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Effects of reducing the value added tax rate on food in Latvia

Conference Paper · July 2013

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 Effects of Reducing the Value Added Tax Rate on Food in Latvia

Aleksejs NIPERS2, Irina PILVERE1, Vulfs KOZLINSKIS1

1
Latvia University of Agriculture
Jelgava, LV 3001, Latvia
2
Riga International School of Economics and Business Administration
Riga, LV 1048, Latvia

ABSTRACT Besides, there is a possibility to exempt several

goods and services from the VAT. By regulating the
The present research analyses the effects of reducing
application of VAT rate in the Member States, it is
the value added tax (VAT) rate for food groups from
possible to limit the distortion of competition in the
21% to 12% on the national economy using
EU’s common economic area.
interdisciplinary approach. A quantitative analysis
According to European Commission (2012a) data, a
was performed by using systemic approach and
progressive increase in the average standard VAT
computer modelling tool developed for assessing the
rate in the EU-27 from 19.8% in 2009 to 21% in
impact of VAT rate changes in the case of limited
2012 was observed. Over the period 2010-2012,
data availability. During the research, information
almost half the Member States raised the standard
science has been used, to retrieve data and manage
and/or reduced rate to increase revenue.
process as well as to determine the VAT rate
The majority of the Member States made use of the
reduction impact on different economic performance
possibility to set reduced VAT rates on certain goods
indicators. The authors analysed the effects of
and services as stipulated in the EU’s legal acts. The
reducing the VAT rate on 14 food groups. The
reduced rates were imposed on water supply,
effects on food consumption prices, food
pharmaceuticals and medical services, food
consumption quantities, value added tax revenues in
products, books, periodicals, TV services, hotel
the government budget, consumers’ and producers’
services, and social services. In several Member
gains, as well as inflation were assessed. According
States, the reduced rate was set on such goods and
to the calculation result, reducing the VAT rate
services as shoes and leather products, bicycle trade,
decreases the retail price level of food, although the
hairdressing services, sport activities, restaurant
expected price decrease is not proportional to the
services etc. Denmark was the only Member State in
VAT rate reduction. Reducing the VAT rate slightly
which no reduced VAT rates were imposed in the
increases the consumption of food. At the same time,
summer of 2012. However, some services in this
reducing the VAT rate decreases VAT revenues in
country are exempt from the VAT (Kozlinskis et al,
the government budget, while the society’s total gain
2012).
slightly exceeds this decrease.
To make food cheaper and more available to the
Key words: food, value added tax, impact on prices, population, reduced VAT rates are imposed in the
impact on consumption, government budget, majority of the EU Member States. In July of 2012,
consumers, purchasers, model, Latvia one of the highest VAT rates (21%) on food in the
EU was in Latvia and Lithuania. Higher VAT rates
1. INTRODUCTION on food exist only in Denmark, Romania, and
Hungary. Among the 27 EU Member States, only six
The European Union’s (EU) legal acts stipulate that countries do not tax food at reduced VAT rates, i.e.,
standard VAT rates in the Member States may not be in addition to the mentioned ones, also Estonia,
less than 15% and reduced rates on certain goods Bulgaria, and Lithuania (European Commission,
and services – not less than 5% in the period from 1 2012b. Therefore, Latvian farmers and food
January 2011 to 31 December 2015. Yet, there might producers request the government to reduce the VAT
be some exceptions for certain groups of goods or rate to at least 12%, so that food prices fall and the
trade territories, including the so called super- consumption of food increases. Given the present
reduced rates (less than 5%) and parking rates (on situation, the aim of this research is to determine the
goods and services that should be normally taxed at effects of a potential VAT rate reduction on Latvia’s
the standard rate) (Council Directive, 2006). national economy by employing modelling.
 2. THEORIES/METHODS Producers’ or sellers’ surplus in the market Sp: [5]
Researches on effects of VAT rate changes on a
national economy may be classified according to
their impact on: 1) prices, 2) consumption, 3) output
quantities, 4) employment, 5) population welfare, 6) The society’s total benefit (in context of the market)
social inequality, and 7) economic growth. ST: [6]
T.F.Crossley, D.Phillips and M.Wakefield (2009)
point that there are two mechanisms through which
the temporary VAT cut might affect spending: first, The model is developed based on equilibrium
it will increase spending power, making households processes under monopolistic competition and on
feel as if they have more income. The second general equilibrium conditions. According to such an
mechanism is the effect that the tax cut will have approach, it is assumed in the model that sellers will
through changing the price of goods. R.Pike, try to maximise their profit (both at the present VAT
M.Lewis and D.Turner (2009) are sure that the rate and in case the VAT rate is changed). Thus, it is
change in the VAT rate had an impact on inflation possible to more correctly assess a potential VAT
rates. T.Kosonen (2010) points to the diverse effects effect on food prices, quantities of sales, tax
of reducing the VAT rate – consumers benefited revenues etc. The basic model forms as follows
from the lower taxes through prices that are lower, (Auzins et al, 2008):
the firms benefited in form of higher profit, but the General equilibrium situation: [7]
government lost tax revenues. R.Barrel and M.
Weale (2009) also have similar opinions, pointing
that the effects of a temporary cut in VAT,
identifying three possible effects: an income effect Demand curve D in food industry: [8]
as people benefit from a lower cost of living during
the period of the reduction, a substitution effect as
people bring their consumption forward and an Total demand d for goods: [9]
arbitrage effect as people buy non-perishable goods
before the end of the period of low VAT for
Total marginal revenue: [10]
consumption after the VAT rate has been raised.
Jeremy M. Panno (2011) points that it is possible for
the VAT to be beneficial to the small business
owner, especially given the reduced compliance Total marginal cost: [11]
costs, if the VAT rate is set at the proper level.
To determine the effects of reducing the VAT rate
on the national economy, several formulas will be Given the VAT effects, an equilibrium situation: [12]
exploited (Auzins et al, 2008):
Market price P: [1]

where: T – VAT rate; a - coefficient of slope of

Amount of sales Q: [2] the demand D; b - intercept of the demand D; m -
coefficient of slope of the demand d; x – intercept of
the demand d (variable value), k – coefficient of
slope of the marginal cost curve; l – the free
Revenue from VAT for the government YT: [3] intercept of the marginal cost curve.
To determine the coefficients for the supply side,
financial data of trade companies for 2010 and 2011
in Latvia were used. To determine the coefficients
Consumers’ surplus in the market Sc: [4] for the demand side, micro data of 3798 households
in Latvia for 2010 were used.
 3. RESULTS AND DISCUSSION In the result, seven groups of food products were
formed:
Analysing VAT rates on food in the EU Member
States, one can conclude that different VAT rates are • bread (wheat bread, rye bread, sweet and sour
often applied to various food products within one bread, and other sorts of bread);
country. Most often, reduced VAT rates are imposed • unprocessed meat (beef, veal, pork, mutton, goat
on bread and grain products, milk and dairy meat, poultry meat, wild animal meat, meat of
products. Almost as often (with a few exceptions), other animals, and slaughter by-products);
reduced VAT rates are applied to vegetables, fruits, • unprocessed fish (fresh, chilled, frozen);
and meat. In some cases (Spain, Italy, Portugal, and • basic dairy products (whole milk, low-fat milk,
Poland), a super-reduced rate is applied to cheese, cottage cheese and curd, cream,
unprocessed or only partially processed food fermented milk products);
products. Reduced VAT rates are applied to food • eggs;
actually in all the EU’s West European countries • fresh fruits (apples, pears, plums, cherries,
(except Denmark). Among the West European strawberries, garden berries, wild berries);
countries, the highest VAT rates are in Denmark • fresh vegetables and potatoes (lettuce, leaf or
(25%) as well as in Sweden, Finland, and over the stalk spice plants, rhubarb, fresh cabbage, fresh
recent years in Greece (12%, 13%, and 13% cucumbers, fresh tomatoes, cucurbitaceous
respectively). The lowest VAT rates are in the plants, summer squash, pulses and paprika,
United Kingdom, Ireland (the standard VAT rate on carrots, red beets, onions, garlic, garden radish
food is 0% in both countries), as well as in the and other root-crops, mushrooms, and potatoes).
richest EU country, Luxembourg, where food is The systemic approach and computer modelling tool
taxed at a 3% VAT rate (Kozlinskis et al, 2012). for various scenarios was employed to make
The situation is different in the EU’s East European calculations in the research. It means that initial
countries. Of 10 Member States, reduced VAT rates calculations were performed for the basic scenario
are applied to food only in Poland (5% and 8%), by using the methodology described in this research.
Slovenia (8.5%), and the Czech Republic (14%). In In this process, indicators for assessing an effect are
all the other countries, the VAT rate on food ranges calculated: quantities of sales, price level, and VAT
within 20%-24% (Kozlinskis et al, 2012). revenue in the government budget, consumers’
In the present research, non-alcoholic beverages are surplus, producers’ surplus, and the society’s total
also included in the category of food, while no gain from various groups of food products. After
alcoholic beverages are included. performing calculations for the basic scenario and
For the purpose of this research, all food products developing an initial market equilibrium model, in
are classified into two categories. The first category the next stage the VAT rate is changed, thus
includes seven basic groups of food products, which developing the so called policy scenario. Data on the
comprise all food products and non-alcoholic new market equilibrium, including the indicators for
beverages: assessing an effect: quantities of sales, price level,
• bread and grain products; VAT revenue in the government budget, consumers’
• meat products, eggs; surplus, producers’ surplus, and the society’s total
• fish products; gain, are obtained after this change is made.
• dairy products, except butter; After the indicators are calculated both for the basic
• oils, fats, butter; scenario and the policy scenario, they are compared
• fruits and vegetables; and the deviation of the policy scenario from the
basic scenario is considered a policy effect.
• other foods (including non-alcoholic beverages).
In the present research, an effect of reducing the
The second category includes seven certain groups
VAT rate on food is assessed if changing it from the
of food products. These food products were selected
present rate of 21% to a rate of 12%. The effect of
based on the following criteria:
reducing the VAT rate is calculated for 14 groups of
1. Products in a group have a comparatively short
food products (7 basic groups of food products and 7
shelf life.
certain groups). Besides, an affect is calculated for
2. Such food products are produced locally.
all groups of food products. The calculations provide
3. Products in a group are not regarded as unhealthy
information on the effect of reducing the VAT rate
food.
on food for several years – two calculation variants
were produced, which show an effect of reducing the
VAT rate if this reduction is done in the beginning summarised in Tables 1 and 2.
of 2013 or 2014. The calculation results are

Table 1. Effect of a VAT rate reduction to 12% on the basic groups of food products in Latvia in 2013 *

Fish Dairy Oils, fats, Fruits, Other Total

Bread Meat
products products, butter vegetables foods
Indicators/Groups of goods and products,
except
grains eggs
butter
Change in sales quantity Q, as 2.5 2.3 3.6 2.8 3.8 3.1 4.6 3.1
a % compared with the basic
scenario
Change in price level P, as a -5.4 -5.4 -5.5 -5.5 -5.6 -5.5 -5.6 -5.5
% compared with the basic
scenario
Change in VAT revenues in -14.06 -23.01 -3.65 -13.77 -3.16 -13.52 -15.47 -86.64
the budget YT, mln LVL**
Change in consumers’ surplus 11.04 17.84 3.00 11.01 2.61 10.95 12.98 69.43
Sc, mln LVL
Change in producers’ surplus 4.44 7.39 1.11 4.26 0.96 4.14 4.79 27.09
Sp, mln LVL
Change in the society’s total 1.42 2.22 0.46 1.50 0.41 1.57 2.30 9.88
gain ST, mln LVL
* Effect of VAT rate reduction if the VAT rate is reduced in the beginning of the corresponding year
** Latvian lat, 1 LVL=0.7028 EUR
After analysing an effect of each certain group of
If the VAT rate is reduced for all the groups of food food products on inflation, one can conclude that in
in the beginning of 2013 (Table 1), one can forecast 2013, reducing the VAT rate on the food group
that the quantity of food sold would increase by “bread and grains” will decrease overall inflation by
3.1%, as prices would decrease by 5.5%. As a result 0.23%, “meat products, eggs” – 0.35%, “fish
of reducing the VAT rate, the government budget products” – 0.06%, “dairy products, except butter” –
would lose a revenue of LVL 86.64 mln, however, 0.22%, “oils, fats, butter” – 0.06%, “fruits and
the society’s total gain is positive and amounts to vegetables” – 0.18%, and “other foods” – 0.25%.
LVL 9.88 mln, which is mostly comprised of the If the VAT rate is reduced for the certain groups of
consumers’ surplus. food products in the beginning of 2013 (Table 2),
An analysis of the certain groups of food products one can forecast that the quantity of sales of these
shows that the largest change in the quantity of sales products would increase by 3.3%, as prices would
is forecasted for the groups of unhealthy food – decline by 5.6%. As a result of reducing the VAT
“other foods” and “oils, fats, and butter” – for which rate, the government budget would lose LVL 38.70
the largest price decrease is expected. The largest mln, which is 55% less than if reducing the VAT
decreases in VAT revenues in the government rate for all groups of food. The society’s gain is
budget are expected from the VAT rate reduction for positive, too, reaching LVL 4.06 mln, yet, it is 59%
“meat products, eggs”, “other foods”, and “bread less than in the first calculation variant. According to
and grain products” – the groups from which the the analysis of the certain groups of food products,
largest gain is expected for the society. the largest changes in the quantity of sales are
Assuming the VAT rate is reduced in 2014, the VAT forecasted for “bread” and “basic dairy products”,
revenue in the government budget would decrease where the smallest changes – for “unprocessed
less than LVL 87.70 mln, while the society’s gain meat” and “eggs”. Owing to the VAT rate reduction,
would slightly increase to LVL 10.05 mln, mostly at the largest decreases in government revenues are
the expense of consumers’ surplus. forecasted from “basic dairy products” and
After assessing the effect of reducing the VAT rate “unprocessed meat”, from which the largest gain is
for food from 21% to 12% on the overall inflation observed for the society.
rate in the country, one can conclude that a one-time Assuming the VAT rate is reduced for certain food
decrease in inflation by 1.35% is expected in products in 2014, the VAT revenue in the
comparison with the basic scenario data. government budget would decrease less than LVL
 38.84 mln, and the society’s gain would slightly
increase to LVL 4.09 mln, mostly at the expense of
consumers’ surplus.

Table 2. Effect of a VAT rate reduction to 12% on the certain groups of food products in Latvia in 2013 *

Basic Total
Unprocesse Unprocesse Fresh Fresh
Indicators/Groups of goods Bread dairy Eggs
d meat d fish fruits vegetables
products
Change in sales quantity Q,
as a % compared with the 4.3 2.1 3.0 4.0 0.2 3.8 3.5 3.3
basic scenario
Change in price level P, as a
% compared with the basic -5.8 -5.7 -5.8 -5.8 -2.2 -5.8 -5.8 -5.6
scenario
Change in VAT revenues in
-6.00 -10.34 -1.42 -11.96 -1.86 -1.52 -5.60 -38.70
the budget YT, mln LVL**
Change in consumers’
5.21 8.40 1.20 10.34 0.59 1.31 4.80 31.85
surplus Sc, mln LVL
Change in producers’ surplus
1.56 2.78 0.36 3.09 1.30 0.39 1.43 10.91
Sp, mln LVL
Change in the society’s total
0.77 0.84 0.14 1.47 0.03 0.18 0.63 4.06
gain ST, mln LVL
* Effect of VAT rate reduction if the VAT rate is reduced in the beginning of the corresponding year
** Latvian lat, 1 LVL=0.7028 EUR

After assessing the effect of reducing VAT rate for • to reduce the VAT rate for all the certain groups
certain food products from 21% to 12% on the of food products;
overall inflation rate in the country, one can • to reduce the VAT rate for a certain group of
conclude that the total one-time decline in inflation food products – the one included in either Table 1
is expected at 0.62% compared with the basic or Table 2.
scenario. However, the experience of other countries in
After analysing the potential effect of each certain reducing the VAT rate has to be taken into account,
group of food products on inflation, one has to as, according to M. Bumpei (2011), the change of
conclude that in 2013, the VAT rate reduction for the VAT rate display three kinds of trends when the
“bread” will decrease overall inflation in the country VAT rate is changed. The first trend is that
by 0.11%, “unprocessed meat” – 0.16%, aggregate consumption and economic growth
“unprocessed fish” – 0.02%, “basic dairy products” increases (or decreases) just before the rise (or
– 0.21%, “eggs” – 0.01%, “fresh fruits” produced in reduction) of the VAT rate. The second trend is that
Latvia – 0.02%, and “fresh vegetables” – 0.08%. they decrease (or increase) relatively dramatically as
Given the calculation results obtained, policy makers soon as the rise (or reduction) is implemented. The
have several options if determining scenarios for third trend is that after the dramatic decrease (or
reducing the VAT rate for food, depending on the increase) they increase (or decrease) gradually.
purpose, expected results, and timing. For instance:
• to reduce the VAT rate for all food products;

CONCLUSIONS
The expected decrease in food prices will reduce the
By means of the using interdisciplinary and systemic overall inflation rate in the country. If the VAT rate
approach and computer modelling tool in the is reduced for all food products, the forecasted
research, one can conclude that the VAT rate decrease in inflation will reach 1.35%; if it is
reduction for food will result in a 5.5-5.6% decrease reduced for the certain groups of food products, the
in food prices. forecasted decrease in inflation is estimated at
0.62%.
 The VAT rate reduction will result in a decrease in economy_finance/publications/european_economy/2
VAT revenues in the government budget. By 012/pdf/ee-2012-6_en.pdf
reducing the VAT rate for all food products in the
European Commission (2012b) VAT Rates Applied
beginning of 2013, the forecasted decrease in VAT
in the Member States of the European Union,
revenues is estimated at LVL 86.6 mln, while for the
Situation at 1st July 2012, p. 27 [Online] Available
certain groups of food products, it is LVL 38.7 mln.
at: http://ec.europa.eu/taxation_customs/ resources/
The society’s total gain from reducing the VAT rate
documents/taxation/vat/how_vat_works/rates/vat_rat
is positive, as the sum of increases in consumers’
es_en.pdf
surplus and producers’ surplus slightly exceeds the
decrease in VAT revenues. By reducing the VAT Council Directive (2006) 2006/112/EC of 28
rate for all food products in the beginning of 2013, November 2006 on the common system of value
the consumers’ gain amounts to LVL 69.4 mln, and added tax. [Online] Available at: http://eur-
the producers’ gain is LVL 27.1 mln. By reducing lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:
the VAT rate for the certain groups of food products 2006:347:0001:0118:en:PDF
in the beginning of 2013, the consumers’ gain Kozliskis, V., Pilvere, I., Nipers, A., Brekis, E.,
reaches LVL 31.8 mln, and the producers’ gain Upite, I., Nazarovs, D., Bruvele, L., Siksna, I.
totals LVL 10.9 mln. (2012) Petijuma Samazinatas PVN likmes
The VAT rate reduction has a positive effect on the
piemerosanas partikas produktu grupam ietekme
food industry’s economic indicators, which will be Latvijas tautsaimnieciba atskaite, 94 lpp.
observed owing to an increase in sales for those
groups of goods on which the VAT rate is reduced – Kosonen, T. (2010) What was actually cut in
3.1-3.3%, respectively. barbers’ VAT cut? University of Helsinki and
By reducing the VAT rate for all food products, not Government Institute for Economic Research,
the consumption of necessities will increase more VATT working paper 18, pp.1-24.
than on average (but, for instance, sweets, Panno, J.M. (2011) A Value Added Tax in the
beverages). From the social and economic point of United States: What it Could Mean for Small
view, it is not a rational idea to reduce the VAT rate Business Owners. Ohio State Entrepreneurial
for food products that are not necessities. Business Law Journal, Vol. 6:1, pp. 329- 360.
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