Price and sales effects of standard VAT rate changes: Evidence and implications for unconventional fiscal policy

Facing the economic consequences of the Covid-19 pandemic, governments all over the world are considering providing a fiscal stimulus. A potentially powerful instrument to do so is a broad-based consumption tax such as VAT. Current theory suggests that a pre-announced permanent VAT increase combined with a reduction in income taxes (or a temporary VAT cut) would enable fiscal policy to boost consumption spending, in particular, consumer spending on durable goods (D’Acunto et al. 2020). 

There is, however, considerable uncertainty about consumer responsiveness at the ‘intertemporal margin’ (Cashin and Unayama 2016). In addition to this, it is possible that conventional assumptions about the pass-through of taxes into prices might not hold (Montag et al. 2020). In order to make concrete policy recommendations, it is therefore important to evaluate the effects of pre-announced tax rate changes on prices and consumer behaviour empirically. 

In a new study, we explore the experience of EU countries, which implemented 33 pre-announced changes of the baseline VAT rate between 2004 and 2013 (Buettner and Madzharova 2020). Our dataset covers household appliances and reports monthly scanner prices as well as unit sales of approximately 110,000 individual products. This feature of the data enables us to overcome important limitations encountered in previous work, which predominantly uses household expenditure and price index data. The empirical identification strategy exploits the trading of identical products in different countries of the EU Common Market. Counterfactuals for unit sales and prices of a product in a country experiencing a consumption tax rate change are constructed from the contemporaneous sales and prices of exactly the same product sold in other EU countries. 

We exploit ‘reform heterogeneity’ along two dimensions: in terms of the length of the ‘implementation lag’ (i.e. the timing between announcement and implementation) and in terms of the motivation of tax policy changes. We show that the implementation lag matters by demonstrating that results are affected if the timing of tax change announcements is explicitly incorporated into the estimation. The classification of the motivation of tax changes follows the narrative approach of the analysis of fiscal policy put forward by Romer and Romer (2010). This is of particular importance when analysing EU countries, many of which increased consumption tax rates in the aftermath of the 2008 recession.

Figure 1 illustrates the results regarding price effects. The dashed line marked with black squares shows the estimated cumulative price pass-through of a one percentage point tax increase, together with a 95% confidence interval based on all reforms that were pre-announced by at least one month. The vertical axis reports the level of the product price relative to the baseline. The figure demonstrates that a change in the baseline VAT rate is fully shifted into prices within a relatively short time. Importantly, prices start to increase three months before implementation, with almost half of the price change occurring pre-reform.

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The basic results for the price pass-through include the effects of tax rate changes that were implemented “to offset developments that would cause output growth to differ from normal” (Romer and Romer 2010). This includes, for example, the 2008 temporary tax rate change in the UK or pro-cyclical measures in other EU countries (enacted due to fiscal crises). Relying on ‘endogenous’ tax reforms when studying how sales and prices react to tax changes could be misleading, since it might be difficult to disentangle the effect of these developments from that of government actions taken in response. Figure 1 juxtaposes the cumulative price pass-through estimated for 15 tax changes that are classified as exogenous by Gunter et al. (2017, 2019) (in red) with that for all tax rate changes. While the confidence bounds for estimates based on exogenous tax changes (in grey) are larger, the qualitative results are confirmed. The pass-through starts two, rather than three, months prior to implementation and is completed in the second month after a tax rate change. 

Figure 1 Cumulative price response to a VAT rate increase of 1 percentage point

We further explore whether the pass-through dynamics varies systematically between products based on their market position but find no significant differences for top 50 or top 100 best-sellers. This finding could point to imperfect competition as a driver of pre-reform price adjustment. Other potential explanations could be staggered price setting (Carare and Danninger 2008), adjustment costs at the level of the retailer, the timing of special offers and price discounts (Anderson et al. 2017), or consumers search effort (Coibion et al. 2015). 

The key empirical results for unit sales are presented in Figure 2. The vertical axis reports the level of unit sales relative to the baseline for a tax rate increase of one percentage point. Again, the dashed line with black squares reflects the estimated effects of all tax rate changes, whereas the red line refers to exogenous changes. The latter indicates that unit sales rise by approximately 2.5% in the last month before implementation. This is followed by a substantial drop in sales by 2% relative to the baseline at implementation. Interestingly, sales continue to decline in the second month after implementation. Including endogenous reforms yields a qualitatively similar pattern, with a smaller peak in sales before implementation and a larger drop once the higher tax rate is in place. The corresponding ‘point estimates’ from our preferred specification using exogenous tax rate changes indicate an ‘elasticity of intertemporal substitution’ factor of approximately two. 

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Figure 2 Unit sales response to a VAT rate increase of 1 percentage point

Exploring differences in unit sales effects between products, we find similar intertemporal patterns for different product groups such as washing machines and refrigerators. The ‘pre-implementation spike’ is found to be particularly strong for top-level brands, which highlights the role of depreciation and secondary market value as likely determinants of the strength of the temporary sales response.

While the temporary stimulus on sales before implementation is confined to durables and storables, our estimates point to a larger elasticity of intertemporal substitution than is found in previous studies. Whereas this finding generally supports the effectiveness of pre-announced tax rate changes as a tool of fiscal policy, policymakers need to be aware of the sharp and lasting drop in consumption after the tax change. Hence, an important caveat to using consumption taxes for fiscal policy is the requirement to predict the future development of the economy with reasonable certainty. 

The stimulus associated with a pre-announced tax rate change depends clearly on the credibility of the announcement. Since any modifications after the announcement would compromise credibility, pre-announcing a consumption tax rate increase constitutes a ‘one-time tool of fiscal policy’. This implies that the policymaker needs to get the timing of the measure exactly right, which may be very difficult in practice. For example, on 03 June 2020 the German government announced a temporary three percentage points VAT cut in July for six months (as an economic stimulus in response to Covid-19). Based on our results, sales of durables will increase sharply in December followed by a drop relative to the baseline that persists in the first quarter of 2021 and beyond. In addition, spending on all types of consumer goods is expected to be higher in the third and fourth quarters of 2020 and return to the normal in 2021.

The above requirement for careful intertemporal design implies that the government needed to be confident in June that the economy will be resilient enough in 2021 (when the tax rate reverts to its original level). Given the uncertainty associated with the future development of the pandemic, it is questionable how the German government could have been confident enough to take such an action. 

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A second problem for an unconventional fiscal policy based on the consumption tax is the necessity to offset adverse income effects associated with a credible announcement of a tax increase. In 2008, the UK government avoided such an offset by deciding to reduce the VAT rate temporarily, which combined a commitment to a future VAT increase with a current tax decrease implemented on a short notice. The German government followed the same approach. A precondition for the effectiveness of the temporary VAT change is that consumer prices follow the temporary change. Our findings of a relatively quick price pass-through suggest that this is indeed the case, at least when it comes to consumer durables. Nevertheless, offsetting income effects by means of a temporary VAT-rate change doubles the sizeable compliance costs, since all transactions along the value chain need to be adjusted twice. 

References

Anderson, E, B A Malin, E Nakamura, D Simester and J Steinsson (2017), “Informational rigidities and the stickiness of temporary sales”, Journal of Monetary Economics 90: 64-83.

Buettner, T and B Madzharova (2020), “Unit Sales and Price Effects of Pre-announced Consumption Tax Reforms: Micro-level Evidence from European VAT”, American Economic Journal: Economic Policy, forthcoming.

Carare, A and S Danninger (2008), “Inflation smoothing and the modest effect of VAT in Germany”, IMF Working Paper 08-175.

Cashin, D and T Unayama (2016), “Measuring intertemporal substitution in consumption: Evidence from a VAT increase in Japan”, Review of Economics and Statistics 98(2): 285-297.

Coibion, O, Y Gorodnichenko and G H Hong (2015), “The cyclicality of sales, regular and effective prices: Business cycle and policy implications”, American Economic Review 105(3): 993-1029.

D’Acunto, F, D Hoang and M Weber (2020), “Unconventional fiscal policy to exit the COVID-19 crisis”, VoxEU.org, 8 June. 

Gunter, S, D Riera-Crichton, C Végh and G Vuletin (2017), “Non-linear distortion-based effects of tax changes on output: A worldwide narrative approach”, Inter-American Development Bank Discussion Paper 540.

Gunter, S, D Riera-Crichton, V Végh and G Vuletin (2019), “Tax hikes are not always contractionary”, VoxEU.org, 1 May.  

Montag, F, A Sagimuldina and M Schnitzer (2020), “VAT reduction as unconventional fiscal policy in Germany: Fast but heterogeneous pass-through in the fuel market”, VoxEU.org, 25 August. 

Romer, C D and D H Romer (2010), “The macroeconomic effects of tax changes: estimates based on a new measure of fiscal shocks”, American Economic Review 100(3): 763-801.

Via VOX EU