For UK retailers it is an unpleasant twist on the ‘pay it forward’ concept. Instead of asking that a good turn done to them be repaid by kindly deeds to others, executives across the sector are grappling with how to pass on to customers the increase in VAT from 17.5 per cent to 20 per cent that will come into effect on January 4 2011.

In the past, when faced with price pressure, retailers have often preferred to pass it back along the supply chain. That route is not readily available this time. “Retailers can’t push too hard,” says Kevan Howe, senior manager of indirect tax at accountancy company KPMG. “Factors such as rising commodity prices mean that suppliers have less scope to absorb reduced margins than they had previously.”

While many retailers fear consumers’ desire to spend is still fragile, their own margins are so thin that the option of swallowing the tax rise themselves and taking the hit is not within reach this time. “We’d like to avoid putting prices up, but on VAT we are the government’s tax collectors, and it’s just part of the tax regime,” says Ian Cheshire, chief executive of Kingfisher, which owns B&Q.

“The base premise around the trade for some time has been that we will have to pass it on,” agrees Richard Pennycook, finance director of Wm Morrison, the supermarket group.

So retailers are looking at what one retail analyst calls “coping strategies” that allow the price rises to happen discreetly enough not to deter spending.

One tactic is to get the move in early to avoid visible price rises on the day the increase comes into force. “There are some signs that prices are going up in midseason ranges currently in store,” says one experienced analyst. “Expect prices to rise this month and next, and then to be ‘held’ in January,” says one industry veteran.

Another approach is to change the product at the same time as the price. At the value end of the fashion market, for example, where the VAT rise might be all-too-apparent to bargain hunters, this may mean keeping prices stable but using a lower fabric weight or single instead of double-stitching. The alternative is to embellish the product to add some obvious value while raising the price to more than offset the tax rise and extra cost. “By adding a bit more detail, say an extra button on the cuff or some extra material on the collar, customers can be persuaded to pay a bit more,” says Jonathan Pritchard, retail analyst at Oriel Securities.

Discounts and deals are another avenue. “At our end we are pretty straightforward, and I imagine the customer will probably see it back in promotional activity,” says Mr Pennycook. “But on big ticket items such as sofas and washing machines, I imagine some retailers will be having ‘We hold your VAT for a month’-type promotions.”

Other retailers of large and expensive items envisage promotions that play to customers’ desire for certainty in troubled times. These deals focus less on a deep percentage discount and are directed instead at assuring customers that weekly or monthly payments will never go above a particular level.

Retailers can also look to other factors to reduce the impact of the tax increase on margins. The precise effect will depend on the currency hedging approach adopted, but as the dollar has weakened, clothing retailers who buy dollar-denominated products sourced from Asia should be better placed for next year’s spring ranges than they were for autumn and winter stock.

Department stores have another option of protecting margins by changing the mix of what they stock. “As part of our medium- to long-term strategy we are changing the balance away from concessions towards own-bought product,” says Rob Templeman, chief executive of Debenhams. “If we continue down that route, our year-on-year margin rises and so helps us mitigate any cost pressure.”

These preparations for a tax rise which, although unwelcome, scarcely looks like a show-stopper, may seem excessive. But retailers are conscious of more significant risks. The immediate danger is, taken with other tax rises, changes to welfare payments and pay freezes, the VAT rise will be the last straw in undermining consumer confidence. “I think the impact will be more subtle, as part of overall pressure on disposable incomes,” says Mr Pennycook.

“It’s another factor to add to the post-Christmas credit card hangover when a lack of inflation already means little urgency in planning purchases,” says Mr Cheshire. Beyond this, the broader concern is that if the VAT rise is managed so it has only a limited impact on consumer spending, politicians may be tempted to believe the tax can be a further source of relatively painless revenue raising.

Unsurprisingly, retailers hate this idea. According to one senior executive, if the government looked to increase the VAT rate above 20 per cent, it would “get a much more hostile response”.

If retailers were to conclude their interests lay in playing up rather than playing down the impact of VAT rises on consumers’ ability to spend, then a further increase would mean that hard choices were not as heavily focused on the sector as they are in the run-up to January’s rise.

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