The Effect of the VAT Rate Change on Aggregate Consumption and Economic Growth

Abstract

The purpose of this paper is to empirically determine the effect of a change in a country’s Value Added Tax (VAT) rate on its aggregate consumption and its economic growth. As for the effect on aggregate consumption, this paper removes the income effect and discusses only the substitution effect. Using panel data models on a sample covering up to 14 developed countries, including Japan, and quarter periods from the second quarter in 1980 (1980 Q2) to the third quarter in 2010 (2010 Q3) and picking up 53 cases of the change of the VAT rate, this paper shows empirically that aggregate consumption and economic growth display three kinds of trends when the VAT rate is changed. The first trend is that aggregate consumption and economic growth increases [or decreases] just before the rise [or reduction] of the VAT rate. The second trend is that they decrease [or increase] relatively dramatically as soon as the rise [or reduction] is implemented. The third trend is that after the dramatic decrease [or increase] they increase [or decrease] gradually. Section 1: Introduction Governments raise taxes for public expenditure, ranging from social security to national defense, education, and infrastructure like highways or airports. The question is what kinds of taxes are raised and what sorts of effects they have. In particular, the difference between income taxes and consumption taxes is important. Consumption taxes are mainly divided into two types. One is general consumption taxes, which are imposed on an extensive range of goods and services. They are usually VATs. The other is excise taxes, which are imposed on specific goods and services like alcoholic drinks, tobacco, gasoline, etc. There are several characteristics to notice in general consumption taxes. First, it is often said that general consumption taxes are better for economic growth than income taxes because of their effect on savings and on labor supply. Since general consumption taxes do not impose on savings while income taxes impose on savings and on the income from savings (interest), general consumption taxes can 1 Bumpei Miki: A visiting fellow of the Center on Japanese Economy and Business (CJEB) at Columbia University from September 2010 to May 2011 (mikibumpei@hotmail.co.jp). The views expressed in this working paper are mine and do not necessarily represent those of CJEB. I wish to thank Jaejoon Woo at International Monetary Fund (IMF) who gave me a basic idea on empirical methodology of this paper. 2 encourage savings, leading to increased investment and growth. Also, general consumption taxes do not affect people’s decisions about whether or not to work, while the progressive income tax system, make people reluctant to work since a higher tax rate will be imposed when people work harder and earn more. General consumption taxes encourage savings and labor supply rather than income tax and subsequently have a positive effect on economic growth. The second characteristic is that general consumption taxes improve competitiveness. The argument that general consumption taxes promote international competitiveness is made most strongly in the comparison between the VAT and corporate tax. Corporate taxes increase the cost of capital and hence the cost of production, thus making it more difficult for the affected firms to compete in foreign markets. In contrast, the VAT is refunded on exports and so has no effect on the ability of domestic firms to export. From this view, general consumption taxes are better for domestic economic growth than income taxes. The third characteristic is that general consumption taxes increase inequality between the rich and the poor compared to income taxes. This is clear because income taxes are generally progressive while general consumption taxes are proportional. Also, since both savings and capital income are more highly concentrated at the top of the income distribution than labor income in general for developed countries, a change from income taxes to consumption taxes, which improves the incentive to save and reduces the taxation of capital income, would lead to increased inequality. In order to weaken this negative effect of consumption taxes on income distribution, many countries adopt reduced VAT rates for necessities such as food and newspapers. These three characteristics imply that a government will raise the share of consumption taxes or income taxes depending on how it assesses the positive effects on economic growth and negative effects on income distribution. According to Organization for Economic Co-operation and Development’s (OECD’s) Policy Brief in 2007, 29 of the 30 OECD countries have a VAT. Although the revenue of consumption tax has declined from 1965 to 2005 (most of the reduction has taken place between 1965 and 1975) because of a decrease in revenues from excise duties and other specific taxes, VAT revenue as a percentage of total tax revenue has been rising, as seen in Table 1. VAT has become more important for developed countries. OECD also argues that countries with increased revenue shares from taxes on consumption have all experienced higher revenue shares from general consumption taxes and all the countries with reductions in the revenue shares of general consumption taxes have experienced lower tax revenue shares from all taxes on consumption from 1995 to 2005. Some countries have experienced an increased share of revenues from general consumption taxes at the same time as a reduced share from taxes on consumption as a whole. This illustrates the fact that revenues from general consumption taxes (and the VAT in particular) have grown faster across the OECD as a whole than all consumption taxes.