Temporary VAT cut on household electricity bills: IFS response

Helen Miller, Director of IFS:

“As a result of the VAT cut announced today, households will benefit from small cuts to their electricity bills. But the measure is not well targeted. If the goal is to support households facing the most acute cost of living pressures, electricity is a poor target because electricity prices have changed little since the start of the war in Iran. If the goal is to help low-income households, a VAT cut is a poor lever since the biggest cash gains will go towards richer households.

This is also a move towards a more complex tax system when what we need is a more coherent way of taxing energy. We will now have VAT on domestic gas, but not domestic electricity. Meanwhile, we have other taxes on electricity, but not gas, that fund subsidies for renewables.  

Government think they have found funding for this financial year – but only by reallocating savings that have not yet been made. If they want to make the policy permanent – or if they find it is politically too difficult to reverse – they will have to find more funding for future years. This is adding pressure to an already very constrained fiscal picture.”

Small benefits for households

The government today announced a temporary reduction to the rate of VAT charged on household electricity bills. The rate of VAT charged will be reduced from 5% currently to 0% for the six months between the start of October 2026 and the start of April 2027. For the average household paying the Ofgem electricity price cap, this will represent a total saving of around £25.1 This will more than offset the forecast rise in the price cap, which (prior to this announcement) was set to increase by 1.2%, costing the average household £5 over the six months from October.  

While the average household on the cap will save an estimated £25 as a result of the policy, actual savings will vary considerably between households. Relative to household spending, today's policy will be most meaningful to the lowest-income households. On average, the tenth of households with the lowest disposable incomes allocate 5% of their spending to electricity bills, compared with just 2% for the tenth of households with the highest disposable incomes.2 In cash terms, however, a disproportionate share of the cost of today’s tax cut will go to higher-income households who use more electricity overall despite it making up a smaller share of their spending. There will also be considerable variation in how much households with similar income levels benefit from the policy with, unsurprisingly, the biggest savings going to those households who use the most electricity (for example, those households who use electricity-based heating systems).

Notably, the electricity price cap has risen by only around 5% following the conflict in Iran, whereas the gas price cap has increased by 24%. If the goal of today’s policy is to help households that have lost out as a result of the war, it is not well targeted at achieving that aim. If the goal is simply to provide a temporary income boost for all households, or for poorer households, in view of broader cost of living pressures, it is not well targeted at that either.

Unspecified savings from departmental budgets to fund the cut for the first six months

The government has said it will fund this VAT cut by cancelling the digital ID programme. This programme was announced after the 2025 Spending Review and the government intended to pay for it through cuts to other areas of departmental spending. It did not specify how much the programme would cost nor where the cuts would come from. At last year’s Budget, the OBR estimated that the programme could cost a cumulative £1.8 billion between 2026–27 and 2028–29, and the Treasury estimates that today’s VAT cut will cost £850 million this year. The government will therefore still need to make around £850 million of as yet unspecified cuts from other departmental spending to pay for this. The choice over which areas to cut will matter for what government departments are able to deliver this year. But the magnitudes are relatively small, smaller than the capital spending cuts planned to fund part of the Defence Investment Plan (£1.2 billion this year) and the additional funding that still needs to be found at the Budget for the remainder of the plan (£1.8 billion this year).  

Looking ahead, a key question is whether this VAT cut remains temporary or is made permanent: the government has stated that any action beyond this year will be considered at the Budget. The lesson from past temporary fuel duty cuts is that they are politically difficult to reverse and become de facto permanent. If this cut did prove to be permanent, the government would have a range of options for how to pay for it in future years. This could include departmental spending cuts, but it is unlikely these can be justified solely by scrapping digital ID. Much of the cost of this scheme was likely to be up-front investment to set it up over the next few years, such that scrapping it cannot fund a permanent tax cut.

A more complex tax system  

There are a range of taxes and levies on energy use. The combined result is that the effective tax rate on carbon emissions varies wildly depending on the source of energy and whether it is used by households or businesses. We discuss this in previous work, here.  

Emissions from electricity are currently taxed at a much higher rate than emissions from gas for both households and businesses. This means heavily taxed emissions from electricity will be prioritised for reduction even if they are more painful to reduce, ultimately making net zero more costly than it has to be. Removing 5% VAT from electricity, and not from gas, will help to bring the two carbon tax rates closer for households, but the discrepancy between businesses’ gas and electricity emissions tax rates, which is much larger than the discrepancy for households, remains unchanged.

Reducing the rate of VAT on domestic electricity will have no direct effect on total emissions because electricity production is included in the UK’s emission trading scheme (ETS). Because the ETS imposes a cap on total emissions from the included sectors, any increase in emissions from electricity production arising from the VAT cut will be offset by reductions in emissions from other ETS sectors. Thus, insofar as today’s VAT reduction increases demand for electricity, the ETS will result in higher prices in other ETS-included sectors such as energy-intensive industries, domestic and EEA flights and shipping.