7. Indirect taxes

Instead of direct taxes, governments can reduce indirect taxes to create expansionary effects in the economy. The effect on the economy is channelled through reduction in final prices.

 

Table 7 presents the effect of a permanent reduction in indirect taxes. The VAT rate is reduced by approximately 0.3 percentage points, which corresponds to an immediate loss in revenue of 0.1 percent of GDP in 2010 prices. (See experiment)

 

Table 7. The effect of a permanent reduction in indirect taxes

    1. yr 2. yr 3. yr 4. yr 5. yr 10. yr 15. yr 20. yr 25. yr 30. yr
    Million 2010-Dkr.
Priv. consumption fCp 650 1160 1517 1791 1989 2506 2894 3290 3614 3855
Pub. consumption fCo -25 -56 -80 -98 -111 -130 -128 -132 -140 -150
Investment fI 326 646 860 1019 1127 1058 758 625 595 593
Export fE 98 116 102 60 -9 -691 -1581 -2276 -2639 -2721
Import fM 383 690 867 993 1069 1006 772 629 569 569
GDP fY 688 1194 1535 1776 1922 1744 1203 929 921 1068
    1000 Persons
Employment Q 0.40 0.90 1.30 1.60 1.79 1.48 0.47 -0.20 -0.45 -0.43
Unemployment Ul -0.22 -0.47 -0.68 -0.83 -0.92 -0.75 -0.24 0.11 0.23 0.22
    Percent of GDP
Pub. budget balance Tfn_o/Y -0.07 -0.05 -0.04 -0.03 -0.03 -0.04 -0.08 -0.11 -0.12 -0.14
Priv. saving surplus Tfn_hc/Y 0.05 0.02 0.00 -0.02 -0.03 -0.03 -0.01 0.00 -0.01 -0.01
Balance of payments Enl/Y -0.02 -0.03 -0.04 -0.05 -0.06 -0.07 -0.09 -0.11 -0.13 -0.14
Foreign receivables Wnnb_e/Y 0.04 -0.01 -0.08 -0.15 -0.23 -0.61 -0.95 -1.29 -1.65 -2.02
Bond debt Wbd_os_z/Y 0.08 0.12 0.15 0.18 0.19 0.30 0.54 0.87 1.23 1.59
    Percent
Capital intensity fKn/fX -0.02 -0.04 -0.04 -0.04 -0.03 0.05 0.11 0.14 0.14 0.14
Labour intensity hq/fX -0.01 -0.02 -0.02 -0.02 -0.02 -0.01 -0.01 -0.01 -0.02 -0.02
User cost uim -0.05 -0.05 -0.05 -0.04 -0.03 0.01 0.05 0.06 0.05 0.04
Wage lna 0.00 0.01 0.03 0.05 0.08 0.22 0.29 0.30 0.28 0.24
Consumption price pcp -0.13 -0.13 -0.13 -0.13 -0.12 -0.07 -0.03 -0.01 -0.02 -0.03
Terms of trade bpe -0.01 -0.01 -0.01 0.00 0.00 0.04 0.07 0.07 0.07 0.06
    Percentage-point
Consumption ratio bcp -0.07 -0.04 -0.02 -0.01 0.00 0.01 0.01 0.02 0.03 0.03
Wage share byw -0.01 -0.01 0.00 0.01 0.02 0.05 0.06 0.05 0.03 0.02

(See details)

 

The cut in VAT immediately reduces prices for final goods and services. This in turn raises real disposable income and thereby private consumption. In the previous income tax experiment, the expansion comes from a direct increase in disposable income. In the present experiment, the expansionary effect arises as the fall in prices increase real income. The short-term effect on private consumption is smaller than the effect in the previous income tax experiment. Fall in income tax directly affects consumption through nominal disposable income, whereas VAT goes through prices and concerns a broader group of goods than just private consumption. The rise in private consumption expands production and employment. It also increases the demand for housing, and house prices and housing investment increase. The fall in unemployment increases wage growth, which in turn raises production costs and producer prices. As a result competitiveness worsens, exports fall and imports rise in the long run. Thus, the positive effect on private consumption and housing investment is counterbalanced by a permanent negative effect on net exports.

 

The VAT reduction affects the relationship between production costs and final market prices. Despite the rise in wages and output prices, consumption prices fall when VAT rates are reduced. Like a lower income tax, the lower VAT has a positive long-term effect on real income, which gives rise to a change in the composition of demand.

 

A fall in indirect taxes has also a positive effect on production. The rise in wages makes capital relatively cheaper and the capital intensity of production increases and makes labor more productive, as a result production increases.

 

Note that there is no VAT on house price. But, there is a negative first year effect on house price. This is because the house price equation determines the real house price – nominal house price divided by consumption price – and the latter falls as VAT rates fall. In the following years the increased demand stimulates house price but in the long run the house price effect is slightly negative reflecting that the supply price, the housing investment deflator, does include VAT. In general, the VAT experiment resembles the direct tax experiment, but there are some differences, for example, there is an immediate positive impact on service exports as the lower consumer price stimulates the fixed-price purchases of foreign tourists. Just like the fall in direct taxes, the reduction in VAT deteriorates the public balance permanently.

 

 

Figure 7. The effect of a permanent reduction in indirect taxes

 

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