VAT causes inflation?

Sat 6th Jan 2018

As the first two Gulf states, Saudi Arabia and UAE, join this week the other 160-plus countries with a VAT regime, the old objection to VAT – that it causes inflation – has arisen.

To counter this, both countries have implemented strict checks on abuse of the change. For example, the UAE’s tax agency inspection team has created a comprehensive database of all commodity prices in the last year to compare to post-VAT launch prices. Saudi Arabia is certainly concerned about the impact of a rise on the less well off. The Kingdom’s ruler, Salman, has authorised monthly payments of around $300 per state employee to help meet any rise in costs as the inflation is passed through to shoppers. This will compensate approximately two-thirds of all the working population.

Economics for VAT dummies

However, VAT alone cannot cause inflation. In economic terms, only a long-term expansion of the monetary base can do that.

Introducing VAT certainly leads to a price spike in most situations since it is designed as a tax on the final consumer.  The resulting price rises may then flow into wages. The full extent of the passing on of new VAT (or increase in VAT rate where the regime is already in place) depends largely on demand and price elasticity.

Also, much of the impact of a new VAT depends on the taxes it is replacing or new spending it is funding. And VAT introductions or rises tend to come in the middle of other austerity measures – witness the rise in average EU VAT rates from 19% to over 21% during the financial and Euro crises. This makes measuring any direct inflation rise challenging. For example, the UK’s 1973 implementation of VAT came in the middle of the oil crisis, which was used as a mask by many retailers to hike prices above the newly introduced VAT.

VAT causes single price spike only in global studies

Alan S Tait did some illuminating work in this area, looking at IMF data, and found no major effect on inflation from the VAT of implementation. He observed that 33 out of 41 countries which had introduced VAT in the past 30 years had seen no material rise.

Of course, direct intervention in price rise supervision around the launch dates of VAT can suppress any inflationary effects. India’s recent switch to GST has come with heavy auditing of pricing rises, including shop-by-shop audits. This follows the historic success of Austria, France, Korea, Norway and the Netherlands.

In summary, there may be a one-off hike in the short term, but then drops out of the inflation measure the next year. Even this rise is usually mitigated or controlled by other government actions. So economists generally agree there is no meaningful inflationary impact to implementing VAT.



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