Germany Adopts a Temporary VAT Cut

This month, the German government agreed to a new round of fiscal support for the economy in light of the challenges from the ongoing pandemic. The total cost of the new package is €130 billion and is in addition to the supplementary budget adopted earlier in the year of €156 billion. Combined, the two fiscal programs amount to approximately 7.3 percent of Germany’s 2019 GDP.

Cutting the VAT Rate

Part of the new support program is a €20 billion 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) reduction. VAT rates will be reduced temporarily from July 1 through December 31, 2020. The standard VAT rate will go from 19 percent to 16 percent and the reduced rate from 7 percent to 5 percent. The reduced rate applies to a portion of consumption in Germany including some foods, transportation options, reading materials, and cultural events.

Germany’s VAT Rates

Temporary Rate, July through December 2020 (vs. Permanent Rate)	Type	Goods and Services
16% (19%)	Standard	All goods and services not taxed at the reduced or zero rate
5% (7%)	Reduced	Some foods, medical supplies, domestic transport, books, tickets to cultural events, flowers, e-books, audiobooks and periodicals, and short-term hotel accommodations
0%	Zero	Intra-community and international transport (excluding road and rail and some inland waterways transport).
Source: Avalara.com, “Germany VAT Rates,” https://www.avalara.com/vatlive/en/country-guides/europe/germany/german-vat-rates.html.

VAT is a significant part of Germany’s tax system, making up 18.2 percent of total tax revenue in 2018. The planned VAT rate cuts amount to approximately 8 percent of the VAT revenue collected in 2018.

As is the case with many countries, Germany’s VAT system is far from perfect, and those imperfections will likely influence the impact of the temporary VAT rate reductions. The most recent VAT Revenue Ratio calculated by the OECD for 2017 was 0.59 for Germany. This means that the VAT system covers almost 60 percent of consumption. The lower the VAT Revenue Ratio, the less efficient the VAT system will be for either raising revenue or delivering tax relief as intended by the German government.

Policy Goals vs. the Evidence

The German government has identified the VAT policy as a tool to boost consumption and provide benefits to lower-income households. However, the evidence on VAT changes raises questions about the efficiency of a VAT rate cut for achieving those goals. Several pieces of evidence from the last recession point to the VAT rate reduction as a weak tool for fiscal support and stimulating demand.

OECD research by Hannah Simon and Michelle Harding examined the interaction between consumption taxes and the Great RecessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. . They found that permanent changes in consumption patterns resulted from increased consumption in necessity items that are generally lower taxed (or not taxed at all) alongside an increase in government consumption. These changes in consumption patterns resulted in less efficient VAT systems in subsequent years, making the VAT a more volatile source of government revenue.

Additionally, an event study by Youssef Benzarti and Dorian Carloni used data on a French VAT reduction during the Great Recession to show that in some circumstances rate reductions are not fully reflected in price reductions. In other words, a VAT rate cut of 2 percent does not necessarily translate into a 2 percent reduction in prices. On the contrary, Benzarti and Carloni found that the benefits of a 2009 VAT rate cut for sit-down restaurants mainly accrued to the businesses themselves, with their customers benefiting the least.

Also, during the Great Recession, the UK implemented a temporary VAT rate cut for 13 months. An examination of the results of that policy by Thomas Crossley, Hamish Low, and Cath Sleeman found that prices did fall initially because of the rate cut but a portion of the price cuts were reversed even after two months. Though retail sales increased by 1 percent during the temporary policy, the expiration of the VAT cut reversed those effects and showed that consumers shifted the timing of their consumption to benefit from the temporary policy. So while a small, temporary boost to consumption was achieved, the boost was not sustained following the expiration of the policy.

The Right Tools for the Job

The severity of the economic challenges faced by Germany should cause policymakers to explore the most efficient ways of providing economic support and designing sound policies that will pave the way for economic recovery. Some of these policies are evident in other parts of Germany’s fiscal response to the crisis including direct fiscal relief to workers, payments to families with children, and changes to business taxation that provide liquidity and improve investment incentives.

Tax policy responses to the pandemic should be designed to provide immediate support while paving the way to recovery. A temporary VAT rate cut in the context of an inefficient VAT system is likely to deliver mixed results at best.

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