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Is VAT the weapon of choice in a recession?

When it comes to fiscal policy, VAT has been subject to intensive debate for many years, especially since the UK pioneered using a VAT reduction to help the economy during the 2008 recession. It is often argued that the current VAT system should be made more uniform to enhance economic efficiency and to protect the functioning of the internal market; but extending reduced VAT to certain products or services temporarily should create undeniable economic benefits.

As governments around the world seek tools to assist in stimulating their local economies out of this Covid-19 fuelled downturn, this debate has never been more appropriate. On the surface, reducing VAT rates appears obvious: make certain goods and services more affordable for your population during times of economic hardship.

Before we can determine whether VAT is indeed a useful weapon against recession, it is important to clarify the VAT measures available to countries looking for a swift stimulus for their economies:

  • Headline-grabbing VAT rate cuts – reducing the VAT rate applicable to all products (like Germany has done in response to the Coronavirus crisis) or reducing the VAT rate on specific services or sectors (like Greece and Belgium have done)
  • Payment holidays that allow companies more time to remit the VAT they have collected.

With the UK mulling over another potential VAT decrease in response to the pandemic, this article seeks to consider whether VAT rate reductions are effective instruments of stimulus in times like these…

Quick and easy

The appealing features of a temporary VAT cut are that it can be implemented quickly and it incentivises consumers to bring forward purchases, stimulated aggregate demand.

The efficacy of a VAT cut as a fiscal stimulus depends on the extent to which firms pass through the price cut to consumers, and the extent to which consumers respond to the consequent price changes.

From a macro perspective, it there is a very strong general argument for having uniform VAT rates – the same rates for all products and services serves as a superior instrument to maintain a high degree of economic efficiency, to minimise otherwise substantial compliance costs and to smooth the functioning of the internal market.

However, from a micro perspective, it seems intuitive that there are real and valid economic arguments for extending lower VAT rates to some very specific sectors, especially in countries characterised by specific economic structures.

Simplicity vs. stimulus

I believe there is an overwhelming argument for using reduced VAT rates, even more so in times of economic hardship. Firstly, reduced VAT can increase efficiency by increasing productivity or by reducing structural unemployment. Secondly, the reasoning seems obvious on equity grounds: reduced VAT can enhance equity by improving the income distribution or by making particular products more accessible to the entire population.

The first point applies particularly to services that are easily substituted for do-it-yourself or underground work, e.g. locally supplied services and many parts of the hospitality sector. The argument is that high tax wedges make it very expensive to buy these services on the market and more attractive to do yourself. The implication is that high skill professionals spend time on low skill work at home instead of spending time with their families or increasing their more productive labour supply. Lower VAT rates serve to counter this development.

The second argument is a theoretical one: government should reduce VAT rates in sectors employing many low skill workers in order to boost low skill demand, e.g. hotels, restaurants and locally supplied services. 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.

Food for thought

What about reducing VAT on food? Here the argument seems obvious: Reducing VAT rates on food 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.

However, extending reduced VAT rates to food also brings about significant complications. Compliance costs seem to be particularly large for the food sector due to its multitude of products, the enticing inclination to treat healthy and non-healthy food differently and the existence of a grey zone between sale of food and prepared food.

In addition, reduced rates on food tend to make do-it-yourself-cooking economically more attractive relative to frequenting restaurants. For this reason, they tend to compound restaurants’ disadvantage competing with homemade meals even when VAT rates are lowered.

Why not drop VAT on all products?

Doesn’t it make sense to simply lower VAT across the board? Surely 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 goods or whether the lower rates in reality serves as a subsidy to high income households initially consuming more “merit” goods.

Therefore, it seems to me that when deciding on your VAT stimulus package, you need to know whether the objective is to help low-income families specifically, or all members of the economy.

Is the juice worth the squeeze?

Empirical evidence from previous VAT reduction initiatives indicates that compliance costs associated with lower VAT rates can be sizeable. Differences in VAT rates between similar products may in particular give rise to a substantial number of administrative and legal conflicts about the proper classification of specific goods.

Did it work back in 2008?

The UK implemented a temporary VAT cut back in late 2008, when they announced an almost immediate, but temporary cut to VAT by 2.5 percentage points for 13 months. The aim was to stimulate consumer spending.  Research from the 2008 cut shows that although firms initially passed through the lower VAT rate, they subsequently reversed at least part of the cut after around two months.

Thus, while prices did respond to the VAT cut, they did not follow the time path of the VAT. This raises interesting questions about consumers anticipation of the path of prices. The consumer response was interesting: the VAT cut boosted retail sales by about 1%, with a particularly marked increase in sales of household goods. Retail sales make up around 34% of aggregate expenditure and so this implies an

increase in aggregate expenditure of 0.4%.  Interestingly, the findings also show that there was a significant increase in purchases only in the first half of the period of the VAT cut. It also showed that there was a drop in retail sales when the temporary VAT cut expired.

Conclusions

It is hard to doubt that a cut in VAT will raise consumption now, but a case nevertheless has to be made for implementing such a policy. The government budget constraint requires that future taxes be increased by an amount whose capitalised value is equal to the value of any current tax reduction

If the tax cut has a favourable income effect, the future tax increase, whenever it comes, must be expected to have an unfavourable impact. It could be argued that there is no net welfare benefit and therefore no point to the exercise.

The research and literature is divided on this issue, but as we embark upon an unprecedented recession caused by the government, to me it seems quite apparent: the government must take whatever action they can in order to prop up the economy, regardless of the future risks. Therefore, a temporary reduction in the VAT rate on specific products and services seems like an inevitable next steps for Boris Johnson and his cabinet.

Watch this space.

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