Raising taxes leads to higher prices, but lowering them leads to greater profits

Mar 17, 2021

Sections Economics Public Policy

Collections Tax Policy

Value-added taxes raise the most revenue of any tax among countries in the Organisation for Economic Co-operation and Development, and some form of VAT has been adopted by almost all countries in the world. While it is commonly assumed that their burden is borne by consumers, there is limited empirical evidence.

But research sheds new light on the question using data from Finland, which implemented a large—14 percentage point—VAT decrease in the hairdressing sector in 2007, which was later reversed in 2012. The magnitude of the cut, its temporary nature, and the richness of the Finnish administrative dataset allowed University of California at Santa Barbara’s  Youssef Benzarti, the Congressional Budget Office’s Dorian Carloni, Jarkko Harju of the VATT Institute for Economic Research, and Tuomas Kosonen of the Labour Institute for Economic Research to track the effect of the VAT cut on prices and company-level outcomes.

Their findings suggest several new conclusions about the incidence of VATs. First, prices responded twice as strongly to the VAT increase as they did to the VAT decrease. Second, prices remained higher, even after the VAT cut was repealed, implying that equilibrium prices are history dependent. Third, and relatedly, both markups and profits mirrored the response of prices in that they reacted asymmetrically to the VAT changes. Fourth, the asymmetry depends on company profit margins: businesses with low markups were more likely to pass through tax increases than businesses with high markups, while pass-through in the case of tax decreases was homogeneous across companies.

These findings are corroborated through the analysis of a larger sample of all VAT changes that took place between 1996 and 2015 in all member countries of the European Union. Using the impact of these reforms on prices, the authors estimate similar magnitudes of asymmetric pass-through of VAT increases and decreases to prices. Importantly, this asymmetry exists in all the subsamples of commodities, types of VAT changes, countries, and periods considered. This EU-level analysis provides reassurances about external validity issues around the Finnish experiment.

These findings have several important policy implications. First, given the magnitude of the asymmetry, policy makers, and in particular, budget scoring organizations, should be careful when using previous pass-through estimates to predict the effect of future VAT changes without accounting for the direction of the change. Second, and relatedly, these findings caution against using VAT cuts during recessions to stimulate demand; such VAT cuts are more likely to stimulate supply rather than demand, since VAT cuts are barely passed through to prices and thus end up benefiting firms. Even more concerning, if VAT cuts are temporary, as was the case for the 2009 UK VAT cut, they could lead to higher equilibrium prices once repealed, further depressing demand.

Explaining the asymmetry is not easy, in part because it is inconsistent with most standard models. The authors suggest that—in certain settings—prices may not be entirely set by market forces alone, and that pricing norms may be strong enough to counteract market forces. Such pricing norms could be driven, for example, by fairness considerations. Indeed, research by Princeton’s Daniel Kahneman, Jack L. Knetsch of Simon Fraser University, and Chicago Booth’s Richard H. Thaler has found that customers will accept price increases when costs increase and do not feel antagonistic when firms fail to adjust prices downwards when costs decrease. Erik Eyster of the University of California at Santa Barbara, London School of Economics’ Kristóf Madarász, and Brown University’s Pascal Michaillat introduce the insights from Kahneman, Knetsch, and Thaler into a simple monopolistic pricing model, which yields results consistent with several of the empirical findings about VAT asymmetry produced by Benzarti, Carloni, Harju, and Kosonen.

This article was produced in collaboration with Microeconomic Insights. For more on this research, see Microeconomic Insights’ full description of it here.