Background
Over the past three years, the world economy has suffered from large swings in economic activity, notably the economy of the Euro area. After an unprecedented challenging period caused by the Covid pandemic, Russia’s war of aggression against Ukraine struck another bitter blow to the world’s economy, with a new set of disruptions, further exacerbating the already unfolding inflation.
As a reaction, several countries have been trying to cushion the blow and the effects of the economic downturn and inflation, adopting exceptional and temporary measures. Many of the measures implemented aim at protecting the most vulnerable, who are particularly affected by the overall increase in prices (of goods and services) and, hence, in the cost of living.
In that vein, governments and policymakers have, unsurprisingly, turned to tax policies. One of the most recent examples of this approach, making headlines in the press and raising both support and scepticism, is the Spanish government’s new raft of measures announced last December. The measures aim at tackling the cost-of-living crisis and include a reduction in VAT on food products over the next six months. VAT reductions and aid will reportedly be transferred directly and immediately to food prices.
Staple foods such as bread, flour, milk, cheese, eggs, fruits, vegetables, legumes, potatoes and cereals will no longer be taxed. The applicable VAT to other foods, such as oils and pasta, will be downgraded from a 10% rate to 5%.
The intended result: to lower prices.
However, without any specific legislation, businesses and retailers are not obliged to reduce their prices and pass the savings from a VAT rate cut on to consumers. A temporary VAT rate cut would not be fully passed on to consumers if it induces businesses and retailers to raise their prices.
Therefore, the key question must be how far will a lower VAT rate actually lower prices?
Quickly understanding VAT
VAT (value-added tax) is a consumption tax (not an income tax) on goods and services that is levied at each stage of the supply chain where value is somehow added, from initial production to the point of sale.
In contrast to a progressive income tax, which levies more taxes on the wealthy, VAT is charged equally on every purchase, regardless of the consumer’s wealth. VAT is, therefore, regressive if it is measured relative to current income and if it is introduced without other policy adjustments, meaning that people with lower income spend a higher share of their income in VAT than higher-income individuals. Thus, VAT might place an undue burden on lower-income taxpayers, missing any social and/or distributional aim.
To correct the unintended effects of VAT application, and as an example of the aforementioned policy adjustments, a government can exclude certain basic household goods, such as food products, from VAT, or it can charge a substantially lower VAT rate. It can also provide rebates or credits to low-income earners to offset the effects of the tax.
Prices behaviour
In order to tackle the cost-of-living crisis fueled by booming prices of goods and services resulting from inflation and affecting lower-income earners and households more harshly, it can be easily understood why governments and policymakers are adopting or considering adopting temporary VAT rate cuts. Assuming that a decrease in the standard rate of VAT applied to any given good or service is likely to be passed through to consumer prices, it can be a “shovel-ready” measure to address it, which is easy to implement quickly.
While this is certainly a meritorious aim, is yet to be proven that applying a VAT rate cut is the most appropriate instrument to achieve it.
Several studies and empirical cases actually suggest otherwise. According to these[1], most businesses, retailers and service providers use VAT cuts to improve their margins and finances instead of cutting prices. VAT cuts are less likely to be passed on to consumer prices than VAT hikes. Moreover, and as a result, following a temporary VAT cut, prices may be even higher than at the onset.
It is true, though, that those empirical cases and even the most careful studies carried out usually focus on the effects of changes in the VAT treatment of a specific set of items, such as hairdressing services, housing repairs, restaurant meals, or specific goods. It is also true that these cases stress that the pass-through can be quite different depending on the nature of goods, services, and the VAT change. In addition, economic theory indicates that several factors should affect the extent to which businesses pass VAT into consumer prices, including the competitiveness of markets and the responsiveness of demand and supply to prices. Therefore, expanding the foregoing results to any given good or service without further analysis is not advisable or desirable.
In any case, evidence advises caution against the conventional assumption that the benefits of reduced VAT rates are fully passed on to the consumer, namely to the poorer households they are generally intended to benefit.
In fact, if there is a trend that can be identified, is that prices respond asymmetrically to VAT changes and that this asymmetric response of prices results in an asymmetric pass-through of VAT changes to profits.
Apart from that, and even if the decrease in VAT would indeed have a symmetric effect on prices, that does not necessarily mean that goods and services will become more affordable. Due to inflation, the price may already be too high, even excluding VAT.
On the other hand, consumption, even of essential items, is mostly done by the wealthiest. So, even assuming a temporary VAT rate cut is reflected in lower prices, it would be those consumers (and not the poorest), therefore, who benefit the most from that.
Finally, from a tax revenue perspective, such an approach could represent significant costs for State budgets with several implications. Any impact on revenues might take a toll on the provision of high-standard public services, once again affecting lower-income households.
Another factor to be considered with this type of tax policy are the indirect effects on the economy. A VAT rate cut could create an incentive for consumers to increase their spending which, in the current inflation context, could even do more harm than good, worsening inflation.
Conclusion
Existing data question the assumption that prices respond symmetrically to variations in VAT rates, namely that a temporary VAT rate cut actually means lower prices.
Unfortunately, despite the strong evidence against the effectiveness of using temporary VAT rate cut to lower prices, the current context might push governments and policymakers to follow that path as a way to appease public opinion and ease social tensions.
Although more complicated to apply, governments and policymakers might instead take a look at compensation measures for poorer households, such as targeted tax credits or direct transfers to low-income earners, which could be a more effective, efficient and equitable way to combat the cost-of-living crisis, especially for those who need it most.
All in all, any measure to tackle the cost-of-living crisis due to the increase in prices of goods and services implies caution, in particular, measures that build on the assumption that lower VAT means lower prices, because that might not be true.
[1] Just to name three: Benzarti, Y., Carloni, D., Harju, J., Kosonen, T., What Goes Up May Not Come Down: Asymmetric Incidence of Value-Added Taxes, in Journal of Political Economy, The University of Chicago Press, Volume 128, Number 12, December 2020; de la Feria, R., Walpole, M., The Impact of Public Perceptions on General Consumption Taxes, in British Tax Review 67/5, 637-669, December 2020; Benedek, D., De Mooij, R., Keen, M., Wingender, P., Estimating VAT Pass Through, IMF Working Paper (WP/15/214), Fiscal Affairs Department, September 2015.
Gonçalo Grade
January 2023