Oleg Krasnopyorov: Who has grain, who has chaff: some reflections on the reduced VAT rate on food

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Lower VAT for typical Latvian fruits and vegetables – what results?

The main results, in my opinion, are as follows:

• Prices for fruits and vegetables have fallen less than the reduction in the VAT rateⁱ. As usual, before the tax cut, buyers were promised that traders would be “fair” and reduce prices in full; it later turned out that buyers should be grateful for even smaller price reductions. The failure of traders to keep this “promise” was not due to traders’ “unfairness” or insufficient supervision, but to economic laws – relatively inelastic demand for food products with changing prices (thus predictable).
• The fact that fruits and vegetables cost consumers a little cheaper is actually paid for by the state budget – with lower tax revenues (see the opinion of the representative of the Ministry of Finance here).
• The ratings available in the public sphere often exaggerate the positive impact on the industry. For example, turnover and wage growth in the industry are often raised. However, the performance of the sector is quite similar to the overall indicators of the economy, so it can hardly be considered as a reflection of the impact of lower VAT.

Farmers, producers have been insisting for years that the reduced VAT rate should also be applied to other food products …

It is only logical that each industry actively defends its interests. But we need to think about the common interest – what will be more beneficial for the country as a whole? Food is a quarter of our consumer basket – lower VAT on all food would create a significant deficit in the state budget. There are five ways to make up for this deficiency (and all five have negative side effects):

1. Increase the VAT rate on non-food goods. I will not envy the Minister of Finance, who will offer something like that. Several sectors are already lobbying for a reduction in the VAT rate, citing the effects of the Covid-19 crisis (books, catering and accommodation). Finding a compromise on a sector-by-sector basis can open a Pandora’s box with an even sharper fight between industry lobbyists for every percentage point of VAT. In this case, there is a possibility that we will have four VAT rate regimes instead (21, 12, 5 a 0%), but even more so that would complicate tax administration, budget planning and assessing the impact of rate changes.

2. Raise other taxes. The two main tax groups are consumption taxes and labor taxes. If there is a large reduction in consumption taxes, it is unlikely that labor taxes (personal income tax, social security contributions) will be raised. I do not support this, because raising labor taxes would increase structural unemployment, the share of envelope wages and directly reduce the competitiveness of Latvian companies in comparison with foreign producers – exports would decrease, imports would increase (because VAT is levied directly on imports, not exports).

3. Reduce government spending. In this case, I envisage a long discussion on what exactly the government’s function is to reduce funding (education, health care, rescue services, roads, etc.). In addition, they are all important functions for society, each has a strong lobby that struggles every year to increase funding …

4. Increase the government deficit, thus placing a higher public debt burden on future generations. I would like to emphasize here that the increase in the deficit is only permissible in the short term, in exceptional cases, such as offsetting the effects of the Covid-19 crisis. However, a permanent reduction in taxes at the expense of growing deficits is not a sustainable solution.

5. Pretend there will be no shortage of tax revenue. Namely, to try to prove that due to the lower VAT rate, the retail turnover of food will increase to such an extent that tax revenues will not decrease at all (I already showed in the article in 2019 that they, of course there is nonsense, as food demand is inelastic to price changes). The fifth option would probably be the worst, as it would mean an “unexpected” shortfall in tax revenue, which would have to be remedied in a hurry with one of the measures no. 1-4.

Does a lower VAT rate on food not help the low-income population, which would be particularly relevant in mitigating the effects of the Covid-19 crisis?

People with higher incomes (quintile 5) spend almost twice as much on food amount of money than the lower income population (1st quintile)ⁱⁱ. Thus, high-income people would benefit more from a lower VAT rate than low-income people. As we can see, the reduced VAT rate on food is a rather ineffective weapon in the fight against income inequality. Much more effective weapons are:

• In the short term, social benefits specifically targeted at the poorest;
• In the long term, ensuring a level playing field with strong “social lifts” (including raising the quality of education).

So why does food have a reduced VAT rate in some European countries?

Low-income people spend on food most of their incomeⁱⁱⁱ. That is why lower VAT on food is sometimes used as an income equalization tool – although, as I said, this tool is not very effective.

It would not be wise to introduce something just because it exists in some other countries. Latvia needs to think with its head what tax rates would be better for our economy. What we see elsewhere may also turn out to be anachronisms that were formed long ago under the influence of the interaction of some lobby groups, and now there is only inertia. An example is here generous support from farmers in several countries around the world.

Does the fact that Latvia has a higher VAT rate than some other European countries not worsen the competitiveness of our products?

VAT has nothing to do with competitiveness, as it is levied on final consumption and not on production. Latvian exports are not subject to VAT. For example, when Latvian companies export curd cheeses to France, their price includes exactly the same (French) VAT as for curd cheeses produced in Poland. Also in the Latvian domestic market – all prices of cottage cheese include 21% VAT, regardless of where the cheese was produced (Latvia or Poland).

And yet, perhaps it is worth reducing VAT on accommodation and meals, thus offsetting the sectoral restrictions on Covid-19?

The VAT reduction is a rather ineffective tool to offset the limitations of Covid-19. At a time when there is no turnover in the industry, the amount of the VAT rate is irrelevant. On the other hand, at the moment when the restrictions are lifted, the turnover is growing rapidly and even exceeds the pre-crisis level due to the delayed demand.^iv – additional support is no longer needed.

In addition, changes in tax rates are a long-term tool for economic regulation: too frequent changes in tax rates would mean an uncertain business environment that could deter companies from investing. More efficient short-term effects on the economy can be achieved through one-off spending. It was in the context of the Covid-19 crisis that one-off expenditures proved to be quite effective: if there were no downtime benefits, wage subsidies and business support in Latvia, the unemployment rate would now be almost twice as large.

In summary – reduction of the VAT rate for certain groups of goods:

• does not provide a symmetrical price reduction;
• creates a deficit in the state budget;
• the positive effects on industries are often exaggerated;
• is not the most effective tool for tackling inequality;
• does not affect the export capacity and competitiveness of the industry;
• generally seen as a fiscally inefficient and costly tool pursued by lobby groups in their own interests.

i According to my calculations, the actual decrease in the prices of fruits and vegetables typical of Latvia was 9.8%. According to the calculations of the representative of LLU Alexei Niper, it was 11.7%. The full impact of the lowest VAT rate on prices would be 13.2%.

ii In 2019 respectively 129 and 74 euros per month per household member.

iii That’s why VAT on food sometimes is considered a regressive tax.

iv We could see it well in March, when there was a great demand for hairdressing services, as well as in the middle of May, when there were no free tables on the cafe terraces.

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