The potential impact of a temporary VAT cut
As part of his Summer Statement, UK Chancellor Rishi Sunak has announced a temporary cut to the value-added tax (VAT) from 20% to 5% across hotels, restaurants and cinemas, a move that many in the hospitality and leisure sector have called for to boost consumer demand and raise consumption. This is not the first time that VAT has been cut as a fiscal stimulus measure in the UK: in 2008, the VAT rate was cut by 2.5 percentage points as part of the UK government’s response to the Global Financial Crisis. However, due to the unique circumstances of the current economic crisis, the VAT cut may instead represent an untargeted stimulus to businesses that ultimately fails to benefit those struggling the most.
European countries have often relied on VAT cuts, both across-the-board and sector-specific, to stimulate the economy: by increasing firms’ profits, governments hope that these windfall gains will be passed on through lower prices, higher wages and investment. The impact of the VAT cut is determined by a number of issues:
1. Will the VAT cut be passed on to consumers through lower prices?
2. Is the VAT cut large enough for consumers to take notice?
3. To what extent does the VAT cut shift forward consumption that would have otherwise taken place in later time periods?
The impact of Sunak’s announced VAT cut, which is estimated to cost HM Treasury £4.1 billion, may not align with that of the 2008 VAT cut due to key differences in the first and second factors. In particular, the cut may not boost consumer demand if households choose to stay home in response to previous UK government communication to the public. It may be impractical for many businesses to meet increased consumer demand if social distancing limits the number of individuals that can enter at any given point. Alternatively, businesses may not be willing to pass on the cut if they face higher costs due to precautionary measures to protect supply chains, employees and consumers.
In general, there is relatively little evidence examining the impact of VAT cuts, especially on outcomes other than prices. A 2014 study by the Institute for Fiscal Studies found that the 2008 cut raised the volume of retail sales by 1%, leading to a 0.4% increase in total expenditures at a cost of £12.4 billion (Crossley, Low and Sleeman 2014).[1] Research examining sector-specific VAT cuts have found much smaller impacts. Reducing the VAT from 19.6% to 5.5% for sit-down restaurant meals in France led to a 2% decrease in prices and no impact on sales, while similar studies of restaurants and haircuts in Sweden and Finland also found little change in prices or sales (Benzarti and Carloni 2019, Kosonen 2015, Harju and Kosonen 2014).[2],[3],[4] In addition to having relatively little impact on sales, the VAT cut mostly benefited business owners, with more limited benefits flowing to employees and consumers.
Unlike ordinary recessions, the impact of the COVID-19 crisis on output and prices varies significantly across sectors: some industries face supply shocks (such as restaurants) while others face demand shocks (such as air transportation). This suggests the need for policies that specifically target demand-constrained sectors, as supply-constrained sectors are likely to be much more responsive to changes in government policies around reopening the economy (Baqaee and Farhi 2020).[5] Given the evidence suggesting that temporary VAT cuts, even those that are sector-specific, do not have the intended effects of increasing demand, delaying tax cuts until social distancing has been more fully relaxed or implementing more targeted stimulus measures (such as wage subsidies reflecting the shadow price of labour) would be more effective in protecting workers and firms that have been worst-hit by the economic crisis.