Željko Garača: The Strange VAT – Can a Reduction in the General VAT Rate Lead to Price Increases?

Recently, the Government presented measures referred to as tax reform. A significant tax relief has been announced, which should generally be welcomed, but it is no less important to consider what kind of tax relief it is and what its impact on the economy and the living standards of citizens will be.

Particularly commendable is the abandonment of the announced reduction of the general VAT rate from 25 to 24 percentage points. Rarely has there been a consensus that this measure is not good. Both the profession and the public have preemptively forgiven the ruling party for not fulfilling its pre-election promise. There is an impression that the Government, hesitating to abandon this measure, pathologically enjoys the general begging to abandon its credibility. Although the majority is against this reduction, the justifications are varied. Will there be a reduction in prices? What does a few lipas on a liter of milk mean? Will retailers keep everything through higher margins? The situation is much simpler. In the best case, there would not be a reduction in prices but rather a smaller increase in prices. The annual inflation rate is already 2.4 percent, and we can possibly say that prices would only rise by 1.4 percent.

As compensation for abandoning the mentioned measure, a reduction in the tax rate for some, primarily food products, is proposed. According to the proponents’ calculations, this measure will improve household budgets by about 73 kuna per month, which is just over 1 percent of the average salary. All this is based on the optimism that prices will decrease, although it seems that even the proposer does not believe this because “he cannot force entrepreneurs to lower prices.” Again, I refer to the current inflation, which realistically reduces the household budget by about 150 kuna per month on an annual basis. Fortunately, we have real wage growth that compensates for this. The problem is that this wage growth is greater than productivity growth, and that cannot last long. Additionally, there is an appeal from unions to entrepreneurs to lower prices, which seems thoughtless, but shows how (un)realistic it is to expect a reduction in prices.

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In my style, always contrary, I will attempt to present a different opinion. Thus, for some products, the tax rate is reduced from 25 to 13, or by 12 percentage points, and it is expected that prices will also fall by approximately that much, actually around 10 percent when recalculating the tax reduction. Will this really happen? Some experts believe it will. I consider this a naive expectation.

When you ask ordinary citizens, at first they will agree with that estimate or at least that it should be so, but they soon recall experiences from previous tax rate reductions that did not lead to price reductions and begin to doubt that prices will actually decrease. Their feeling could indeed prove correct and is even in line with the economic laws of the market.

If you ask an economics student who has just passed an exam in microeconomics, referring to theory, his estimates will be that a price reduction of about 5 percent can be expected because, according to theory, the supply and demand curves will establish a new market equilibrium somewhere in the middle of the change, meaning the effect of the VAT reduction will be shared between consumers and those in the supply chain: producers, distributors, and retailers, and it can be expected that the price reduction will not be as announced.

However, the existing price of the products in question is formed in the market, meaning there is a sufficient number of buyers willing to purchase these products at those prices. We can assume that there are no significant unsold stocks of these domestic products because otherwise, there would have been a price reduction. Similar reasoning can be applied to importers.

Economists like to differentiate between short-term and long-term effects. The continuation of this story relates to the short term. As for the long term, Keynes said: In the long run, we are all dead. The economy reacts to market changes first with prices and only later with quantities because additional production requires time and capital. Now we can ask why entrepreneurs would lower retail prices and forgo additional profit immediately after the VAT reduction. Their task in a market economy is to earn as much as possible, not to worry about the standard of living of other citizens. Therefore, it is to be expected that they will raise producer prices to which higher margins will be added by others in the supply chain, and by keeping old retail prices, everyone will earn more, while citizens will not feel the VAT reduction.

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Now let’s expand the analysis to a hypothetical situation where the general VAT rate is reduced on all goods and services. With considerable effort and imagination, let’s also assume that the state would compensate for the shortfall in tax revenue by reducing imports of expensive cars and weapons, although it is more likely that it will incur additional debt. Part of the earlier analysis regarding the retention of existing prices can be applied in this case as well, but a new element arises here. Let’s assume that all entrepreneurs have achieved higher revenues by compensating for the VAT reduction with price increases. This additional income will at least in part be shared with their employees and raise their incomes. For the same quantity of goods and the same prices in the market, a higher disposable income is now competing, which creates inflationary pressure and prices begin to rise. They will be higher than before the reduction of the general VAT rate.

In all of this, exporters would fare the worst. For them, VAT is not significant, but the increase in incomes in the goods and services sectors in the domestic market will negatively affect their competitiveness.

The Strange VAT! Do not make exceptions! Do not touch VAT!

Always contrary!

Author: Prof. Dr. Sc. Željko Garača