Standard or Implicit VAT Rate?

Standard or Implicit VAT Rate? SOUKOPOVÁ Jana 1,a, ŠINKYŘÍKOVÁ Tereza 1,b 1 Faculty of Economics and Administration, Masaryk university, Lipová 41a, 602 00 Brno a soukopova@econ.muni.cz, b 99835@mail.muni.cz Abstract This paper deals with the standard and implicit VAT. The VAT is a key tax collection resource, representing an average of 7.7% of GDP. Standard VAT may not provide a simple key to defining VAT collection (as % of GDP). The implicit VAT rate, rather than the standard VAT rate, is relevant for defining VAT collection. This paper focuses on whether the VAT correlate with the VAT share of GDP revenue, and compares standard and implicit VAT to determine which has a stronger correlation to the VAT share of GDP. The aim is to show which rate of VAT (standard or implicit) is better for comparing and gives more complex information for decision. We analysed the data of European Union and the ten-year period from the beginning of 2002 to the end of 2011. We used an analysis tool set comprising the theory of sets and correlation analysis. The results of the analysis did not provide a clear answer, especially as regards the standard VAT rate. It is not possible to say that there is any definite causality between the standard VAT rate and tax revenues. In contrast, causality was confirmed with the implicit VAT rate. Keywords: Value added tax, standard rate, implicit rate, tax revenues JEL Classification: H21. H25, H83 1. Introduction Value Added Tax (VAT) is one of the most successful and prodigious phenomena in the contemporary fiscal structures. Developed in the 1950s, it has rapidly become the most widespread consumption tax in the world, deeply entrenched in the tax systems of more than 140 countries [1]. Despite the strong harmonization of taxes within the European Union (EU), especially in the field of indirect taxes, VAT are far from unified. Each EU member state sets its own VAT rate according to Council Directives, especially 2006/112/EC. The standard VAT rate may not be less than 15% (Article 98). Member states are not limited by tax brackets, only by minimum. Differences between the (standard) are possible, such as the difference between Hungary (27% VAT) and Luxembourg (15% VAT). Each member state can freely decide the VAT rate while observing different goals, e.g. budgetary, including increased tax income, the stimulation of aggregate demand or the level of consumption, increasing or decreasing the relative emphasis on indirect taxation (in the overall tax burden), etc. To mitigate the regressive impact of indirect taxation, reduced are sometimes applied. The list of goods and services to which reduced may be applied is set forth in Annex III to Directive 2006/112/EC. There are also super-reduced and zero. The original objective of VAT (enshrined in the first VAT directive, Directive No. 67/227/EC), i.e. taxation in the country of origin, has not yet been pushed through, and it seems probable that this objective will remain a theoretical vision in future decades; see [2] where abandoning the objective is mentioned explicitly. However, VAT as such, including its parameters, continues to be a key issue. Is it actually possible to compare VAT revenues (as a relative share in GDP) considering the aforementioned considerable differences in the application of various VAT? Indirect taxes, including VAT, gained increasing importance in total tax revenues. This is true even though the VAT actually collected represents about 50% of the theoretical VAT revenues that would be collected if there were no evasions and all final consumption was submitted to a standard rate [2]. This is one of the main reasons why exploring standard VAT may be insufficient and why we decided to further extend the research conducted in 2012 [4] with implicit. Moreover, according to the neoclassical assumption, an efficient 90

(economic) tax rate has a greater impact on economic decisions on savings and investments, and hence on the Gross Domestic Product (GDP) of a country in general, than the standard rate. As already mentioned, changes in VAT, applications of various (basic, reduced, zero, etc.), tax exemptions, etc. are based on EU directives on the one hand, and serve as political tools aimed at stimulating domestic consumption, etc. on the other hand. The issues related to the tax revenue level and increases in the VAT rate used as tools for filling public budgets have recently come to the fore in connection with the economic crisis. If this policy instrument for increasing revenues, i.e. increasing VAT, does not result in increases in VAT revenues, it is appropriate to ask the question: Is increasing the standard VAT rate actually a suitable and relevant political tool for increasing tax revenues? To answer this question, we analysed the strength of the relationship between standard VAT and the amount of VAT revenues (% GDP). To extend the analysis and discover the importance of the issues related to the tax base in comparison with standard, we supplemented this analysis with an analysis of the relationship between the implicit VAT rate and tax revenues. The aim of this paper is to compare the relationship between the standard tax rate and the amount of tax revenues, and to subsequently compare the relationship between the implicit tax rate and the amount of tax revenues. It s because the implicit tax rate provides information that standard rate or tax revenues do not. On the basis of both analyses, it will be possible to answer the question of whether the standard VAT are a relevant policy instrument in relation to tax revenues. If increasing the standard rate of VAT should lead to decrease implicit rate of VAT, then the consumption and tax revenues would be reduced. The increase in VAT would prove as ineffective, even counterproductive. In this respect, the ITR serve as an indicator of political instruments VAT Rates. We relate both to the macroeconomic tax base, exploring the interconnected development of these with respect to the proportion of tax revenues in GDP. We chose a 10-year time period from the beginning of 2002 to the end of 2011, and all 27 EU member states are covered by the analysis. We consider this set of countries to be sufficiently comparable in terms of historical, political, and other factors. The paper is based on prior studies. According to Mathis: [5] The EU average for standard VAT is at 20.6% with a statutory minimum of 15%. For the implicit VAT rate, which takes into account all the VAT in force, the EU average is lower, at 15.9%, which corresponds to about a 20% discount of the previous EU average standard rate. But the dispersion is to a certain extent higher, with a minimum and maximum of 10.9% and 25%. From this perspective, there is a big difference between the standard and implicit VAT rate. Cnossen [6] compared implicit tax in the EU and USA for various taxes, including VAT. Aizenman and Jinjarak [7] dealt especially with political and structural factors influencing VAT collection efficiency in terms of the implicit VAT rate. The implicit and standard VAT from the point of consumption were studied in [8] and [9]. Keen s [10-13] approach to VAT is more complex, studying VAT in terms of the overall concept and anatomy of VAT. In the Czech Republic, the issues related to implicit taxation were studied by Vašková [13], who compared implicit average tax as parameters of economic decision making for selected taxes (including VAT), illustrating this with examples of the Czech Republic, Hungary, Poland, and Slovakia. Klazar et al. [14] addressed the issue of VAT rate harmonisation in the Czech Republic. Pavel Vitek and [15] addressed the question of the effectiveness of tax collection, also dealing with VAT. 2. Material and Methods We used data from the Eurostat statistics database [16] and from publications of the European Commission [16]as the sources of information on the share of the VAT revenue in GDP, the total household consumption, and tax revenue from VAT for our subsequent calculation of implicit. All these data were for the 27 EU member states (without Croatia) for the period of 2002 to 2011. 91

The data on which we focused were: the standard VAT rate (STR), the implicit VAT rate (ITR), and the share of VAT revenues in GDP (%). In the analysis, we compared the relationship between the standard and implicit VAT. The implicit rate was constructed as follows: VR ITR = (1) C where ITR is implicit VAT rate for the period, VR are VAT revenues for the period, and C is the private household consumption for the period 1. The G SIR indicator, i.e. the gap between the standard and implicit VAT rate in % points, which was already used by Mathis [5], was supplemented for the sake of completeness: G SIR where STR is standard tax rate of VAT. = STR ITR (2) In the analysis, we used a tool set comprising the theory of sets and a correlation analysis in which we divided the basic set of the EU member states into individual subsets in a breakdown according to their specificities. For the basic analysis, we divided the basic set of the EU member states into four equally large subsets, each comprising 7 member states, depending on the average amount of the standard and implicit VAT rate in the whole studied period. The only exceptions were the subset of countries with the lowest standard VAT - Low, which contained only 6 countries, and the Lower Middle subset of implicit VAT, which also contained only 6 countries. The subsets were made so that any two countries with the same average were always included under the same subset. We titled the subsets (groups) according to the VAT rate amount, as shown in Table 1, which contains the titles of the subsets and the ranges of in the breakdown by the standard VAT rate and implicit VAT rate. Table 1: Division of member states into subsets according to the amounts of tax The tax rate amount Standard VAT rate interval Implicit VAT rate interval High < 21.0, 25.0> <15.5, 20.7> Upper middle <19.8, 20.9> <13.3, 15.4> Lower middle <18.6, 19.7> <11.8, 13.3> Low <14.8, 19.6> <9.9, 11.7> Source: Authors We supplemented this analysis with a correlation analysis on the same sets. We then showed the relationship between the standard and implicit VAT for individual EU member states to support the analysis outcomes. 3. Results and Discussion The following graph shows the outcomes of the analysis of the relationship between the standard VAT rate and the share of tax revenues to GDP for four groups of member states according to their standard tax rate. 1 We use C because private household consumption is relatively stable indicator. Private household consumption cannot fall below a certain level (people cannot stop consuming). We know that ITR is possible to construct also using investments VR/(C + I), but we wanted to focus more on consumption. 92

Figure 1. Share of VAT Revenues to GDP for the standard rate of VAT (Source: Authors) 9 8,5 VAT to GDP, in % 8 7,5 7 6,5 6 5,5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Year High Upper Lower Low The chart suggests that the member states with higher also have a higher average share of VAT to GDP. Obviously, the member states with the highest tax (BE, DK, IE, HU, PL, FI, SE) from the High Rates subset then have the most stable tax revenues. The decrease in revenues that occurred in 2009 in all groups except for the member states from the High Rate group is considered of interest for the subsequent analysis. The most significant decrease was in the group of member states from the Upper Middle Rates group. This is particularly interesting when taking into account that, within the whole EU 27 set, the standard VAT rate was increased in 5 countries (IE, HU, EE, LV, LT) and decreased in just 1 member state (UK) in 2009. We expect that the tax revenue loss was caused by the global financial crisis resulting in reduced consumption, although, holding other things constant, the decline in GDP would otherwise mean an increase of VAT revenue to GDP, even though this would not change its nominal value as compared to the previous period. A correlation analysis has been added to complete the analysis. Its outcomes are shown in Table 2. Source: Authors Table 2. Correlation coefficients, standard (Source: Authors) EU27 High Uper middle Lower middle Low 2002 0.602 0.806-0.488-0.349-0.030 2003 0.591 0.807-0.414 0.098-0.007 2004 0.608 0.878 0.359 0.457-0.083 2005 0.494 0.791 0.250-0.412-0.027 2006 0.438 0.860 0.363-0.753-0.072 2007 0.400 0.830 0.344-0.827-0.191 2008 0.383 0.901 0.296-0.416-0.195 2009 0.520 0.849 0.381-0.102 0.180 2010 0.451 0.936-0.075 0.148-0.335 2011 0.529 0.883 0.464-0.021-0.106 µ 2 0.502 0.851 0.148-0.218-0.087 cv 3 0.155 0.054 2.223 1.771 1.494 2 Mean 3 Coefficient of variation equals standard deviation by the mean. This is a good indicator of volatility. The higher number is, the more volatile the situation. 93

Interestingly, there are large differences between the results of the High Rates group and all the other groups. Not only did the correlation for the High Rates group work out positively in all cases, but the lowest value of the correlation coefficient was 0.791 and the average for the whole period was 0.851, which indicates a correlation between the amount of the standard VAT rate and the amount of revenues. Moreover, this group had the lowest standard deviation of the set. The correlation for the other groups was significantly weaker and often negative, which can be partially explained by the negative impact of the standard rate increases on consumption. Especially during an economic recession, consumer behaviour may be influenced by negative expectations associated with uncertainty. In combination with an increase in prices, tax revenues may decline subsequently as compared both to previous periods and original objectives resulting from the existing tax measures. This is because the fluctuation in tax may result in price changes, which will subsequently have an impact on consumption. The impact of increased on consumption (and consequently on savings) were studied by Alm and El-Ganainy [18], who stated that: VAT tax rate is negatively correlated with the level of aggregate consumption when one percentage point increase in the VAT rate leads to about a one percent reduction in the level of per capita aggregate consumption. In contrast, the impacts of the temporary rate reduction in the UK in 2009, when the standard rate was 15%, were studied by Crossley, Low, and Wakefield [18], who stated that the temporary VAT cut also caused a decline in prices, though generally speaking, the market does not necessarily respond with declines in prices. Regardless of the revenue situation, there was an increase in consumption which approximately corresponded with the price decline. Crossley, Low, and Wakefield [19] hence assumed a temporary shortfall in revenues from VAT, which was also confirmed. Compared to 2008, when the share of VAT in GDP was 6.3%, it decreased to 5.6% in 2009. It is possible that the differences in correlation coefficients between the High Rates group and the other groups were caused by a small number of changes in the for the studied period. There were three changes for the High Rates group, compared to ten changes for the Lower Medium Rates group and seven changes for the Upper Middle Rates and Low Rates groups. Thus, in addition to the development of and the VAT share in GDP, the frequency of changes in the may be another issue to be discussed. Since we assume that, in accordance with the neoclassical assumption, the effective (economic) and implicit tax influence tax revenues more than the standard rate, we analysed the influence of the implicit tax rate on the amount of tax revenues. The relationship between the implicit VAT rate and tax revenues with respect to GDP is shown in Figure 2 and Table 3. Figure 2. Share of VAT Revenues to GDP for the implicit rate of VAT (Source: Authors) 9 8,5 VAT to GDP, in % 8 7,5 7 6,5 6 5,5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Year High Upper Lower Low Comparing the graph with the table of correlations, it is noticeable that while the graph shows very similar results to the standard VAT, the table mostly provides different information. Dependences, which are also similar, were proved for all sets. Differences between 94

subsets are not so significant here. It is interesting that the sets with lower (Lower Middle Rates and Low Rates) show the highest correlation coefficients. In general, it can be concluded that the correlation between the implicit and VAT revenues with respect to GDP was not negative in any of the studied groups or periods. The most stable group here is the one with the lowest implicit (EL, ES, IT, LV, LT, RO, UK). Source: Authors Table 3. Correlation coefficients, implicit (Source: Authors) EU27 High Uper middle Lower middle Low 2002 0.774 0.811 0.566 0.698 0.527 2003 0.720 0.679 0.239 0.829 0.555 2004 0.706 0.642 0.168 0.770 0.226 2005 0.625 0.559 0.142 0.815 0.749 2006 0.592 0.533 0.613 0.799 0.817 2007 0.559 0.490 0.612 0.784 0.893 2008 0.641 0.511 0.907 0.504 0.903 2009 0.809 0.564 0.660 0.754 0.880 2010 0.681 0.401 0.645 0.727 0.768 2011 0.579 0.203 0.487 0.706 0.897 µ 0.669 0.539 0.504 0.739 0.722 cv 0.120 0.288 0.464 0.120 0.291 The comparison of the standard VAT rate and implicit VAT rate can be summarized as follows: The standard and implicit VAT correlate with revenues from the perspective of the whole EU set. If we divide the set into smaller sets according to the rate levels, great differences emerge between the correlation coefficients for standard VAT. In general, the relation between implicit and VAT revenues was more important. It can be assumed that there are significant differences between individual member states as there are significant differences between individual rate levels. Therefore, the analysis will be complemented by a correlation analysis for all the studied member states for the whole period of 2002 to 2011, and the average gap between the standard VAT rate and implicit VAT rate and the coefficient of variation related to them will also be specified. This analysis is shown in Table 4. Because one-third of the studied countries did not change their standard over the whole period, it was not always possible to determine the correlation coefficients. However, in the other cases, it turned out that there are significantly higher correlations between the implicit rate and the share of VAT in GDP (the correlation coefficients higher than 0.8 indicating a strong degree of dependence are highlighted in bold type in the table). The only exception is Finland; however, both values are relatively low there. Most notable are CZ, IE, ES, LV, and SK, as they have a negative correlation for the standard (with the value being even lower than -0.5 in CZ and LV), while the correlation of the implicit tax and VAT revenues is concurrently high and positive (always above 0.9). The gap between the standard rate and implicit VAT rate is more varied in these countries than is the average for the EU 27 countries (6.17), but it still does not rank among the highest. 95

Table 4: Correlation Coefficients and the Gap between the STR a ITR in % points (source authors) Correlation coefficients Correlation coefficients Country STR ITR GSIR cv Country STR ITR GSIR cv BE na 0.851 7.57 0.04 LU na 0.617-2.24 0.76 BG na 0.929 5.78 0.28 HU 0.681 0.929 8.36 0.23 CZ -0.636 0.929 6.47 0.29 MT 0.921 0.958 5.53 0.10 DK na 0.923 4.31 0.10 NL na 0.344 3.71 0.17 DE 0.959 0.977 5.73 0.10 AT na 0.754 5.48 0.04 EE 0.237 0.831 3.00 0.28 PL 0.262 0.971 9.84 0.10 IE -0.375 0.944 6.39 0.24 PT 0.56 0.945 8.07 0.14 EL 0.191 0.788 9.59 0.21 RO 0.437 0.905 8.54 0.18 ES -0.132 0.993 6.48 0.24 SI na 0.204 4.50 0.11 FR 0 0.964 7.06 0.05 SK -0.059 0.967 7.27 0.21 IT na 0.857 9.86 0.03 FI 0.415 0.052 5.88 0.13 CY 0.693 0.984 1.29 0.87 SE na 0.893 5.95 0.12 LV -0.559 0.988 7.60 0.31 UK 0.943 0.971 7.28 0.09 LT 0.421 0.957 7.27 0.16 Source: Authors 4. Conclusion This paper provides an analysis of the relationship between the standard VAT rate and the share of VAT revenues in GDP. The relationship between the implicit VAT rate and VAT revenues to GDP was also analysed. The analysis suggests that it is not possible to confirm an unequivocal causality between the standard VAT rate and VAT revenues. In contrast, it can generally be said that implicit VAT are a more relevant tool in terms of the relation to tax revenues, as we had assumed. The objective of the analyses was to determine, at least at the theoretical level, whether changes in VAT are a relevant political tool for increasing tax revenues. No universal answer can be given to this question. In the UK, the answer so far seems to be yes. Nevertheless, this country has shown a stable rate in the long run (with the exception of the rate increase in 2011), with its temporary decrease. In general, however, the causality between the standard VAT rate and tax revenues cannot be confirmed. In contrast, this causality was confirmed for the implicit VAT rate. We realize that the implicit VAT rate is not something what the government has under control. ITR reflects many economic contexts that may affect rate changes. Many of them are mentioned above. Therefore ITR is giving supplement information on how the economy (consumers) can respond to changes in VAT. The fact that the differences between the ITR and SR are not the same just shows that we cannot indiscriminately adopt conclusions: Higher tax means higher return and vice versa. If we were to summarize the findings as recommendations for the Czech Republic, we definitely would not recommend any unilateral increases in VAT to stimulate tax revenues. There is a significant risk that the result would be the opposite of what was intended. For most EU countries, the rate should be a supporting tool and the focus should also be on the tax base, as it ensues from the results of the analysis for the implicit VAT rate. 96

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