http://www.guardian.co.uk/business/2007/dec/14/marksspencer.europe

This is interesting. Let's do some economics.

A quantity of an untaxed product is supplied at the producer price. This quantity is increasing in the producer price - firms produce more goods when they get paid more per unit. This plots out the supply curve.

VAT raises the price paid by the consumer. If a producer supplied ten units of the good if he could sell them (untaxed) at £10 each, then with VAT at the usual rate, he would have to be able to sell it at £11.75 for him to be happy to still supply ten units. The tax shifts the supply curve up - same quantity will be supplied at a higher price.

People demand products in a quantity inversely related to the price - the lower the price the higher the demand. This plots the demand curve. The equilbrium market clearing price is that which makes demand and supply coincide. So what is the effect of a tax? Obviously, the price rises. However, it does not rises by 17.5%. Some of the tax is paid by the customer, while the rest is paid by the producer.

Why? Because higher prices reduce demand. This reduction in demand means firms need not supply as much of the good. They require a lower price to be happy to meet the new demand, and it is this price which the tax is added to. Thus, the new equilibrium price increases by less than the tax rate - and it is only the price rise that is passed on the consumer.

So, how much should M&S be paid back, if the tax wasn't valid? Clearly its more complicated than repaying all the tax paid on teacakes - some of this was paid by the customer. Furthermore, the only really interesting metric is lost profits, not lost revenues. If it can be demonstrated that M&S lost profits because of this tax, then this is what they should be claiming.

One last point - as customers paid some of the tax, are they entitled to a rebate? It would be hard to say how exactly to implement that, and anyway, all customers were presumably willing to part with that much money for the product. Other customers would have bought the product if the price had been lower (without the tax), so maybe they should be compensated in some way. This complicates the question enough, but just to add one more level, we really have to think about why the tax was imposed. The revenues from the tax probably were spent on something useful and good for society (like a poster that tells me what wonderful things governments spend their money on). Plus, cakes are bad for you - the higher prices may have helped save a few people from themselves.

Yes indeed.