luxury market – London, Paris, New York, Shanghai, and others. London, along with every other city, has suffered greatly from the COVID-19 pandemic, with a 9.9% GDP decline in 2020 alone. However, London has been losing its appeal as a luxury shopping capital for a number of further reasons. Recently, the pound reached $1.39 and €1.15 since Britain’s effective vaccination programme has provided hope for a faster than anticipated economic recovery. This, however, makes it more expensive for international tourists to shop in the UK. Furthermore, the UK’s transport and shopping infrastructure is aging and is less appealing than other international leaders such as Paris or Milan. Finally, with many shops either going bust or remaining closed due to lockdown, there is very little experiential appeal.

Harrods, Selfridges and many other smaller boutiques pride themselves on the experience they offer to international tourists each year, but they have been unable to fully operate since the beginning of the pandemic, which raises questions as to how they are going to be able to win back the tourists who have not visited in over 18 months. Therefore, in addition to the dire situation that the UK retail market is in right now, the loss of the VAT Retail Export Scheme can only worsen the situation.