Economic Effects of Change in the Value-Added Tax Rate in Europe: Implications for the Japanese Economy

In Europe, economic fluctuations associated with a change in the value added tax (VAT) rate are small. It has been pointed out that one reason for that is the way a VAT rate change affects prices. Many studies have been conducted on how price transfer occurs when a VAT rate changes. In Europe, there is a tendency to gradually change prices before a VAT rate change takes effect, reflecting an increase in demand. The ultimate price hike implemented at the time of a VAT rate change is equivalent to around 70% of the tax increase, and this less than full price transfer is said to be a reason for the moderate price change. However, previous studies have not made clear why a price change at the time of a VAT rate change is moderate. The purpose of this paper is to study factors that may have kept price changes after VAT rate changes moderate in Europe. That is because price changes affect economic activity through their effects on real income (income effect). In particular, this paper’s study focuses on the viewpoints of (i) the effects of the presence of multiple tax rates, including reduced rates for some particular items, and (ii) the situation of inflation in countries where VAT rates have changed. The effects of a VAT rate change on prices identified in this paper are as follows: 1) In cases when a VAT rate was raised by one percentage point, a price transfer equivalent to only 3.6% to 76.8% of the tax increase occurred. It was confirmed that this trend becomes more pronounced when a reduced rate is raised at the same time. Changes in VAT rates are not fully transferred to prices. 2) The effects on prices before the VAT rate change takes effect are observed to a significant degree under the following conditions: (i) a high-inflation region, (ii) a tax rate hike of 2 percentage points or more, (iii) a simultaneous raising of a reduced tax rate, and (iv) application of the tax change to durable consumer goods. In other words, it may be said that the effects are significant in an environment where prices may be easily raised (a high-inflation region) or when the difference between prices of items subject to the standard tax rate and prices of other items tends not to expand (a simultaneous raising of a reduced tax rate). However, regarding durable consumer goods, prices dropped before a VAT rate change took effect in many cases. 3) Because of the presence of reduced tax rates, items subject to the standard tax rate ac-counted for around 65% of overall consumption items on average. This means that if a change of one percentage point in the standard tax rate causes the same level of price transfer as the one estimated from my analysis, the effects on prices are even smaller. As shown above, the effects of a VAT rate change on prices in Europe are small presumably because (i) the real effects of a VAT rate change are mitigated by the effects of a reduced tax rate and also because (ii) tax rate changes are not fully transferred to prices. In other words, the situation in Europe is such that consumers tend to be insulated from the effects of a tax rate change. On the other hand, at the time of a VAT rate change, retailers are supposed to set new prices in a way that fully reflects the tax rate change, as tax-inclusive pricing is applied in the case of VAT. However, given that actual price changes after past VAT rate changes were moderate, it is possible that retailers may have shouldered part of the tax increase or that the quality or quantity of goods and services may have been changed. From consumers’ viewpoint, this point may not emerge as a problem if they take a price change more seriously than a quantity change. However, a more detailed analysis needs to be conducted as to why the price change at the time of a VAT rate change is small relative to the tax rate change.