In this sense, while the predictions are certainly sensational and undoubtedly entertaining, they offer admittedly little to those looking for information upon which to base a serious business management of investment decision. For the latter purpose, it may be worthwhile to consider more bland but methodological explanations of what might be possibly expected in a market following a VAT rate increase. This is the point of the discussion found here -- to provide some insight using several fundamental concepts offered by economic theory. We proceed in two parts. Presently, the analysis focuses on the effect of a VAT rate increases on market prices (both base prices and final prices) as may be pertinent to business managers and investors; subsequently, Part 2 will explore the merits of a VAT increase from a social planning perspective.
Basic Supply-Demand Framework
The key concept in much of economic analysis, and especially with regards to taxation, is elasticity. By definition, elasticity simply measures percentage changes in economic quantities. The simplest example of this is the elasticity of demand, which quantifies the the percent change in quantity demanded due to a percent change in price. Therefore, if a 10% price increase for certain good leads to a 20% decrease in the total quantity consumed of that good, then its demand elasticity is 20/10 = 2. To that end, demand is said to be elastic when the elasticity is greater than one and inelastic when it less than one, to characterize the degree to which consumers respond to price changes, and therefore, exert influence on the market equilibrium. The more inelastic is the demand, the more of consumers' influence is reflected in the equilibrium outcomes.
Of course, the same definition applies to any other combination of quantities as well. Specific to our interest, we'll particularly focus (in addition to demand elasticity) on the elasticity of supply -- the percent change in quantity supplied due to a percent change in market price, and the elasticity of price with respect to the VAT tax -- the percent change in price due to a percent change in the VAT. The terminology of elastic and inelastic likewise apply. Especially when comparing elasticities of supply and demand, the terms denote the shares of influence in determining market outcomes attributed to consumers and producers.
In this context, demand elasticity reflects both the preferences of the consumers as well as the availability of imperfect substitutes, the consumers' awareness of such availability, search costs (i.e. for alternative products and their prices), along with a variety of other factors. The industry supply elasticity, on the other hand, accounts for cost elasticities of individual firms, degrees of competition, etc. In both cases, elasticity is closely related to the the time frame considered in the analysis (in our case, short/medium term) -- given enough time, most imaginable market demand and supply curves tend towards perfect elasticity, and moreover, elasticities across various related markets are closely intertwined.
Before proceeding further, we must clarify several things. First, in the presence of a VAT tax, there are in fact two types of prices in the market: the base price charged by the producers and the final price paid by the consumers, after the VAT is applied. In applying the VAT, a producer multiplies the base price, $p$, by a tax multiplier, $t$, to arrive at the final price $\tilde{p}=tp$. This tax multiplier is, of course, nothing more than 1 plus the quoted VAT rate. Therefore, until 30 June 2010 the multiplier in Romania was 1.19, while starting with 1 July 2010, the new multiplier is 1.24, which implies a percent change of 0.05/1.19 x 100 = 4.2%.
What this means in the very simplest terms is that if a producers in a given market charge $p$ = €100 for the product, then until 30 June 2010 a consumer was paying $\tilde{p}$ = €119 and starting 1 July 2010 would pay $\tilde{p}$ = €124, as long as the producers continue to charge €100 after the rate change. So, in this very naive example, the VAT increase leads to no change in the base price and a 4.2% increase in the final price. Therefore, the implied price elasticity with respect to the tax multiplier is 0, if we're talking about the base price, and 1 if the final price is the one of interest.
As previously emphasized, however, this example is quite naive in assuming that the producers will not react to the VAT change and continue to ask the same base price for the product. In that case, what kind of reaction may we expect? It turns out that standard theory of supply and demand has a very intuitive answer. As long as demand is downward-sloping (meaning the higher the price, the less is demanded) and supply is upward-sloping (meaning the higher the price, the more is supplied), then ceteris paribus the base price in equilibrium must decrease after the rise in VAT.
Of course, this is quite sensible -- at €124 total quantity demanded is lower than at €119. In fact, the drop in demand is such that it is no longer optimal to charge €100, and producers are surely able to increase profits by slightly lowering the base price, thereby restoring a portion of the demand lost as a result of the VAT increase. In this sense, the burden of the tax increase is borne by both the consumers and the producers: producers receive a lower price for their product, consumers pay a higher price for the same product, and the total output of the market falls.
By how much should the base price be optimally lowered? What should be the resulting full price faced by consumers and the new market output? All these are effectively determined by the demand and supply elasticities. A more technical discussion of the latter is provided shortly. However, explicit computation is not necessary to understand the following conclusions: under these basic conditions, following an increase in the VAT rate, the effects on prices and quantities will vary from industry to industry, according the the respective demand and supply elasticities.
In general, base prices must fall while the final prices paid by the consumers are destined to rise. However, the latter increase quite obviously cannot be more than the percent change increase in the tax multiplier. In our previous example, therefore, since a decrease in $p$ implies a final price $\tilde{p}$ that is lower than €124, a percent increase in the final price is consequently lower than 4.2%, the increase in the tax multiplier. In other words, nothing in the basic supply-demand framework supports inflation rates exceeding the rate of increase in the VAT, as a result of the tax raise.
The basic supply-demand scenario is represented graphically as follows:
To keep exposition simple, the initial market equilibrium ($p_0$, $q_0$) represents a scenario with no VAT. After a VAT is introduced at the base rate of ($t$-1)%, the consumers' reaction elicits a distortion (both through a vertical shift and a slope adjustment) in the demand curve from $D_0$ to $D_1$. This, in turn, causes a drop in the base price acquired by the producers from $p_0$ to $p_1$, and simultaneously an increase in the final price paid by the consumers from $p_0$ to $\tilde{p}_1 = tp_1$.
At the same time, the industry output shrinks from $q_0$ to $q_1$. More interestingly, note the shaded regions on the plot. The sum of the yellow and orange rectangles represents the amount of tax revenues collected by the government through the new VAT; the yellow rectangle quantifies the portion of those revenues taken from consumers' surplus, while the orange region represents the portion taken from producers' profits. Thus, both consumers and producers contribute to the tax revenues by sacrificing a portion of their respective surpluses (e.g. benefits otherwise retained in a no-tax equilibrium). In this case, the fact that the yellow rectangle is slightly smaller than the orange rectangle reflects the fact that producers bear a greater burden of the VAT, and is directly related to the fact that the elasticity of demand is slightly higher than the elasticity of supply in this industry.
Observe further that the red region also accounts for lost consumers' surplus and lost profits resulting from the imposition of the VAT. However, this does not form part of the government's tax revenues. Indeed, economists refer to this region as the deadweight loss of taxation, reflecting the fact that taxes are inherently inefficient in terms of social welfare: even if the tax revenues are used to the maximum benefit of both consumers and producers, taxation induces losses in profits and consumers' surplus that are inevitably unrecoverable. A more elaborate exploration of this issue will follow in Part 2 of the discussion, through a forthcoming entry.
A Simple Quantitative Model
For those that are technically inclined, the above analysis may be represented through a simple quantitative model as follows. Let the industry demand and supply curves be given by the functions $D(\tilde{p})$ and $S(p)$, respectively. We continue to hold true the assumptions of non-increasing demand and non-decreasing supply (but with no other impositions on the shapes of the demand and supply curves). Accordingly, denote the elasticity of demand as $\epsilon_d$, elasticity of supply as $\epsilon_s$ and the elasticity of the base price with respect to the tax as $\epsilon_p$. Then, standard economic theory and a bit of calculus reveal a very simple relationship between the three types of elasticities:
\[\epsilon_p = - \frac{|\epsilon_d|}{|\epsilon_d| + \epsilon_s}\]
where $|\epsilon_d|$ represents the absolute value of $\epsilon_d$ and reflects the fact that demand elasticity is inherently negative due to the downward-sloping nature of the demand curve.
Several implications immediately stand out from the relationship above. First, the elasticity of the base price with respect to tax is strictly negative, reinforcing the previous point that base prices must fall as a result of VAT increases. Second, $\epsilon_p$ cannot be lower than -1, which means that the base price cannot fall by more than percentage that the tax multiplier increases. This, of course, emphasizes the other major claim above that the percent increase in final price $\tilde{p}$ cannot exceed the percent VAT rise.
In fact, the latter may be considered more explicitly by deriving analogously the elasticity of the final price, $\epsilon_{\tilde{p}}$, which is easily shown to be
\[\epsilon_{\tilde{p}} = 1 - |\epsilon_p|\]
Combining the two representations together, it is easy to see how consumers and producers share the burden of taxation according to demand and supply elasticities. As a simple example, suppose that demand and supply elasticities are equal. Then, following the relationships outlined above, it is clearly the case that $|\epsilon_p| = \epsilon_{\tilde{p}} = \frac{1}{2}$, meaning that for any percentage increase in the tax multiplier, the percentage decrease in the base price and the percentage increase in the final price are exactly half that. In other words, when the demand and supply elasticities are equal, the tax burden is shared likewise equally, and more generally, the proportion of the tax burden shared is directly related to the proportion in elasticities.
Remarks
If you are in position requiring a fairly serious decision in the near future that depends on how a particular industry will react to the VAT hike, I hope the message is fairly clear: concentrate on assessing the demand and supply elasticities. Beyond this, keep in mind that increasing the VAT is a contractionary policy -- the immediate market tendency is to drive down both the base price as well as the output -- and in general, rely on the basics to contemplate more complicated effects.
To expand on the latter, observe that this simple supply-demand framework along with the relevant conclusions it generates (as discussed here) relies on several important assumptions:
1. the VAT does not directly affect the firms' costs
2. there are no exchange rate effects
3. the setting is static
Relaxing any combination of these assumption has the potential to significantly alter the conclusions derived here, in certain special cases, and would be the advisable path to follow in seeking alternative explanations. Nevertheless, it should be emphasized that the simple framework is generally sufficient as a general guidance instrument. In addition, the effects of any generalizations are not directly obvious and must be implemented with care, if one is to obtain useful conclusions through such a venture.
To that end, the most realistic dynamic that may be expected following 1 July 2010 is perhaps the following: in the immediate, short run, we may very well observed marked instability in market prices. Many are expecting producers to, in fact, raise base prices in a response to the VAT increase, and this might indeed turn out to be initially the case. However, such a reaction will only accelerate the already falling demand and provide new incentives for individual producers to cut prices and entice the ever more valuable customers away from their price-hiking competitors. In fact, we may even observe a period of notable price dispersion (i.e. different producers charging vastly different prices for essentially the same products). Nevertheless, the medium-term horizon that follows will likely involve markets contracting both in base prices and in output, guided by the respective supply and demand elasticities.
This will set an even more arduous challenge for small and medium firms to persevere. With the increasing uncertainty in the regulatory regime, and particularly, a imminent hike in the income tax rate looming, the challenge may still not have reached its peak yet. Understanding the drivers of demand and supply elasticities may help prepare business managers and investors for the near future, but for a number of small companies the an extended period of losses at this point may be quite inevitable. Of course, a better understanding of the business risks in the coming periods, for better or worse, is always useful, even if it serves to sooner realize that packing up shop is the most sensible alternative.
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