Thursday 19 January 2012

"How cutting VAT helped Ireland's hospitality industry"

We've been having a futile argument in the comments to an earlier post as to what would happen if the VAT rate on pubs and restaurants were reduced - would it lead to lower prices, higher profits or some combination of both? I have looked at real life evidence and come to the conclusion that a VAT cut is split roughly one-third in lower prices and two-thirds in higher gross profits. But rather than bicker over hypotheticals, let's look at some more real life evidence.

Three months after the Irish VAT cut for pubs, restaurants and hotels in Ireland, Caterer.com published this fine article:

Since the 1 July [2011] announcement that the VAT rate across the hospitality and tourism sectors was to be slashed from 13.5% to 9%, occupancy has increased, hundreds of jobs have been created and a cautious feeling of positivity has gripped an industry that, until recently, had been struggling to recover from the effects of the global recession...

Consumers are seeing the best value for money in the wedding market with hoteliers able to offer savings of up to €400 (£348) on a typical €10,000 (£8,700) event. But rather than simply deducting the €400, innovative operators are upgrading their customers, throwing extra cocktails or canapés in with the original price.

"You've got to be creative, you've got to keep pushing the boundaries and coming up with new concepts," says Fergus O'Halloran, managing director of boutique hotel the Twelve in Galway, and chairman and director of the RAI. "The more people that are optimistic, the better - that's what it's about."...

Indeed, the Irish Central Statistics Office has released pricing data for August showing that hotel prices are now 1.9% lower than they were this time last year while restaurant prices are down by 1.4%.


If the VAT cut had been 'passed on to the consumer' in its entirety, then we'd expect prices to fall by 4% (109/113.5 = 96%), but prices fell between 1.4% and 1.9% (average 1.65%), so only forty per cent of the cut was passed on (1.65%/4%) and the other sixty per cent of the tax cut went in to higher profits; reduced losses; or turned small losses into small profits etc.

The Golden Rule is that who bears a tax depends on what is less price elastic (or 'price sensitive'). If quantity supplied is price inelastic (i.e. fixed), the supplier bears most of the tax; if quantity demanded is price inelastic (i.e. for necessities) then the consumer bears most of the tax. The opposite applies to tax cuts, as is the case here. Unfortunately, the article does not tell us the fall in pub prices, which I would expect are even less than slightly more than for restaurants, as going to the pub is even closer to being a necessity.

As Mr O'Halloran explains, the sector maintained its overall turnover by providing more for the same price, rather than reducing prices, which in turn provides extra jobs above and beyond those which would have been lost in the businesses which would otherwise have failed.

25 comments:

ontheotherhand said...

very good evidence MW. Very intersting although I sometimes have to pause and get the brain going to compute price elasticities and the like, but you are right.

Anonymous said...

Good stuff, I haven't been entirely sold on this VAT-issue, but you are doing the lord's work gathering evidence like this.

-Kj

Mark Wadsworth said...

OTOH, Kj, thanks.

But this is all GCSE level economics, you do your supply/demand chart with an estimate of supply and demand elasticity and then shift the supply line upwards by the amount of the tax and see what happens.

The only surprising thing is that people are prepared to throw such basic and timeless principles out of the window on the basis of complete flannel by politicians who describe VAT as "a tax on consumption". A tax is a tax is a tax and the impact is exactly what yer supply/demand chart says it will be.

Lola said...

"..the sector maintained its overall turnover by providing more for the same price..." That's the bit I really love about capitalism - it does more for less every day. It's a system guaranteed to reduce prices - or increase quality or quantity - all the time and miraculously it passes on a share of those gains to its workforce. Loverly jubbly.

Bayard said...

"The only surprising thing is that people are prepared to throw such basic and timeless principles out of the window on the basis of complete flannel by politicians who describe VAT as "a tax on consumption".

That's because people generally aren't cynical enough to make themselves realise that a politician will generally tell people either what they want to hear or what he wants them to hear and not necessarily the truth.

Mark Wadsworth said...

B, that's even more surprising, because most people, if asked, will say that politicians are all pathological cheats and liars and they don't believe a word they say.

In practice, as you point out, politicians just pander to people's prejudices (while lining their own pockets), so people do very much believe them. If a pol says something that reinforces an existing prejudice or misconception, people will take it as gospel.

James Higham said...

VAT is a killer for any economy. The sooner there is a general outcry over it and the economy can breath again, the sooner things will be up and running.

Sobers said...

So you are admitting that the consumer does bear (in this case at least) up to 50% of the cost of the VAT imposed? And that may understate the case as suppliers may have supplied more goods and services for the same headline figure?

I would also say that a small(ish) cut in VAT is not a particularly good one to study - a cut of 4% points doesn't make a huge amount of difference to the overall price, even if passed on 100%, and thus suppliers may have more pricing power, as the natural variation between suppliers is greater than the 4% VAT cut. If however you looked at a situation where a rate of VAT was cut to zero, my contention is that you would see a much greater fall in prices, probably in region of 60-70% of the VAT cut.

For example if VAT on meals were cut from 20% to 15% (a 25% reduction) the cost of a £10 meal would drop by about 42p, if passed on totally. If it dropped to zero however the saving would be £1.67. My contention is that a saving of a few pence will not make that much difference to purchases, but that of a pound or two would, and the competitive response by retailers is entirely different. My guess is that under a zero rate a £10 meal would drop to just under £9, thus passing on about two thirds of the VAT cut, whereas under a small cut it would drop little at all.

Mark Wadsworth said...

JH, agreed, but two big problems:
1. The EU.
2. People who perpetuate the myth that VAT is a "tax on consumption".

S: "So you are admitting that the consumer does bear (in this case at least) up to 50% of the cost of the VAT imposed?"

I have done proper research and calculations on this, and the simple fact is, about two-thirds of the VAT is borne by the supplier and one-third by the consumer.

As ever, you do not present the slightest shred of evidence for any of your claims, and use the politicians favourite weasel tactics of claiming I "admit" something when you are merely repeating what I said, and then rounding up "one-third" to "up to half".

If you think that amount of a cut (or increase) passed on to the consumer is greater when the change in the VAT rate is greater, why don't you find some hard evidence?

You might be right, you might be wrong*, but so far I have correctly given hard facts and figures and drawn conclusions from them, whereas you just make up explanations out of thin air and then claim that the observed facts would follow these rules.

Saying "my guess is..." is hardly proper supporting evidence, is it? That's not proper economics.

* There are plenty of examples where the VAT rate on something has changed significantly in a short space of time, i.e. domestic fuel up from 0% to 8% (and then back down to 5%), tampons down from 17.5% to 5%, Innocent Smoothies up from 0% to 17.5% and so on. And other EU countries reduced their VAT rates on hospitality quite dramatically (i.e. Germany, down from 19% to 7%).

Why don't you toddle off and do some research, present your evidence and then we'll discuss the matter properly? As I said, it is possible that you are right.

Deniro said...

When there is competition taxes are passed on as there is no spare margin to absorb them.

As for reaserch the change earlier this month may provide some data.

Rob said...

I think it is disgusting that at a time when hard working homeowners are struggling to keep the family E400k investment over their heads, the government is GIVING MONEY to people so they can go on the piss.

Anonymous said...

Er, Rob, just so we can be sure we fully understand your point, could you perhaps come back and flesh it out a bit ... explaining what government is giving what money to whom to go out on the piss would be a great help ... and if you could then explain why the incidence of people going for a "meal out" or "having a night relaxing in a pub" somehow makes the struggle of those hard working homeowners worse, all the better ... or are you just saying that first and foremost "the government" should pay off everyone's mortgages for them, or just some people's mortgages, those people that are hardworking and never, to use your phraseology, "go on the piss"

(apologies to MW for butting in and t'ing, I fully realise this is your blog ...)

Anonymous said...

Rob, are you a troll? or are you Comrade Fuckov under another name?

Mark Wadsworth said...

Den, half-right answer, wrong explanation.

Let's agree that the cigarette market is competitive and, as we observe in real life, tobacco duty is passed on more or less in full.

But that's because supply is price elastic and demand is price inelastic, and not because there is "no spare capacity".

There are plenty of examples of reasonably competitive markets for discretionary spending (such as restaurants) where the bulk of the tax is borne by the supplier.

To assume that a competitive market (low barriers to entry or exit, lots of producers of similar generic goods) is equivalent to "no spare margin" is a contradiction in terms; as capacity can be shed or added very easily (by definition).

The opposite case to tobacco duty is the land market, where there is (by definition) no spare capacity. It is not competitive in the slightest, which is why land in different locations has wildly different values (it is local monopolies) and we observe that supply is price inelastic and demand is price elastic, and again, as a matter of fact and observation, a tax on land is almost entirely borne by the landowner.

Rob, :-b

Deniro said...

The margin I'm refering to is the profit margin. What is missing from you're analysis is competition. You say landlords absorb property taxes as there is no cometition but you don't concede the oppositw situation exists in retail. Yuo can't have it both ways.

Fraggle said...

If we're playing 'Spot the Comrade', I submit comment #11 on http://www.moneyweek.com/blog/should-the-seller-pay-the-stamp-duty-57117 as my entry.

Rob said...

Obviously the irony wasn't heavy enough. The clue was "family investment over their heads".

:/

Mark Wadsworth said...

Den: "The margin I'm refering to is the profit margin."

That's a fair point, but try following the logic and comparing like-with-like:

1. In a competitive market, there is little profit margin above basic return on capital employed + risk element, there is no super-profit or monopoly element.

2. So if a new tax comes along, they have to try and add it to prices to stay in business, by definition it cannot come out of existing profit margin.

3. Case A: demand is price elastic. Most consumers refuse to pay the new higher prices and some businesses go out of business (low barriers to exit). Supply falls until the new equilibrium higher price reaches a sufficient level for the surviving businesses. Because demand is also price elastic, quantity has to fall a lot. So while prices are higher, the industry is absolutely devastated. Those businesses who failed bore the brunt of the tax.

4. Case B: demand is price inelastic like cigarettes, the consumer bears the tax.

5. Case C: supply is less elastic than demand, which is the case for most things most of the time - the supplier bears most of the tax. Please draw a supply demand curve and satisfy yourself as to the veracity of this, I've provided enough examples to show that suppliers bear two-thirds of the VAT.

6. As to "retail", you're going to have to explain that. Either the retailer is in a competitive situation or he has a local monopoly, please give a real life example and explain which tax you are talking about, what happened to quantity supplied/demanded, what happened to prices and why.

Mark Wadsworth said...

5. Case C: this applies also to Employer's NIC. Let's assume that most people earn as much as they can, and there's an upper limit of 40 or so hours that people are prepared to work. So supply is fixed and price inelastic.

Conversely, demand by employers for labour is very price elastic (go and look up "determinants of price elasticity").

It is more or less universally accepted that any increase in Employer's NIC leads to a corresponding fall in net wages, rather than it leading to more people being unemployed.

Which fits in with my general observation that whoever is less price elastic bears the tax.

Mark Wadsworth said...

Rob, I did sense a note of irony.

F, yes, that's 24-carat Home-Owner-Ist gold.

Deniro said...

When you say,- the supplier bears the cost, - do you meen that the supplier is making less money after the tax increase because even if he succsefully passed it on to the consumer in full, he is now making less money than before because demand has fallen off. Is that how you are using the phrase - bears the cost.

Mark Wadsworth said...

Den, in your hypothetical case, I agree, pricese would have to increase by the amount of the tax. But why are you arguing hypotheticals rather than real life?

In real life, there are no 100% competitive industries. The text book example is wheat farming, as more or less identical wheat is grown in huge quantities all over the world. What they miss off is that wheat farmers need to own or rent land, and that is where the super-profits are hiding. Any tax on wheat would be borne by the least elastic factor - the land owners!

I have done another post which links to two good articles on the topic. Give them a read and have a think.

Anonymous said...

Apologies to Rob ... in my defence, I have an cold and the leetle grey cells aren't receiving the requisite number of "short sharp shocks which make them work" as usual which might be why the irony didn't register, but then again, your comment was so very very close in tone - and the upper case emphasis of giving money especially so, to those "but surely we are entitled" bleats that fall from the mouths of members of that well known interest group ...

I'll go get me coat ...

Deniro said...

On a different subject. If a publican is making 5% profit on beer and serves you a 19 twentieths full glass , then he is doubling his profit , so keep an eye on those conical wide top glasses.

Anonymous said...

Uhh what? If you buy a pint and don't get a pint, that's false advertising. If he has a "happy hour" or something, is he then doubling his loss?