The economic impact of VAT
Business Page
By Patrick van Beek
Stabroek News
January 14, 2007
Introduction
Following on from last week's article I would like to highlight Nigel's Supermarket for being the first supermarket I have visited since the implementation of VAT for which the majority of sticker prices were VAT inclusive. It makes shopping easier and will be a significant factor in determining where I choose to shop. For the businesses which are still incorrectly applying the VAT exclusive method - take note, the VAT inclusive method can be done. Given that if you advertise VAT exclusive prices you must show the amount of VAT with equal prominence, why not just show the VAT inclusive price and save having to put up two prices? I am not sure how long the Guyana Revenue Authority will turn a blind eye to the `16% will be added at the till' signs, in order to effectively fulfil their mandate they will need to start enforcing the law as written.
VAT remains an ever popular topic of conversation. Businessmen I have spoken to are lamenting the lack of understanding by the general public with respect to their stock on hand on which consumption tax has been paid and for which no relief can be granted. The general public appears unhappy that in many cases VAT has been applied simply by adding 16% to the previous sticker price without any thought.
I was interested to read today that some suppliers were discovering that demand has been dropping off after prices were marked up by 16%. This is one aspect of the VAT which I do not think has been touched on by the media a great deal - the expected economic impact. Today I will look at the incidence of VAT; that is on which segment of society the burden is accepted to fall. I will examine whether VAT is regressive in nature, the impact on supply and demand and end with a brief look at inflation.
Inelastic Demand Elastic Demand
A regressive tax is one where the effective rate of tax decreases as the amount to which the rate is applied increases. Expressing the amount of VAT payable as a proportion of net level of income it can be seen that VAT on a particular basket of goods is in a sense regressive. Paying $1600 on a basket of goods worth $10,000 is 8% of a net income of $20,000 while only 0.8% of a net income of $200,000.
Strictly a tax is regressive if it causes a disproportionate shift in the incidence of tax to those with smaller incomes. If a good or service on which VAT has been applied is more likely to be purchased by the poor and less likely by the rich then applying a tax on this good or service would be regressive.
That is why the last minute amendments to the VAT legislation were so crucial. Many of the goods which would originally have been subject to VAT were staples and as such represent a greater proportion of the budgets of those with lower incomes. In economic terms these goods are said to have an income elasticity of demand of less than one. If VAT had been applied on these goods then those with lower incomes would be paying proportionately more than those with greater incomes.
VAT still remains on some staples such as clothing and flour: thus overall the introduction of VAT would be expected to have a disproportionate effect on those with lower incomes and hence is regressive.
Supply, demand and deadweight loss
One thing that I was curious about was whether after applying a 16% mark up businesses would still be doing the same amount of business as before. I remembered studying economics and the imposition of a new tax, and how, in theory the burden is shared between producers and consumers. Thus I was curious whether, when VAT was implemented (on those goods previously not subject to consumption tax at 30%) prices would increase by less than 16%. Sadly we live in the real world and not one where economic theory prevails and I think very little has increased by less than 16%.
However if there is any substance to the theory of supply and demand suppliers should be preparing for a significant drop in sales on goods where demand is elastic. As the graphs above show, where demand is inelastic the supplier can increase prices and most of the burden of the tax is borne by the consumer. However where demand is elastic the seller must bear the brunt of the tax. Equivalently, a supplier of an inelastic good who tries to pass on the tax to the consumer will be in for a rude shock as sales will fall rapidly.
I cannot believe that every good in Guyana has inelastic demand -people will simply stop buying the goods and services on which 16% VAT has been charged and which they do not really need. Where the elasticities of supply and demand are equal the burden should be split 50/50 - I gather this is a rather uncommon occurrence, so look out for 8% increases.
In any event, the imposition of VAT on goods and services which were previously not taxed will lead to a loss of economic efficiency as goods are no longer clearing at equilibrium prices. The effect is rather difficult to quantify, though I am sure it would make an interesting research project for a UG student majoring in Economics!
Inflation
The final point I would like to touch on is inflation. I have no doubt that when January's cost of living as represented by the Georgetown consumer index is published it will see a spike in prices. This is typically a one-off and unlikely to result in a sustained increase in prices unless there is a series of inflationary wage/price spirals in response. It will mean though that real incomes will fall, again having the largest impact on those who least can afford it - those with low incomes to begin with.
Conclusion
By and large economic theory dictates that proportionately VAT falls most heavily on those with low incomes. As many consumers fall into this bracket I can foresee a decrease in economic activity as a result. On goods where demand is elastic suppliers should be expecting to share some of the cost of applying the VAT with the consumer - or face a serious drop in sales.