Ifo Viewpoint No. 66: Some Facts on VAT

Hans-Werner Sinn
Munich, 21 July 2005

CDU and CSU want to raise the value-added tax (VAT) by 2 percentage points and cut the employer contribution to unemployment insurance by 2 percentage points. This means a net revenue surplus and thus an additional tax burden, because the tax base of VAT is markedly higher than the part of wages that is subject to social security contributions. Estimates of the annual additional tax burden range from 1 to 3 billion euros.

The government needs the money to help consolidate the budget. The contribution to this is small, however, considering that genuine consolidation without further debt increases would require about 75 billion euro, the size of the 2005 budget deficit. Just reducing the deficit to the 3 percent limit would cost 9 billion euros.

The rationale for the change in financing is the attempt to reduce that part of the labour costs that is relevant for international location decisions and to shift decisions on investment locations in favour of Germany again. This rationale is correct in principle, as VAT is levied according to the so-called destination principle and is thus not relevant for decisions on production locations. Output is taxed with VAT of the country of destination and not with VAT of the country of origin. Unfortunately, however, the effect is minimal. At about 27 euros per hour, western Germany’s average labour costs of industry workers lead those of major neighbouring countries like Sweden (23 euros), France (20 euros), Austria (21 euros) and Great Britain (19 euros). The planned reduction of the contributions to unemployment insurance will cut German labour costs by only about 20 cents, and do so only if, in the next bargaining round, the unions abstain from using the distributive margin to their own advantage and raise wages.

There is practically no reduction in domestic labour costs, i.e. if supplier country and destination country are identical. Here VAT has a similar effect as a wage tax and hardly differs from social security contributions. A minute role may at most be played be the subtlety of differentiating between in one-hundred and of one-hundred calculations. Consider an average-income west German worker, whose spouse earns one third extra and who has two children, say a journeyman painter. The painter is working already when another client appears for whom a paint job is done. For this the paint-shop owner writes a bill that includes the cost of paint, paint brushes and transportation as well as an amount of 1000 euros for the pure labour costs including all taxes but excluding any profits. Of these 1000 euros, at present 643 euros go to the government and only 357 euros go to the employee, i.e. only about one third. Included in the 643 euros received by the government are 138 euros VAT and 46 euros contribution to unemployment insurance. The planned reduction of this contribution by 2 percentage points corresponds to a reduction of fiscal charges of about 15 euros, and the planned increase in VAT corresponds to an increase in fiscal charges of also 15 euros. The marginal tax burden remains at 64 percent.

With such a marginal tax burden, Germany ranks at the top of the world, surpassed only by France, with even 70 percent. High-tax countries like Sweden, the Netherlands or Denmark only levy a marginal tax rate of 61%, 59%, and 55%, respectively, on an average-income worker with identical marital status, and the neo-liberal Great Britain even takes only 49%.

Any hope is misplaced, therefore, that the planned change in financing will contribute to a reduction of moonlighting, that Germans will again exchange some leisure for work or that the low domestic demand for construction, restaurant services or other services, which is caused by high labour costs, might rise noticeably.

VAT is essentially a hidden wage tax and can therefore only contribute in a very limited extent to the solution of the German core problem of extremely high taxes and fiscal charges on wages. True measures to reduce German labour costs must start at the collective bargaining law and at the wage competition of the welfare state that fixes the wages for simple work, but that is another topic.

Aside from all of this, it remains correct that VAT has a broader tax base than a pure wage tax and can thus be used as an instrument of redistribution in favour of employees subject to social security contributions. That is because it is also levied on all other income recipients like civil servants, recipients of statutory pensions and of other government transfers.

Above all, VAT is an implicit tax on the stock of assets existing at the time of its introduction, because it becomes effective at the time the assets are utilised for consumption whenever that takes place. The real value of total assets declines in line with the increase in the tax rate, whenever these assets are used to feed consumption in Germany. And it is unimportant in principle whether the tax is passed on or not, as this question only determines how the owners of real assets and those of financial assets, whose nominal value is guaranteed, share the burden.

Hans-Werner Sinn
Professor of Economics and Finance
President of the Ifo Institute

Published as "Verfehlte Hoffnungen”, Wirtschaftswoche, No. 30, 21 July 2005, p. 122.