Jaffa Cake Economics

How a classical legal case explains the problems with VAT

The Jaffa Cake is one of the nation's favourite biscuits. Or is it a cake? Everyone knows the story of how a court was forced to decide what is the legal test for a cake and what is the test for a biscuit. However, what fewer people know is the reason why the Tax Tribunal in 1991 had to decide to make this decision. The answer: value-added taxes. In the UK, chocolate-covered biscuits must pay 20% VAT, but chocolate-covered cakes don’t pay any. So, the difference between this product being a cake or a business could literally make or break the business. 

The economic basis behind this decision to tax chocolate-covered biscuits and chocolate-covered cakes at different rates most likely won’t make sense to the laymen, but that’s fine because it doesn’t make sense to economists either! VAT, in theory, is a very good tax, because it is taxed at every stage of production where value is added. This means it is very easy for the taxman to trace ensuring that avoidance and evasion are extremely difficult and it does not distort the activities of corporations given it applies equally to all resources. However, where the VAT base only applies narrowly, then these benefits largely fade away.

Sadly this problem is not limited to the Jaffa Cake but haunts almost every area of the economy. Under the EU’s 2006 VAT directive, it is mandatory that things like gambling products, currency land acquisition and many others are tax-free. The reason for this? When the Directive was passed some countries held powerful special interest groups who would have been upset had these products not been tax-free.

This raises considerable problems in that it makes an incredibly non-distortionary tax, distortionary. This can best be shown through the example of financial services. Under the 2006 VAT Directive, financial services are tax-free but the products they use are not. So, if Goldman Sachs were to pay for an external specialised cleaning company then they would have to pay 20% tax on that. However, if they were to use their own then that would be completely zero rated saving them a ton of cash. 

This may seem pretty inoffensive, but on a macroeconomic scale its damages are huge. The reason VAT is so useful is that at every stage of production is taxed, so it’s very easy for the state to track where money is coming in and out, as well as how much they’re owed from these transactions. However, it gets much more complicated when you have these exceptions. They’re forced to look through and consider: is this a financial service? Does this count as credit? Or is it insurance? Or even is this a biscuit or is it a cake? 

All of this unnecessary complexity adds up and it does not just hurt the taxman, but businesses as well. If a company doesn’t pay sufficient tax on its products then they’re liable for a huge fine that could hurt its position. Clearly, they’re going to be overly cautious and invest heavily in compliance costs to ensure they don’t get a fine. However, the problem with this is that the incidence of such costs ends up falling largely on consumers, and so results in us all having to pay more for pretty essential goods and services.

The IFS analysed the impacts of merely getting rid of the 5% bracket and increasing all of these goods to 20%, and found that the welfare gain would be as much as 3.5% of total VAT receipts, or £4.65Bn. However, more importantly they found that if this additional revenue was invested in cutting the VAT rate the average family would actually save as much as £1 every week! 

Now we’ve left the European Union we’re no longer mandated to keep to the 2006 VAT Directive. The Government, therefore, has an excellent opportunity here to present a reform that would mean more £s in the people’s pockets, more £s in their pockets and less money wasted on compliance and tax avoidance with the added benefit that it can be sold as the first of many Brexit dividends.