Differentiated VAT, flat VAT – which is better?

In recent weeks, the most current political and economic topic in the country has been the numerous proposals to abolish VAT, which seem to be pouring in from absolutely all sides of the political spectrum in the Bulgarian parliament. After the initial proposal, which came from the DPS, alternative ideas for abolishing the value-added tax have appeared in both the BSP and GERB.

However, these otherwise attractive (at least at first glance) proposals for the taxpayer have also led to some confusion, with some media and experts describing them as populist and misleading. In this article, I will examine point by point the potential pros and cons of both introducing a differentiated VAT on certain specific goods or entire sectors, and abolishing VAT altogether. I will start, of course, with the most topical question on the topic, which is...

Does lower VAT always mean lower prices?

Proposals for the introduction of differentiated VAT rates on certain goods (bread, medicines, books, etc.) are mainly argued that this will lead to lower prices. However, whether the removal of VAT in a given sector will lead to a drop in prices depends on the specifics of the sector. If the sector has a high level of competition, is not strongly regulated by the state and is accordingly more flexible with respect to the wishes of consumers (such as food), then yes, most likely the removal of VAT in it will result in lower prices than we would have otherwise. However, if it is a sector in which the level of competition is relatively low, there is a strong level of state regulation and, accordingly, the businesses in it are not particularly flexible, then the removal of VAT may have almost no effect on prices for the consumer.

The phrase "lower than we would have otherwise" is key when talking about the effect of removing VAT in flexible sectors. Removing VAT by itself will not in every situation lead to a visible drop in prices (i.e. price deflation), because, as should be clear, this tax is not the only factor that influences pricing. In fact, I would not even define VAT as a main factor. The most basic factor is always the demand for the goods in question, which exists on the market, and after it comes, of course, the purely material ability of producers and traders to provide the goods in question at a profit. Thirdly, the level of monetary inflation (i.e. depreciation of the purchasing power of money), which depends on monetary policy, also plays a serious role.

Fraud risks and potential market distortions

Another point to be careful about when discussing the introduction of differentiated VAT rates is the risk of tax fraud and causing market distortions. The most dangerous here are particularly specific proposals to reduce VAT on only certain goods from a given sector (for example, bread), instead of all (i.e. for all food products). You can imagine how easy it would be if a 5% VAT were introduced only on bread, traders of all approximate goods made from dough (including various types of pastries) would start reporting sales of bread in order to pay lower VAT.

The risk of fraud will always increase when VAT is differentiated, but it can at least be minimized. The pattern is quite simple – the more specific the VAT differentiation, the more and easier opportunities for tax fraud there are. If VAT is going to be differentiated, let it be differentiated only for ENTIRE categories of goods and sectors (food, medicines), and not just for specific goods from a given sector (bread, books).

When introducing a differentiated VAT, the risk of tax fraud must always be taken into account, because the negatives of such fraud can be very serious. And I am not talking about purely fiscal negatives here. In fact, I do not find this to be such a serious problem at all. The more serious problem is that not all market players will be able to benefit from the implementation of tax fraud. If it is possible to save tax through fraud, all market players have a financial incentive to do so, but not all can. What would happen in practice is that some will do it with impunity (those who take bribes and have political connections), and another part will still try to do it, but they will not be able to because they do not have the political connections of their competitors.

All this means an increase in the risk of corruption, regulatory arbitrariness and ultimately a distortion of market conditions in favor of those businesses that have the connections and means to bribe the authorities. The more specific the level at which VAT differentiation is implemented, the more acute this type of risk becomes. This is the most important thing to remember when discussing such proposals. Therefore, in order to minimize such risks, if VAT is going to be differentiated, let it be done only on entire categories of goods/sectors. The market distortions thus caused will not be so significant.

Wouldn't it be better to remove VAT entirely?

Of course, in this line of thought we should discuss why we don't just remove VAT entirely, on all goods? This is certainly the most elegant choice, which would not lead to any market distortions and would have the most significant effect on absolutely all consumers. Let's not forget that in addition to practically privileging some traders over others, VAT differentiation also privileges some consumers over others. For example, removing VAT only on food goods privileges those who spend the most significant part of their income on food, compared to those who spend relatively less on the same.

In Bulgaria, we have the opportunity to reduce VAT on all goods to 15% - that's the minimum in the EU. Why don't we take advantage of it? Reducing VAT on all goods by 5% would certainly have a much more serious macroeconomic effect than just the specific differentiated reduction of the rate by 10-15%, but only on some goods. The overall level of savings that would be realized by traders, producers and consumers would be higher. Don't come out with the argument that there is no need for such a large-scale reform, because our taxes were low anyway. As we have explained before, this is simply not true.

What about the treasury?

Of course, if we remove VAT on all goods, this will also lead to a more serious decline in treasury revenues. But the loss of tax revenues should never be used as an argument against removing one or another tax. The fact that cutting a tax will lead to lower tax revenues is, if not an obvious truism, then at least an expected consequence in principle. The logic is extremely wrong, in which the removal of taxes must necessarily be considered not only as a benefit for taxpayers, but also as a benefit for the treasury. After all, their interests are radically opposite in this case! After all, the treasury is filled with the money that is seized from taxpayers. There is no way that both the wolf and the lamb are full. At the moment, by the way, it is the last chance within the current business cycle to undertake such a serious tax reform - when tax revenues are still high due to the economic boom that we are now emerging from. With regular fiscal surpluses, cutting VAT will not have such a tangible effect on the treasury balance at all.

But the bottom line is that cutting VAT benefits everyone else – traders, producers, workers and, of course, consumers. Period. I include all of these groups because, although traditional VAT theory holds that the burden of the tax is borne entirely by consumers, in reality this is not always the case. In reality, it is not at all easy to implement a consumption tax that is borne entirely by the end consumer in every situation. But that is a topic for another article.

Alas, the best proposal has the weakest lobby

For the purposes of this public debate, it should be abundantly clear that even without doing any calculations on the matter, reducing VAT on all goods by 5% would have a much more significant positive macroeconomic effect than reducing VAT on just one category or, worse, on one specific good, by up to two or three times as much. A lower overall VAT would also be far more attractive to foreign investors, which could stimulate the creation of more jobs in the country and lead to faster income growth in the long run.

The problem is that while there are serious lobbies (from the relevant businesses) for privileging a certain type of traders and producers through differentiated rates, such a lobby does not exist for the complete abolition of VAT. Why? Well, because each sector only looks after its own interests (as is logical). Why would bread producers lobby for a tax reform that would also help pharmaceutical companies and pharmacies? Alas, dear taxpayers, we cannot expect the various industry organizations and lobby groups by sector to lobby for a complete reduction in VAT, even if this would be the most beneficial. This lobby can only come from us - ordinary taxpayers and economists, who have the claim to a sober judgment regarding the effects of the state's tax policy.

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