Macroeconomic benefits from the VAT increase from 18 to 20%

The Government suggested to raise the value added tax (VAT) from 18 to 20% as from January 2019.

If it is a choice between the increase of VAT, PIT, insurance contribution, profit income tax, the increase of VAT seems to be more favorable from the theoretical point of view as it distorts least of all solutions of economic agents in the sphere of consumption, investment and hours worked in comparison with other taxes. For example, an active current discussion is going on in the academic and political circles of Eurozone on partial substitution of PIT by VAT with a goal to boost the economy at the expense of a more intensive engagement of capital and labor in the production.

Let’s try to figure out the possible implications of the increase of VAT and of other taxes in order to rank the existing alternatives. Before making a research on the impact of this or other reform, a baseline scenario of the economic development without a tax reform has to be agreed upon, and further comparison made with this scenario. However, this scenario could be interpreted only as a thought experiment, knowing that its implementation is practically not feasible as lack of any action by the Government may involve a crisis of the pension system and lead to even further impoverishment of pensioners.

A scenario suggesting reduction of the Government expenditures on defense with a goal to finance pension funds could serve, for example, as another basic hypothetical option for the economic development. This scenario is effective from the economic point of view, that is, within its frame it is possible to increase consumption of goods and services of all population groups. However, the likelihood of its implementation under current geopolitical environment is close to zero.

The impact of the VAT increase means the following: the increase of VAT will be followed by a rise of inflation and increase in consumer prices. Furthermore, this maneuver may give rise to a decline in purchasing power of the economically active population due to the increase in prices. There are plans to index pensions, and discussions are carried on about their growth by a value exceeding the increase in prices. Cumulative impact of the tax maneuver on consumption is not that obvious as from the first sight there will be just a simple redistribution of income between groups of population with the total revenue unchanged. However, decrease in purchasing power of the employed population, i.e. the reduction of actual wages, will discourage people from working due to the increase in prices and decrease of the aggregated hours worked in the economy, which in its turn will lead to reduction of actual production and real income, thereby lowering real aggregated consumption. There is also a reason to expect the decline in investment as less job will involve depreciation of the capital value and increase in prices will lower the income of the capital owners. According to our estimation, the VAT increase from 18 to 20% will lead to decrease of GDP, consumption, export and import with regard to the basic scenario of the economic development mentioned above, by approximately 0.4-0.6% based on general equilibrium model.

The impact of PIT and insurance premiums changes is relatively close to the impact of VAT changes. The increase of PIT rate will discourage employed population from working and the increase of the insurance premiums rates will discourage employers from hiring employees. As a result, the real income of the employed population and the amount of hours worked are lesser in both cases and as a consequence, a lesser amount of capital, production and investments in economy. However, benefits of financing the envisaged increase of pensions just by raising VAT rather than PIT and insurance premiums mean that VAT has a higher tax base, which will require a lesser rise of the tax rate if financed at the expense of the VAT increase. Thus, for instance, financing of the envisaged increase of pensions by raising insurance premiums would requires to increase their rate approximately by 4% and it would lead to the reduction of GDP in the long term perspective by 0.8-1.1% and to the decrease of aggregated consumption and investments by 1-1.5%.

The option to finance the envisaged increase of public investment by increasing the profit tax will have to a greater extent a punitive effect on total investment. With the increase of profit tax, the profitability of the investment projects and optimum capital level will go down, thereby affording the reduction of the investment activity. As per our estimation, the increase of profit tax would involve a reduction of investments by 1.8-2.5%, a lower aggregated consumption of the households by 0.4-0.7%, a decrease of real GDP by 0.6-1%.

Therefore, financing of the envisaged increase of public investment by raising VAT from 18 to 20% seems to be less painful when selecting from the above - mentioned alternatives. Will this tax maneuver lead to a slowdown in the economic growth in the foreseeable future? If economic agents took their decisions on consumption and investments based on the expectations that no taxes will be increased, then, the envisaged VAT rise from January 2019 will most probably slow down the growth of Russian economy in 2019. Our estimation is that due to the VAT rise this scenario suggests the decline in the GDP growth rate and consumption of the households will lower by 0.2-0.35%, investments and import will go down by 0.4-0.7% and 0.35-0.45% respectively and inflation will go up by 0.9-1.5% in 2019.

However, slowdown of the VAT growth rate shall not be expected in 2018. In 2018, one may see a slight boost in consumption of the households, who will increase current consumption expecting a future price boom. By our estimates, this effect may increase the growth rate in consumption of the households by 0.15-0.3% in 2018 and compensate negative influence on production as a result of decline in other components of the aggregated demand.

It should be noted again that estimates of the negative impact on production in the medium and long terms as a result of VAT increase were obtained in the course of selection of a basic scenario of the economic development which lacked any changes of the tax system. This assumption seems to be unrealistic when applied in practice. The Russian Federation tax reform was long debated, and economic agents envisaged some form of further possible amendments to the tax system when they took current decisions. It is quite possible that one of the factors of low economic growth rate is that business expected increase of the insurance premiums or profit tax, which had a large adverse effect on economy. In these terms, the increase of the VAT rather than of other taxes could increase growth rate of Russian economy compared to those rates currently observed.

Another positive factor is reduction of uncertainty in the economic policy. There is more and more proof in the recent academic research in favor of negative influence of uncertainty on business activity. In the period when uncertainty is high, employers prefer to delay taking their decisions regarding hiring new employees and regarding investments until the uncertainty goes down, as wrong solutions could involve heavy profit losses. Consequently, recent information about the envisaged VAT increase could reduce a number of scenarios for the development of taxation, provide clarity to the rules of the game, thereby, having a positive impact on business activity.

This can be summed up by the conclusion that an envisaged VAT increase from 18 to 20% with a goal to finance the growth of government investment is a sufficiently favorable measure of the economic policy if chosen among realistically implemented alternatives. In general, more effective measures of the economic policy could be suggested which could theoretically solve the deficit issue of the pension system avoiding the increase of taxes. For instance, improvement of the state sector efficiency, reduction of corruption, etc.

Andrey Polbin, Head of Macroeconomic Modeling Department of the Gaidar Institute