Consultation paper on VAT – Review of existing legislation on VAT reduced rates

Lithuanian Free Market Institute analysed the effects of reduced VAT rates on the economy, competition and states finances. Statistics data for the analysis was taken from a report by the National Audit Office of Lithuania[1].

Comments on reduced VAT rates’ effects on prices, supply, demand, and employment

One of the main aims of reduced VAT rates is to provide the end-consumer with benefit from decreased prices of products. The National Audit Office of Lithuania has commissioned an economic study the purpose of which was to examine, by econometric and statistical methods, the effect of reduced VAT rates on prices, supply, demand etc. This report found no significant price impact of reduced VAT rates. This is clearly stated in the conclusion of the study:

“An economic study has shown that the reduced 5 % VAT rate did not produce an effect, or had only an indirect insignificant effect upon prices, supply, demand and employment. <…> The reduction of VAT rate was of greatest benefit to the producers and service providers and not to consumers of the goods/services.

The study found that retail prices of some goods decreased once lower VAT rates were implemented , but either this effect was short-lived or caused by reasons other than VAT rate reduction (e.g.: imports of cheaper goods, decrease in buy-up price). The short-lived effect of VAT rate cuts on retails prices might also be explained by companies temporarily decreasing their retail prices so that they could justify the reduced VAT rates and then increasing them again.

The ineffectiveness of VAT rate cuts is also confirmed by consumers. A public opinion poll made for the study has shown that only 7 percent of respondents thought the prices of art, culture and sporting event tickets had fallen slightly after implementing reduced VAT rate. Respondents do not perceive any significant changes caused by the introduction of reduced VAT rate.

Not surprisingly, general trend of reduced VAT rate’s impact on the number of workers is that there is no impact. The mentioned study shows that the number of workers increased, but would have grown regardless of the VAT concession, while in some sectors the reduced rate had a negative influence on the number of employees due to increased investments into physical assets (machinery, etc.).

Moreover, reduced VAT rates did not produce direct effect upon either supply or demand, although this was the objective of its introduction. Since the drop in prices, if at all present, was only temporary, the real benefit from tax cuts was appreciated by entities producing or selling goods with reduced VAT rates, in the form of increased profits.

One of the reasons why reduced VAT rates did not significantly affect prices was that there is no direct connection between company’s costs and product prices. While decreased payable taxes should be considered as decreased costs for the company, the prices of the products are formed by supply of and demand for the products and therefore are not directly influenced by costs. Other things equal, decreased costs turn out into increased profits for the producers.

Thus, reduced VAT rates are state subsidies, they satisfy interests of interest groups and not consumers, and they harm competition.

Below answers to specific questions of the Consultation Paper are provided:

8.1.4. Do you see any possible problems for the functioning of the internal market? Have you experienced problems of this kind?

An increased profit of entities producing or selling goods with reduced VAT rates is a sign of market distortion. A company operating in a particular segment, for which reduced VAT rate is applied, is subject to comparably higher profits than companies operating in segments with usual VAT rate. In this case part of profitability comes not from the nature of the business and not because particular company is doing well and satisfying customer needs, but because of reduced cost from VAT. Different VAT rates create different conditions for competition among market segments. This scenario suggests that it is likely for a company to enter a segment that is taxable by only part of VAT and therefore to become more profitable. Reduced VAT rates can thus be regarded as an indirect state subsidy that distorts the market: companies are making their decisions based on unequal conditions for different segments. There is no rational cause why one segment should be discriminated against others, and therefore reduced VAT rates are not the right measure to achieve any social objectives.

8.1.6. Are there any additional arguments in favor or against reduced rates in this respect?

1) Reduced VAT rates pose a danger to state’s financial stability

Reduced VAT rates imply that state budget inflows are not as large as they could be. According to the Lithuanian Ministry of Finance, in 2007 state budget did not receive 285 mln. litas (82.6 mln. euros) due to reduced VAT rates; together with VAT compensations for heating and hot water, the amount lost rises up to 405 mln. litas (117 mln. euros). This constitutes 5.2 percent of VAT inflows. Lithuania’s state budget heavily relies on VAT (they make up almost half of the budget). Consequently, state budget in 2007 lost 2.5 percent of the state budget due to reduced VAT rates and VAT compensations.

Budgetary losses would not be a problem in case of a surplus budget. However, Lithuania has never even had a balanced budget. In 2007, budget deficit made up ~0.5 percent GDP or 1.7 per cent of state budget inflows. Forecasts show that in 2008 losses due to reduced VAT and VAT compensations will make up 2.1 per cent of state budget, while the budget deficit will once again be 0.5 percent GDP. Reduced VAT rates are thus endangering the stability of state finances.

Politicians and state financiers face difficult times ahead: the Law on Fiscal Responsibility will limit 2009 budget deficit, while budget liabilities are, as always, on the rise. As a solution to budget problems politicians are proposing to raise VAT rate (currently 15 percent) as well as corporate profit tax, labour tax, introduce property tax, etc. However, few politicians are concerned these propositions would harm the taxpayers and Lithuania’s competitiveness. Abolishing all the reduced VAT rates on specific goods and VAT compensations would partially deal with state budget problems.

2) Reduced VAT rates are contagious

Once VAT rates are reduced to a specific good, producers of a similar good begin bargaining for a similar reduction in VAT rate. The general tendency is thus for reduced VAT rates to spread. In 2003-2006 reduced VAT rates were granted to 9 groups of products in Lithuania:

Products granted a reduced VAT rate
Date of VAT reduction
Reduced VAT rate
Passenger carriage and luggage carriage services
Agricultural services by agricultural entities provided to their members
Dwelling construction, renovation, heat insulation services
Books, newspaper, magazines (except of erotic and violent nature)
Hotels and special accommodation services
Freshly chilled meat
Freshly chilled, frozen, deep-frozen poultry
Live, fresh and chilled fish
Medicines and medical equipment
Organic foodstuffs
Art, culture and sporting events
Creative or performing services provided by writers, composers or performers
Fruits and vegetables

As recorded in the table, VAT rates on meat and poultry products were reduced in 2003; a year later, VAT rates were reduced on fish products. This clearly illustrated how reduced VAT rates tend to spread as producers of similar products launch demands for similar protectionist measures. This contagion of reduced VAT rates results not only in more damage to competition in the markets, but also in an ever-increasing hole in state budget.


Reduced VAT rates should be abolished Europe-wide, because they are state subsidies that do not reach their main aim, which is to benefit the consumers. Moreover, they distort markets by preventing equal competition. Finally, budgetary losses due to reduced VAT rates threaten the financial stability of countries and even lead to calls for tax increases.