Reduction of VAT for Albania should happen now

Reduction of VAT for Albania should happen now

Despite common misconception, the European Union does indeed allow member states to decide their own rates of VAT on a number of categories of goods and services. In 2009 the EU amended this Directive to allow all member states to permanently reduce VAT to 5% on the renovation of private dwellings, excluding materials. Therefore EU rules are not a barrier to the UK government choosing to apply a reduced rate of VAT on this type of work.

But, since the new VAT law was introduced in Albania in 2015, the discussion of the economic operators from tourism sector and also for other utilities that are used from the broad base of consumers are asking for the reduction of VAT standard rate. But is possible for the Albanian government to make and manage an reduction of VAT rate for some of the most important basic needs?

In this regard we want to explore the effects of a temporary cut in VAT, identifying three possible effects:

– an income effect as people benefit from a lower cost of living during the period of the reduction,

– a substitution effect as people bring their consumption forward, and 

– an arbitrage effect as people buy non-perishable goods before the end of the period of low VAT for consumption after the VAT rate as been raised.

International evidence suggests a clear overall impact on consumption, although the nature of the pattern depends on the way in which the data are analyzed. However, the key policy issue is the impact of the VAT change on output and to examine that a simulation model of the whole economy is needed. 

The reduction in VAT from 20% to 15% is likely to result in consumption being augmented by 1-2 per cents by the year 2017, if the changes will take place in the mid of the year. However, GDP is likely to be raised by less 1 per cent relative to what would have happened without the VAT increase. After the temporary reduction is over both consumption and GDP are depressed as a result of the policy.

Is this political decision so harmful for the economy and state budget?

Let’s see some evidences of consumption trends from EU countries and after to make a logical comment based on these facts.

Households account for 60 % of all VAT liability across the EU-27 countries. The average EU-27 household faces a VAT bill that amounts to 11 % of their total expenditure. This ratio is highest in Romania and Hungary (17.8 % and 17.5 %), followed by Latvia (15.3 %), Lithuania (14.7 %) and Slovakia (13.7 %). Households in Luxembourg (6.2 %), Cyprus (6.8 %), Spain (7.2 %), the Netherlands (7.7 %) and the United Kingdom (8.0 %) face the lowest VAT bill as a proportion of expenditure. 

In most countries, the largest part of private households’ VAT bill relates to goods and services belonging to the category “Transport”: Expenditure on the purchase and use of vehicles is high and usually taxed at the standard rate. In those countries where food is taxed at the standard rate, VAT paid on food and non-alcoholic beverages is substantial. 

Expenditure on housing and energy is usually taxed far below the standard rate. However, as expenditure on housing is an important part of total expenditure, VAT payments relating to these categories are high in many countries.

In all countries, high-income households pay more VAT than low-income households in absolute terms. The largest gap is in Luxembourg, where the highest income quintile pays seven times more VAT than the lowest income quintile and the smallest gap in the Czech Republic, Austria and the Netherlands. Looking at VAT bills as a proportion of total expenditure, seems that Hungary to be the only country with a regressive system (low-income households face a higher VAT burden as a fraction of total expenditure than high-income households). The VAT system in 11 countries (Spain, Romania, Bulgaria, Lithuania, Slovakia, Estonia, Greece, Austria, the Czech Republic, Cyprus and Latvia) is approximately proportional: that is, all income quintiles pay roughly the same share of their expenditure in VAT.

On the other hand, a progressive system in the United Kingdom, Luxembourg, Italy, Belgium, Poland, Malta, Slovenia, Finland, Ireland, Denmark, Sweden, Portugal, France, the Netherlands and Germany. Poorer households tend to spend a larger share of their income on consumption than wealthier households, who tend to have a higher savings rate. As a consequence, VAT payments  disproportionally burden households at the bottom of the income distribution. The reduced rates therefore work to redistribute purchasing power from richer to poorer households.

Coming back in Albania, based in the facts from the EU countries we should say that consumption will not be very sensitive to short-term fluctuations in income, because many consumers will add to or draw down their savings to smooth their consumption, and others may be able to repay or add to their debts in order to do so. 

The argument that there is no income effect is that, with perfect capital markets, it makes no difference to consumers at what point in their lives income is received. Since the government faces an inter-temporal budget constraint, a tax reduction has to be offset by higher taxes in the future, so, if everyone including the government faces the same interest rate, consumers receive no  discounted net addition to their income and, on these grounds there should not be any income effect. This is a form of Ricardian equivalence.

There are a number of objections to this argument. Some consumers are borrowing constrained, and hence there will be an income effect from a temporary VAT cut. It is also clear, that borrowing constraints rise very strongly during a financial crisis. Hence in order to evaluate the impacts of the recent temporary cut in VAT in the UK it is necessary to estimate the proportion of consumers who  might be currently borrowing constrained.

Obviously, the effect of a temporary VAT change depends on the extent to which businesses pass on the change to consumers. If the change is not passed on the income effect is likely to be delayed since it appears in profits rather than real wages. 

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