Why Europe likes austerity VAT rises

With financial markets looking for reassurances on the credit worthiness of the Euro states, VAT is fast emerging as a key strategy to turn around failing deficits. Following many VAT rises in 2009 and 2010, a new wave is upon us, and spreading across the region.

In the last year, there have been sharp hikes announced in the UK, Spain, Greece and Ireland to help meet debt repayments. With the latest wave of market turmoil in the past couple of weeks, Italy and Cyprus have declared their plans to raise VAT. Portugal and France now seem to be considering similar increases. The average GNP weighted EU VAT rate is 21%, compared to 19% in 2009(See below for comments on some of these individual plans).

The underlying phenomenon of the recent credit crunch was the shattering collapse in corporate earnings, which in turn led to sharp falls in fiscal revenues across Europe. For many countries, such as the UK, Ireland, Spain, Portugal and Greece, this led a substantial spiralling of budgetary deficits to new record levels. This has forced these highly indebted nations to rush through a range of severe austerity measure to prop up declining revenues and convince the markets that repayments can be met. At the forefront of these measure have been rises in VAT – some 17 in the past two years in the Euro territories. VAT has many attractions, outlined below, for states facing with huge deficits and nervous markets, as well as locked into a stable currency union via the Euro.

1) Speed and flexibility

To plug these gaps many territories are turning to consumer taxes. The flexibility in timing increases in VAT is what makes it particularly attractive to governments. Rises can be quick and easy to implement – a VAT rise can be introduced overnight and the additional revenue is immediately forthcoming. For example, Romania introduced its 5% VAT rise to 24% with just two weeks’ notice in 2010. Or, any increase can be delayed to encourage consumers to bring forward spending prior to the rise and give the economy a quick fillip. For example, the UK gave six months notice on its 2% VAT rise at the start of 2011.

2) Low administrative costs

The collection and administrative costs of a VAT system are minimal - it is left to private companies to act as unpaid tax collectors.

3) Enables internal devaluation in fixed Euro currency system

Prior to the introduction of the Euro, many of the most indebted EU nations regularly used currency depreciation as a way of cutting the costs of their goods and thus boosting exports and escaping recessions. However, these states are now tied to the stable Euro which is buoyed by the relative strength of the Germany economy. They therefore must resort to tax rises and spending cuts to produce an internal devaluation – cutting living standards and spending to reduce input costs which gives the same deflationary impact (by lowering export price) as a currency devaluation. VAT is a quick and effective tool for this strategy.

4) Enables states to cut business taxes in the face of globalisation?

A further factor behind the rises in consumer taxes has been the increasing competition to attract job-creating inward investment as international growth stutters. Global production is increasingly seen as fickle in its location decision making – favourable business taxes can make the difference. So in addition to providing investment subsidies, EU countries have been looking to cut corporation taxes and switch the burden to relatively immobile consumers. Recent reductions in business taxes in locations such as the UK and Germany have all been funded by rises in VAT.

Italy

Plan to raise VAT from 20% to 21% in 2014 as part of 1st austerity package. Whilst this increase remained untouched in last Friday’s emergency 2nd austerity package, it is widly believed it will have to be brought forward.

Cyprus

Announced plans last week to increase VAT by 2% to 17% in September to meet a budget shortfall

Portugal

Last week, the Central Bank produced a recommendation for a further VAT rise of 2% to 25% - the maximum in the EU. This is seen as essential to secure the next IMF/ECB bailout round

France

Now at the centre of the latest debt crisis as the largest major Euro creditor country. In 2007, it openly discussed a VAT rise but shelved it due to political uncertainties. President Sarkozy wishes to delay a consumer tax rise until after the 2012 Presidential elections – but market pressures may force his hand in the next few weeks

Other Increases in the past 12 months:

UK, Spain, Greece, Portugal, Romania, Czech Republic, Finland, Jersey and Switzerland