Global trend – Steady Growth of VAT rates

What lies behind government politics to increase the VAT rates?

It has been witnessed in the last few years and more that countries all around the world are intrinsically connected to the necessity to raise the VAT rates. Of course, this doesn’t mean that the governments haven’t acted with some degree of “empathy” during Covid-19 times and decreased to some extent VAT rates, mainly the ones which have been connected to grocery items, food, or medicines to help people cope better with the economic meltdown. When the pandemic has been “officially” finished, some of the countries have returned “fast” to the decreased rates to pre-Covid levels, and others have “run” towards the steady increase of their rates.

This year we have seen that many countries have increased their VAT rates, even significantly, and in the next few years, we can expect that this trend will continue. Some states have already announced via legislation that this shall happen.

Some of the countries which are planning to increase their VAT rates during the next two-year period are:

• Switzerland;
• Estonia;
• Singapore;
• Indonesia.

To go back to our initial question, what lies behind the “risky” and “bold” move of the national governments to increase the VAT rates within their borders, and what effect would that produce as regards the domestic economy, as well as what kind of effect would that move create as regard that country and its international business environment?

We would try to explain the drivers and effects of the VAT rate increase using the macroeconomic and microeconomic lenses.

Relevant Microeconomic effects:

1. Consumption Patterns: An increase in VAT makes products and services more expensive, which can alter consumer behavior. This might lead to decreased demand for certain goods, particularly those considered non-essential.
2. Business Margins: Small and micro businesses may find it more difficult to absorb the VAT increase, leading to higher prices for consumers or reduced profit margins. This might impact their competitiveness.
3. Supply Chain: Firms might seek to restructure their supply chain to minimize the VAT effect, possibly impacting contractual relationships with suppliers and customers.
4. Income Inequality: Those with lower incomes may feel the impact of the VAT increase more acutely since they spend a higher percentage of their income on consumption, leading to increased inequality on a micro level.

Important Macroeconomic Effects:

1. Inflation: The immediate effect of a VAT increase can be a one-time upward level shift in the price level. If the increase is significant, this could translate into higher inflation.
2. Consumer Spending: If consumers cut back spending due to higher prices, it might lead to a decrease in overall consumption, one of the significant components of Gross Domestic Product (GDP).
3. Government Revenue: An increase in VAT typically results in higher revenue for the government. This could be used for deficit reduction, investment in infrastructure, or other public spending, which could have positive effects on the economy if used efficiently.
4. International Competitiveness: An increase in VAT can affect the prices of domestically produced goods compared to foreign goods. If the domestic products become too expensive, it might reduce exports and increase imports, potentially affecting the balance of trade.
5. Interest Rates: Central banks might respond to the inflationary effects of a VAT increase by adjusting monetary policy, which could impact interest rates. This has further consequences for investment and consumption.
6. Economic Growth: The net effect on economic growth is ambiguous and depends on how the additional government revenue is used and how consumers and businesses react. If the VAT increase reduces consumer spending significantly, it could slow down economic growth. Conversely, if the government uses the additional revenue for productive investments, it could offset some of the negative effects or boost growth.
7. Business Investment: Higher prices might reduce demand for goods and services, leading to a reduction in business investment. However, if the government uses the additional revenue wisely to improve infrastructure or other business-friendly initiatives, it might offset this effect.

There are various formal reasons that government officials have mentioned as regards what are the pivotal drivers behind these decisions, and they can be, to some extent, very different.

If we take a look at the drivers of the change in the tax policies of Switzerland and Singapore, we would read that there is a continuous need to increase the portion of the state budget which needs to be allocated for pensions and public health care system.

I would address one of the most surprising VAT rate changes in the way it was announced the VAT rate change happened in Turkey. Just a month back, where really “without previous notice,” the government decided to change the VAT rate just a few days after the publication of the amendment to the Tax Code.

To move forward toward the conclusion, at this point, where the truth lies is the question that many are asking.

We would quote at this point due that our opinion is aligned with the opinion of OECD analysis on the trends regarding the continuous, decades-long trend of growth of consumption taxes, and that survey states that the trend lies in the fact that the government has seen the indirect taxes as a great tool to accumulate more money for the state budget, and it’s one of the best ways to do so. This approach has been followed for more than two decades, and it’s expected that it would be followed in the future also.