VAT reduction: Budget neutrality or budget overrun?

In principle, the efficiency of the VAT system is well-known through every country that apply this tax on consume. It is a in every time a good and neutral VAT system, the ones that changes consumers’ buying decisions as little as possible. This again depends strongly on the price elasticity of the taxed goods and services. When the price elasticity is high, it means that even small price hikes slash demand significantly. In this case, levying VAT on top of the price may alter consumers’ buying decisions significantly.

Clearly, price elastic goods are not likely to be good candidates for high VAT rates in an efficient tax system. On the other hand, price inelastic goods may be good candidates for high VAT rates as they only modestly modify consumers’ buying decisions. It follows from the above considerations that an economically efficient VAT system necessarily must be non-uniform, imposing higher VAT rates on price in-elastic rather than price elastic goods.

The popular argument is that reduced VAT rates, by boosting demand for such services, stimulate demand for low skill workers, and push up their wages so that employment becomes a more attractive option than unemployment.

However, experiences indicate that the overall impact on demand for low skill workers is unimpressive because differences in low skill employment between industries are limited. Indeed, making standard VAT rates apply for all sectors currently benefiting from reduced rates is likely to create a similar sized demand boost for low skilled workers. If implemented, reduced VAT rates may have some limited implications for the functioning of the internal market, in particular through tourism.

Reducing VAT rates on food and some basic services which constitutes a larger share of consumption for low income households than for high income households implies a cost saving that is particularly beneficial for low income households. The larger the difference in consumption shares is, the more effective the argument becomes. It is not clear that the best instrument for improving the income redistribution is the VAT system. Reduced VAT rates on food are not likely to have significant consequences for the functioning of the internal market.

Demand can be boosted on any product by lowering VAT rates.

However, it is often difficult to verify whether low income households in reality are induced to purchase more merit goods or whether the lower rates in reality serves as a subsidy to high income households initially consuming more merit goods.

In addition, extending lower VAT rates to e.g. energy-saving appliances have limited effects on CO^2 emissions if they are covered by other regulatory instruments such as emission trading schemes and may give rise to non-trivial complications for the functioning of the internal market.

Furthermore, effects on total energy use are ambiguous: it may well switch consumption from less to more energy efficient hair dryers for example but may at the same time switch overall consumption in the direction of energy intensive products (more hairdryers). Reduced rates on some merit goods such as books and music tend to create some serious tensions with the functioning of the internal market, primarily due to the ease of electronic trade.

The strength of the impact of lower VAT rates on production and employment depends significantly on the consumer response to lower prices and the level of competition within the sector. If consumers react only weakly to lower prices (if consumption is price in-elastic), production and employment will not increase significantly. This is typically the case for basic goods, for example food, as consumers prefer to preserve their level of food consumption and use the saved expenses to increase other types of less basic, more luxury expenses.

In contrast, if consumers react strongly to new prices (if consumption is price elastic), production and employment may increase significantly. This is the case for less basic, high value goods as for example package holidays, books, and electronic equipment’s.

In sectors with limited competition, pass-through to prices may be less than full, and thus, the impact on production and employment may be muted. If the price initially has been set at a high monopolistic level, firms are not likely to adjust the price downwards to the full extent of VAT reduction, but will re-optimize in order to maximize profits, typically leading to a pass-through that is less than full.

On the fiscal consolidation point of view, we can say that when Government decides to use reduced VAT rates in a specific sector, it also decides to give up tax revenue. These amounts can be quite significant.

Many countries in Europe and in other parts of the world are using lower VAT rates today already relinquish up to 5-8 percent of their total tax revenue. If budget neutrality is a relevant policy goal, the lost tax revenue must be compensated by raising other taxes. This can for example be achieved by raising VAT rates on other goods or increasing taxation of labour income. We stress that budget neutrality is a highly relevant policy goal.

Most countries are fiscally constrained because they have significant deficits on the government budget today or because they can foresee significant deficits in the future due to population ageing.

The agenda is budget neutrality rather than budget overrun. For this reason, the fiscal policy needs always to examine the benefits of reduced VAT rates in the context of budget neutrality.

It means that in order to finance reduced VAT rates in a particular sector they should, as a benchmark, to increase the standard rate of VAT so that the combined effect on the government budget is zero.

For the policy to be economically effective, Government would have to be prepared to forego much of the lost VAT revenue over a period longer than one year. The simulations suggest that the positive economic impact could be significant, especially on the tourism sector if Government is prepared to absorb the fiscal cost.