Value Added Taxes (VAT) don’t exist in the US but they are actually one of the most important and powerful forms of taxation. They are in fact so powerful that they have been labeled the “money making machine”. In European countries, they raise 30% of total tax revenue, which amounts to 12% of GDP. VATs exist in every single developed country and were introduced in 160 countries over the past 50 years. In spite of the importance of VATs, there is very little research investigating them
In “What Goes Up May Not Come Down: the Asymmetric Incidence of Value Added Taxes”, Professor Youssef Benzarti explores the effect of changes in VAT rates on prices. He finds something surprising: when VAT rates increases, prices inclusive of the VAT rate tend to increase to compensate for higher VAT rates; however when VAT rates decreases prices inclusive of VAT remain constant. This implies that firms tend to benefit from VAT cuts, but it is consumers who pay for VAT increases.
Some Governments use temporary VAT cuts to stimulate demand. This research implies that because prices tend not adjust downwards, temporary VAT cuts are not a good measure to stimulate demand. They are desirable if Governments want to stimulate supply by providing them with a transfer of money. However, ultimately Governments cannot control what firms will do with the windfall of money they receive as they can distribute it to their shareholders with no direct benefits to the economy.
Second, if VAT cuts are temporary and are supposed to be repealed once the economy recovers, the asymmetric pass-through suggests that this might result in a higher equilibrium price and will end up being paid for by consumers. As an illustrative example, assume a VAT cut of 10 percent that lasts three years. If firms pass through 50 percent of the VAT decrease but 100 percent of the VAT increase, then firms will receive a permanent windfall of 50 percent of the VAT decrease, consumers a three year long windfall of 50% which will be paid for by the Government through lower taxes. But once the VAT rate is increased, will stop receiving the 50 percent windfall and instead will start paying for the 50 percent windfall that firms are receiving through higher equilibrium prices. For this reason, a temporary VAT cut can hinder the demand side and is only desirable if the Government wants to permanently transfer money from consumers to firms.