The announcement of a planned 5 basis points increase in Romania's VAT rate, effective 1 July 2010, has sparked (as usual) a wide spectrum of frantic analyses and predictions in the past week. A brief read of the Romanian print media produces a tsunami of awe-striking figures: 10-12% growth in prices, devaluation of the currency to 6 RON/EUR, additional tax revenues of RON 3-4 billion, etc. Likewise as typical, the numbers are accompanied by little to no justification, neither empirical nor hypothetical in nature. In the context of the foreseen inflation, for example, it is not even clear weather the proclaimed dramatic growth in prices refers to the prices charged by producers (i.e. before applying the VAT) or the prices paid by the consumers (i.e. after applying the VAT), nor what currency they are being assessed in (e.g. RON, EUR, USD, etc.).
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.
