Due to the renewed debate on the preferential treatment of consumption of particular goods and services utilizing changes in regards to the value added tax (VAT), we reiterate the key arguments as to why this is not a good idea.
Herewith we publish the opinion that the Institute for Market Economics (IME) sent to the Committee on Budget and Finance in the Bulgarian Parliament.
General Remarks on the Utilization of Differential VAT Rates Based on Specific Consumer Product Categories
The creation of public benefit and the setting of governance priorities are pursued via the public spending policy. Whether it be enforcing the rule of law, guaranteeing personal freedoms, protection of property and contracts, access to education, safe food and social support for the disadvantaged, etc., the quality of public services is mostly a function of how well they are financed.
Taxes are the very tool to achieve these priorities – they are the source of funds necessary to finance spending programs. All over the world, but especially in an open and developing economy like Bulgaria’s, a good tax system is one that manages to collect taxes effectively, while simultaneously minimizing the impact of its interventions in incentives for saving, innovation, investment and labor to the least possible extent.
In essence, the tax system must be designed so that it allows for the efficient securing of public revenues, while at the same it does not distort free market competition and does not limit incentives for productive commercial behavior. Each tax has a different impact on economic behavior – saving, investment, entrepreneurship, employment and labor supply, etc.
The decision to change the relative weight of one tax in relation and at the expense of another significantly affects business and household incentives behavior, it will encourage some life and economic decisions made by both, while it will discourage others.
A country’s tax system may undergo changes that have taken into consideration the medium- and long-term challenges of the factors involved in increasing the productivity and quality of human capital, the structure and specifics of its economy, as well as the tax policies of countries that may be seen as regional or international competitors in attracting foreign or domestic investment.
Bulgaria and Central and Eastern European countries, which have joined the European single market coming from a position of a significantly lower GDP per capita and striving to catch up with richer economies in the union, generally choose a tax policy that encourages savings, entrepreneurship, investment, labor, and to a lesser extent – consumption.
In addition, it should be noted that such a taxation strategy is more adequate for smaller open economies in which international exchange of goods and services plays a huge role. Other countries in the region with a similar level of economic cohesion are generally competing to attract and retain foreign investment.
The tax system must also be designed to be capable of efficient collection of tax revenues. On the one hand, this is related to proper management of resources and costs (efficiency) that the revenue administration must account for in order to administer revenue collection.
On the other hand, the more complex the tax system becomes with the introduction of various tax exemptions and special regimes, the more probable it will be for economic agents to attempt abusing this to avoid taxation, which in turn would constitute a loss of efficiency. This usually leads to political pressure to increase tax rates in an attempt to compensate for lost revenues from exemptions, preferential tax treatment and poor tax revenue collection as a result of it.
Systems that rely on the widest possible tax base for taxation, but imposing flat and lower rates, are more efficient and effective than complex systems that rely on a narrower tax base, but with differing and higher rates.
Although seeming to have a relatively limited effect at first glance, the VAT rate reduction represents a change in the core philosophy of the country’s tax system. So far, tax policy in Bulgaria has relied on two main pillars – first, a broad tax base with as few as possible exceptions, allowing for low rates to be maintained.
The second pillar is the incentivizing of employment and investment through lower direct taxes at the expense of consumption taxes.
The introduction of insufficiently thought-through tax privileges will lead to a rapid deterioration in the budget balance, as seen in the previous crisis and as it has become clear from statements by several ministries that there will be no spending cuts on their side. This is in addition to declining budget revenues while expenditures grow as a result of the effects of the pandemic.
Therefore, the tax system must be considered in its entirety and looked at with attention to all its country-specific dynamics. Such preferential treatment for a range of economic activities are already putting pressure towards introduction of new taxes or increases in current rates, including VAT.
This is shown by the quick review of the structure and tax rates of VAT in other countries – in all countries with a reduced rate for food in restaurants the standard VAT rate is higher than in Bulgaria (except for France and Austria, which have a standard rate of 20%, Romania recently introduced differentiated rates and reduced the standard rate to 19%, however it has to be considered that the country runs an excessive deficit.
In some of the countries that are often cited as an example in support of the arguments in favor of preferential VAT treatment, the imbalance is significant – in Greece the standard rate is 24%, in Poland – 23%, in Hungary – 27%, in Sweden – 25%.
Unclear Effect on the Market, Consumption, and Prices
• The effect of a reduced rate, or in other words, determining how benefits of lower taxation are distributed among market participants, is a function of many characteristics specific to the market in which the goods and services are traded.
In general, with such treatment preferences built into the system, “support” – as it may be called – can either come as a result of increased consumption by lowering the final price for the consumer, or by having the trader’s profit increase while maintaining end prices for the consumer.
• The expected change in consumer prices as a result of tax cuts generally depends on two factors: the elasticity of demand, and the market structure is one, the intensity of competition and the elasticity of supply is the other factor.
Consumers are differently sensitive to price changes depending on the exact characteristics of a good – for some goods a small change in price can lead to a significant increase in consumption (superior goods) for others the change in consumption will be much less noticeable.
There are also goods with fixed consumption quantity due to its nature of being consumed out of necessity, for example, thus the consumption of those does only to a small degree or not at all depend on price levels.
On the other hand, traders may be applying pricing strategies, aimed at improving public image, attracting long-term customers, and creating loyalty. In those cases prices are unlikely to be seriously affected by changes in tax rates, at least in the short term.
At the same time, in some regional markets, the free unfolding of free market competition is often naturally limited by strong market shares by only a few suppliers who have significant power in the formation of final prices.
• Some recent measures to introduce differential tax rates in the region give an idea of the possible effect on prices. For example, Greece introduces a reduced rate for restaurants in May 2019 – 13% while maintaining a standard rate of 24%. In the first month after the new differential rates were introduced, there was a minor decrease in the level of prices in restaurants by about 0.2%, and within a 12-month period there even was an increase of nearly 2%.
More generally, even in competitive food markets, any tax cut will only be partially carried over into a reduction in the final price. Similarly, in Slovakia in 2016 and in Romania (in 2013 and 2015) lower rates were introduced for some food products.
An in-depth analysis of the effects has not yet been completed, but the immediate effects, measured through a change in prices in the months following the tax changes, indicated the following: following the reduction of the tax rate for bread from 24 to 9% (15 percentage points) in Romania in 2013, the average price of bread decreased by about 8-9%, while in the same period it decreased by over 2% in Bulgaria.
Also, during this time period the price of wheat on global exchanges fell by about 40%. With a reduction in the rate for other food products in 2015, average prices fell by 6%. In Slovakia, the rate for bread and milk was reduced from 20 down to 10 percent, with the resulting change in final prices being up to 2.5 percent, at a time when the price of raw cow’s milk was falling sharply on the European market.
If similar analogies with other countries are to be seen as adequate in the first place, which by design they not always are, these examples show a “carryover” rate of between 25% and 50% of the cut taxes to be actually subtracted from pre-tax cut price levels.
• The argument that lower prices (assuming that this is to be expected) will encourage visits to restaurants, etc., should be examined while also considering the specific circumstances that have led to the problems which the industry experiences. As a result of the continuation of some social distancing measures, the capacity of the restaurants or similar venues will be reduced.
Many Bulgarian households will voluntarily give up visiting public places in the coming months, even if safety measures are going to be further lightened or even abolished. Restrictions on international travel are likely to be maintained in some form, despite the measures discussed by the European Commission, which would apply to both Bulgarians traveling abroad and foreign tourists visiting Bulgaria.
But even without restrictions, at least for the next year, the inflow of short-term foreign tourists, increasing their consumption in restaurants attracted by lower prices, is unlikely to recover. In the short and medium term, it is even debatable whether or not lower prices will have a large enough effect on attracting more visitors and by this, more turnover.
• This leads to the conclusion that the efforts to selectively reduce VAT rates are in direct assistance to companies in the industry, allowing them to retain more of their turnover and thus increasing their profits.
However, there is no reason for entrepreneurs who have suffered adverse effects from the pandemic and the subsequent anti-epidemic measures not to take advantage of the various financial measures to support their business. They can participate in the measure for maintaining pre-epidemic employment (the so-called 60/40), they can take out loans guaranteed by the Bulgarian Development Bank (BDB).
They can also receive a direct subsidy of up to 10.000 BGN (granted for micro and small enterprises in the industry) and up to 100.000 BGN for medium-sized enterprises.
Increased Risk of Tax Fraud and Abuse of Legal Loopholes
The wording of the drafted law does not provide sufficient guarantees for the exclusive application of the reduced rate for the declared taxable product supplies only. The proposal was made without an in-depth analysis by the National Revenue Agency and difficulties regarding control over the lawful use of tax credit can be expected.
Also, the application of differential tax treatment on companies offering both in-house dining and the sale of food for domestic consumption will lead to additional confusion and the possibility of abuse. There is no clear control mechanism to prevent very probable cases of applying the reduced tax rate on sales on which in reality the standard tax rate should be applied.