The Portuguese government has introduced plans to exempt “essential” food items from its value-added taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. (VAT) in response to the recent inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. spike. While the basket of “essential” goods is to be determined, Finance Minister Medina hopes the temporary policy—effective from April to October—will provide relief to consumers. While this may sound like a reasonable measure on the surface, it comes with numerous unintended consequences that compromise its effectiveness.
Portugal already has a complex VAT system, consisting of a standard rate of 23 percent, a reduced rate of 13 percent, and a second reduced rate of 6 percent, which mainly applies to food items. Portugal’s current VAT system is the 7th least efficient among EU countries, losing out on 20.93 percent of potential VAT revenues due to exemptions and reduced rates in 2020. The additional exemptions would cause Portugal to miss out on even more; the government projects a revenue shortfall of €600 million (approximately $655 million) from the six months of implementation.
Past versions of the proposal included VAT exemptions for 44 different food items, with additional lists involving narrow and seemingly arbitrary distinctions between food categories that count as “essential.” This would likely distort the market and encourage households to buy products they wouldn’t pay full price for, creating an inefficient outcome.
Portugal’s temporary VAT carveout also sparks concerns about whether the policy provides effective support to low-income households. Because a VAT applies a flat rate to all affected consumption, and low-income earners spend a relatively larger portion of their incomes on consumption (as opposed to savings), VATs can be regressive.
Policymakers sometimes try to solve this problem with exemptions for goods consumed by lower-income households. However, things are more complicated in practice. Such carveouts are not the most efficient way to increase the progressivity of a VAT. A significant portion of the benefits will likely leak into the pockets of higher-income households because they tend to spend more on these goods in absolute terms (e.g., by purchasing higher-quality products).
Further, some share of the gains from temporary VAT carveouts will typically be captured by producers and retailers instead of consumers, as households need time to search for lower prices. For example, a recent study of Germany’s temporary VAT rate cuts in 2020 found that about 30 percent of the rate reduction was not passed on to consumers during the policy’s six-month period.
Another problem arises when exempted goods are used as inputs for other goods. When producers use goods that are exempt from VAT, they do not get credits when they use these “essential” goods in the production of other goods. If producers do not pass on the VAT exemption in this business-to-business context, then the price of other goods might rise. If manufacturers are accustomed to paying certain prices for their inputs and suppliers are able to keep these prices even though the VAT exemption would allow for price reductions, then prices for goods using exempted products as inputs (e.g., artisan cakes or restaurant food) might face further price increases. The VAT exemption is only neutral if it is passed on completely in supplier-manufacturer relationships.
VAT exemptions also create more complexity and increase compliance costs. Both manufacturers and suppliers must keep track of which products are exempted and how this influences their prices—and then switch back in a matter of months.
Temporary VAT carveouts would be ineffective, and there are better ways to target lower-income households. For example, countries can implement permanent structural reforms to finance directly targeted transfers. Permanent reforms are more stable and predictable, making firms more likely to respond to incentives.
VAT systems function best when applied to a broad base, using uniform rates and few exemptions. These features provide high simplicity and transparency and reduce compliance costs. A broad base provides an effective way to raise tax revenues that can be used for redistribution to lower-income households via direct transfers. Redistribution via direct and targeted transfers is preferable because they can be tailored to the intended beneficiaries without imposing hidden costs in the process. Direct transfers would only be made to those low-income households that are intended to benefit from the current VAT exemptions. Furthermore, retailers and producers would not have opportunities to capture portions of the transfers.
The current VAT debate in Portugal shows how an economic perspective can shed light on the unintended costs of a policy that may superficially seem like a good way to support low-income households during times of high inflation. While temporary VAT cuts may be popular, politically expedient, or welcomed for revenue gains and marketing purposes of affected firms (as witnessed in countries such as Germany during the pandemic), they do not represent sound tax policy.
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