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Classic VAT DoubleThink

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The myth is that VAT is a relatively benign tax because it is a “tax on consumption”. Anybody who knows anything about tax incidence and bothers to look at actual statistics on what happens to prices, output levels and profits or wages when VAT rates change; or price differences in the USA where each state has different Sales Taxes knows that this is nonsense.

Value Added Tax is the worst of both worlds, it acts like a tariff, so dampens economic activity and is also, quite literally a tax on “value added” i.e. wages and earned profits. It’s a crude profits tax that is payable even if a business isn’t actually profitable (but would be if there were no VAT).

In the UK, businesses pay about three times as much VAT as they do corporation tax, so surely, if you interested in the tax system, you focus on VAT. But all the attention is directed at corporation tax. There are loads of headlines that Starbucks or Apple (or whoever) pay little or no corporation tax in the UK, which is quite probably true. But they still hand over £ billions in VAT.

So far so bad.
Mombers spotted this at Bloomberg:

There’s 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.

Reducing VAT from 20% to 17.5% was the best thing that Alastair Darling could have done back in 2009. He did it and it worked i.e. softened the impact of the financial recession. The benefit was measurable and large and far from ‘limited’.

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 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.

This is of course exactly what you’d expect to happen (it has been observed countless times).

So, having made the false assumption that VAT is a benign tax because consumers pay it, they argue that VAT cuts are bad because consumers don’t pay it? Do they not realise that they are contradicting themselves? Everybody’s entitled to be wrong, but at least be consistent!

As to “fostering a consumer-led recovery”, people can’t consume more unless somebody else is producing more. And do they not realise that restaurant owners, restaurant staff and restaurant suppliers (and their employees) are all consumers too? If they have more money to spend, they will probably spend it.

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