A Bad New Tax Idea Is Doing the Rounds

Theres a new bad idea doing the rounds in Europe. Many governments are convinced that a reduction in value-added tax will help relaunch their economies. Some, including Germany, have already wielded the ax. Others, such as Italy and the U.K., are taking this option seriously. But the benefits of cutting VAT are limited, and the costs are large.

As with any other tax cut, the key question is who gains from it. The answer for VAT depends on a concept economists call “incidence,” which refers to how the tax burden or benefit is shared between companies and consumers. In the case of VAT, retailers can either pass on any reduction to shoppers by lowering their prices or they can keep their prices unchanged and pocket the difference. Unfortunately, research shows they‘re more likely to do the latter, which wouldn’t be much use for any policymaker looking to use such cuts as a way of fostering a consumer-led recovery.

Youssef Benzarti, a professor of economics at the University of California, Santa Barbara, and Dorian Carloni, an analyst at the U.S. Congressional Budget Office, have produced a very detailed study on VAT. They looked at a large cut (from 19.6% to 5.5%) for sit-down restaurants in France in 2009, after the financial crisis.

The results showed that consumers weren‘t the chief beneficiaries of the reduction. It was the restaurant owners. The price of a restaurant meal decreased by a mere 1.4% in the month after the steep VAT cut, and it didn’t fall much further over the next two and a half years. The two researchers showed that restaurant owners pocketed 41% of the economic gain from the VAT reduction, while consumers got 19%. Restaurant staff obtained 25% in the form of higher wages, and suppliers accounted for the rest.

The poor consumer gets the short end of the bargain when VAT is increased too, the study shows. When the French government hiked VAT again in 2012 and 2014, between a third and a half of the tax hike was passed on to consumers in the shape of higher prices.

These results broadly mirror those of another study, of Finnish hairdressers, and another that looked at a wide range of commodities and European countries between 1996 and 2015.

In fairness, a VAT cut would still have some benefits. Retailers, which have suffered during the Covid-19 lockdowns, would get the chance to improve their profits and repair their balance sheets. This targeted help might make some sense for some sectors such as tourism. But it‘s not the “demand booster” of governments’ dreams. Moreover, the winners from this policy would include internet retailers such as Amazon.com Inc., which have done very well in the pandemic. Do European politicians really want to give them extra assistance？

Another problem is that VAT cuts are very expensive. Germanys reduction, which will last six months, is expected to cost about 20 billion euros ($22.4 billion) in lost tax revenue. In Italy, lowering the main VAT rate from 22% by a single percentage point would cost between 4 billion euros and 4.5 billion euros a year. In Britain, each percentage point reduction costs a little less than 7 billion pounds ($8.7 billion). Even at a time of fiscal largess, one needs to ensure that such hefty sums are spent well.

There are better options for governments. If they want to get their economies moving, boosting public investment is the best approach. If they want to lift consumption, then income tax cuts are a shrewder option. Finally, if they want to help companies directly, they can reduce their social security contributions temporarily. That might let them hire people too.

These are all better ideas than a generalized VAT cut.