Doubts on effectiveness and pass through to consumers as inflation rockets and government reach of energy and food VAT reductions
The Organisation for Economic Cooperation and Development (OECD) has raised doubts on the effectiveness of temporary VAT rate cuts to help consumers during rising inflation. Last month, the IMF challenged VAT rate cuts on the same basis.
The OECD points out that whilst cuts in VAT and similar excise duties can give near immediate relief and are easily communicated. In this sense, they are popular with politicians like price controls.
EU VAT cuts to combat inflation are rife at the moment as June Eurozone inflation hit 8.6%.
However, the OECD raises several problems with the policy:
- fiscal revenues immediately decrease, and the budgetary cost can be high over time.
- a VAT rate cut does not guarantee a consumer price cut of the same extent (Benzarti, Carlonie and Kosonen, 2020).
- the pass-through of tax cuts into consumer prices may be lower in times of constrained supply, as is the case today (Marion and Muehlegger, 2011).
- Apart from reducing the effectiveness of government support, there may also be fairness concerns when tax cuts directly translate into larger profits for fossil fuels producers.
The OECD therefore suggests countries should therefore aim to support vulnerable populations through targeted income support, while developing alternative energy sources and transportation modes.
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