Will the new VAT rate lead to large price increase?

Published: May 29, 2017 21:46:17 | Updated: October 23, 2017 00:52:48

A major concern with indirect tax reform (e.g., VAT and sales tax, etc.) is the potential impact on prices faced by the consumers. Expansion of tax base and rate usually have two impacts: (i) increase in revenue and (ii) increase in prices.  The revenue impacts of the reforms in the context of the new VAT Law have been estimated and reported using the data of FY2014. The paper found that the revenue impact at the import stage (i.e. due to the replacement of supplementary duties by VAT) is moderate at around 3.0 per cent over the current import stage VAT-related revenue collection. On the other hand, revenue gains from the domestic-stage VAT system may range from 15 to 20 per cent over the current domestic stage VAT revenue collection. However, since there could be one to one relationship between the increase in tax incidence and price changes in the market, the paper tried to estimate the likely impact of revenue impact on general price level in the country. Experiences of other countries suggest that the pass-on effect of revenue increase on the general price level is significantly less than the impact on revenue. (For instance: On January 04, 2011, the standard rate of Value Added Tax (VAT) increased from 17.5 to 20 per cent in UK implying a 2.5 percentage-point rise. Office of National Statistics (ONS) estimates that the impact on the January 2011 Consumer Prices Index (CPI) from retailers and service providers passing on the VAT increase (between the December 2010 and January 2011 collection dates) was to increase the 12-month rate by around 0.76 percentage points. This suggests that pass through impact is lower the rate increase.) Likely factors include: (i) the structure of CPI (Consumer Price Index) basket; (ii) weights of the commodities/services on which the taxes are imposed or raised; (iii) exemption of essential items; and (iv) the extent of tax avoidance due to inefficiencies in tax administration (particularly relevant in a country like Bangladesh). 
CPI baskets for rural and urban households along with weights of major items are shown in Table-1. The weight of food (including beverage and tobacco) items for urban CPI is 47 per cent and thus non-food weight is 53 per cent. Out of the food/beverage/tobacco weight of 47 per cent, food alone accounts for about 43 per cent. Almost all these food items are of primary agricultural type, and will likely be enjoying exemption even under the proposed new VAT law. Thus, at least 40 per cent, the urban CPI will be unaffected by revenue increase. On the other hand, for rural CPI the weight of food (including beverage and tobacco) items account for 61 per cent of the total CPI basket and thus non-food weight is only 39 per cent. Out of the food/beverage/tobacco weight of 61 per cent, food alone accounts for about 57 per cent. Thus, at least 55 per cent of the rural CPI (including house rent) will be unaffected by revenue increase as explain above.
As mentioned above, since there is one to one relationship between revenue increase and price change, private think tank PRI (2016) adopted a 'heuristic' assessment of price impacts at macro level using the data of FY2014. At the macro level, the paper tried to assess what would be overall price impact if the entire revenue gain is assumed to pass through the marketing system on to final prices. Since VAT and related revenues are essentially consumption tax paid by the final consumers, any increase in revenue from these sources would need to be paid by the consumers and therefore increasing their cost of buying these products. In general, consumers would be required to pay this additional revenue in the form of higher prices for their consumption goods. Accordingly, the total increase in revenue from the new VAT system will increase their cost of living by the same amount. 
The issue then boils down to what percentage of the total consumer spending this additional VAT revenue will constitute. Total consumption expenditure in Bangladesh was Tk. 10,583 billion in FY14 based on national accounts data of BBS. Total revenue gains from the new VAT law are estimated to be in the range of Tk. 57.3 billion to Tk. 97.2 billion under the three scenarios considered in the paper. Two sets of price impacts can be identified. (i) General Price level (economy wide) may vary from as high as 0.7 to as low as 0.4 per cent. (ii) Consumer Price level may increase by as much as 0.9 to as low as 0.5 per cent. 
The methodology applied in this estimation is very simple but robust. Because whatever additional revenue comes to the government due to the introduction of the new VAT law will be borne by the consumers and will increase their consumer spending by the same amount. This simple comparative static analysis does not capture any elasticity effect on revenues through price and income effects. If price and income elasticity effects on consumption behaviour are introduced, both the revenue estimate and the corresponding impact on the CPI will also be somewhat lower but not that much. Based on these considerations, it will be safe to argue that the increase in the overall price level to be faced by the consumers will likely be limited to significantly less than 1.0 per cent. 
The paper argues that "an impact of this magnitude would be hardly noticed by the households, in particular if this issue is combined with the ongoing Bangladesh Bank efforts to reduce inflation further to 5-6 per cent level in the next few years. Bangladesh Bank's monetary policy may also be used to neutralise this limited impact on the overall consumer price level or the CPI".     
Note: * In this case revenue gain under tariff value system refers to 50 per cent increase in the prices of missing products. 
** In this case revenue gain under tariff value system refer to only gain from consumer products and gains from intermediate and capital goods are not considered. 
IS THE RATE HIGH IN BANGLADESH? Another concern raised by different quarters is whether the VAT rate is high in Bangladesh. The VAT rate of 15 per cent was introduced in 1991 replacing the sales tax at import stage and excise duty at the domestic stage. Before the introduction of VAT in 1991, sales tax had multiple rates of 10, 15 and 20 per cent. The 15 per cent rate was determined in a way so that the new system would ensure revenue neutrality. For comparison purposes the VAT rates of 61 countries are provided in Table-3. The VAT rate generally range between 10 and 20 per cent, with most countries charging at rates more than 15 per cent. It is found from Table-3 that 77  per cent countries in the sample have basic VAT rate of 15 per cent and above. 
Key question is should the rate be reduced? A reduced VAT rate will have small salutary effect on general price level - although we have seen from the above discussion on price (i.e. UK example and Bangladesh calculation) that the there is no one to one relationship between VAT rate and price change due to exemptions, weights of commodities in the consumption basket, and nature of products. However, lowering VAT rate would imply almost corresponding reduction in VAT revenue. With gradual expansion of the VAT base, expansion of income tax collection and removal of exemptions, a lower VAT rate may be considered at a later stage. 
 Dr. Bazlul Hoque Khondker is a professor of the Department of Economics, University of Dhaka. 
He can be reached at bazlul.khondker@gmail.com
 Dr. M. Abu Eusuf is a Professor and Chairman, Department of Development Studies & Director, Centre on Budget and Policy, University of Dhaka. He can be reached at eusuf101@yahoo.com

Share if you like