Who doesn’t understand economics?

11. februāris, 2010


Vjačeslavs Dombrovskis

There is a curious argument between Nellija Jezdakova, acting head of State Revenue Service, and Ainars Šlesers, Riga's vice-mayor. The point of contention is whether VAT rate should be reduced for the hotels. Mrs Jezdakova argues that hotels should not get a special treatment, because then "all the tax-payers will have to pay for the hotel and tourism industry". Mr Slesers angrily retorts that Mrs Jezdakova "is not capable of understanding economic relationships", and that "hotels are paid for by tourists, and not tax-payers". Well, non-economists should think twice before accusing someone of not understanding economics. That's trespassing on our turf - and we don't take it lightly.

So, who doesn’t understand economics here? What are the effects of reducing VAT rate for the hotels? A tax reduction reduces the wedge driven the prices received by the producers and prices paid by the customers. Usually, producers (hotel owners) will get higher prices and, therefore, higher profits. Buyers would benefit by paying less for the service. Of course, a crucial question is whether a tax reduction can increase tax revenue? In theory, it’s possible, provided both demand and supply are sufficiently elastic. In other words, a VAT cut may increase revenue if the resulting decline in prices will bring lots of new tourists to the hotels (and if the hotels would accommodate this increase at given prices). Naturally, if the inflow of foreign tourists were to increase as a result of lower hotel prices, we would expect higher tax revenue above and beyond that generated by the VAT on hotels. As rightly pointed by Mr. Šlesers, tourists spend on taxis, restaurants, etc. So it might well happen that VAT reduction for the hotels is a good idea.

At this point it’s worth noting that commodity exports are not subject to VAT, which amounts to subsidization of exports vis-a-vis trading partners. It’s an example of what is known as a “beggar-thy-neihbour” policies, where one country is trying to gain at the expense of the others. And of course, it only ‘works’ for as long as your neighbors don’t do the same thing. Since all of Europe uses VAT taxation, this policy only works vis-a-vis countries like the U.S., that don’t have VAT. Thus, one might make a point that since hotels export services, one may try to increase the competitiveness of our hotels vis-a-vis competitors by making them exempt from the VAT. And of course, the policy would stop working the moment everyone else adopted it, which is what would inevitably happen if such policies became widely used.

Does this make Mr. Šlesers right? It might, if these supply and demand elastisticities are sufficiently high. Basically, Mr. Šlesers would be right if VAT reduction would lead to two things. A first necessary (but not sufficient) condition is that it should reduce prices charged by the hotels. Whether it would do so depends on the market structure. The second condition – a necessary and sufficient one – is that reduction in prices would attract sufficient number of new tourists. ‘Sufficient’ meaning that the additional tourists need to make up for the loss from VAT revenue resulting from ‘existing’ tourists (who would come anyway) paying lowers prices for the hotels. Is this plausible? Some of my colleagues think it’s a long shot. Potential tourists consider many things, hotel prices being just one of them. If at least one of the above conditions is not fulfilled, VAT reduction for the hotels would result in net revenue loss, and the taxpayers would have to make up for this if we want a balanced budget (but hotel owners would still gain). Then, Mrs. Jezdakova would be absolutely right.

I haven’t answered the question of whether we should cut VAT for hotels, have I? The answer is we don’t know. Moreover, we CANNOT know unless we have some estimates of these demand and supply elasticities (also average tourist spending on other goods and services). Simply economic theory allows for both possibilities: Mr. Šlesers and Mrs Jezdakova both might be right. One needs to do some hard work to put numbers on those elasticities in order to answer a question like this.

However, I think I can answer the question posed in the title. Both Mr. Šlesers and Mrs. Jezdakova seem to misunderstand economics. An argument like this is settled with empirical evidence, not with whoever can raise his(her) voice most.

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