Temporary VAT Cut Passed on to German Supermarket Shoppers

German VAT rates were temporarily reduced in July 2020 to alleviate the economic impact of COVID-19. A stimulus package reduced the standard rate from 19% to 16% and the reduced rate from 7% to 5% until January 2021 at an estimated cost of EUR 20 billion. A recent study indicates that the VAT cut has been passed on to supermarket customers.

Ifo Institute, a Munich-based economic research institution, studied data on daily prices of 190,000 supermarket products and found an immediate 2% price cut following the temporary VAT reduction, an almost full pass-through of the VAT cut. The study used Austrian prices as a counterfactual, in part because Austria adopted a stimulus package like Germany’s that didn’t include a general VAT cut. Before the German VAT reduction, the price trends in Austria and Germany matched closely. Prices then began to vary in June after the VAT cut was announced. Most German price reductions were made on 1 July, the effective date of the rate change, and continued to November when the study was published. Price cuts were noticeably greater in competitive product segments, suggesting a positive relationship between the pass-through and market competition.

Stimulating spending

The goal of temporary VAT reductions is to stimulate consumption, but that doesn’t happen unless the tax cuts are passed on to consumers through reduced prices. This study is significant because little is known about the effectiveness of temporary VAT changes, rare and relatively new fiscal tools, in advancing that goal. The authors describe their findings as “surprising” because studies on other temporary VAT cuts indicate more limited price effects, and studies on sector-specific measures indicate that VAT cuts largely benefit businesses over consumers. You could say the study’s context is unique. The COVID-19 crisis doesn’t have an economic origin, and its progression depends on non-economic factors. The policy response to the crisis has also been unprecedented in scope, speed, and objectives. Germany’s finance minister even stressed that businesses have a “moral obligation” to pass the VAT cut on to customers, given the pandemic.

The pandemic will surely continue into 2021, when the rate reduction is set to end. As one of the study’s authors warned, “When the tax cut expires at the end of 2020, spending will decline significantly. And we can’t expect the crisis to be over by then.” There is evidence that prices might be even higher than they were originally, as prices tend to respond more to VAT increases than to decreases. On top of menu costs from adjusting prices twice, businesses will need to take other costly and time-consuming steps to comply with the return to original VAT rates which we will continue to monitor together with all other global VAT developments.

An historical perspective

Although this rate cut may be unique in its non-economic origins there are comparisons to be made. The last major financial crisis was the banking crisis of 2008/09. To counter economic downturn in the UK, the standard VAT rate was temporarily reduced from 17.5% to 15% for the period November 2008 to December 2009. After returning the rate to 17.5% in December 2009, it was then increased to 20% in January 2011 where it has been ever since. Was this increase to 20% caused by the effects of the temporary reduction to 15%?

During this year’s crisis, the UK resisted such action and instead chose a targeted reduction to 5% for the hospitality sector only. Perhaps the UK treasury learnt a costly lesson in 2008/09.