"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.