According to basic models of taxation all economic activity should be taxed at the same rate (ignoring externalities and fairness consideration). This is called tax-neutrality.
If you are taxing the sale of Pepsi at 10% and the sale of Coke at 20% you create distortions by artificially making people drink more Pepsi. Moreover since the economic damage from tax rates is not linear but quadratic in the tax rate, each dollar collected from the tax on Coke at the margin does more damage as the Pepsi tax. There are therefore efficiency gains from harmonizing the two rate rates.
This model is however an oversimplification. The neutrality principle implicitly assumes that all economic activities are equally tax-sensitive. Ramsey’s principle of optimal taxationdictates that we should tax activities proportional to tax sensitiveness. Different economic activities differ in price sensitiveness. For instance taxing land has a very small effect of supply whereas taxing foreign capital can substantially reduce supply.
For consumption taxes the overriding principle has been to equalize taxes across goods. This is sometimes claimed to be optimal taxation. But I disagree. In Gary Beckers model of household productionthe ability of households to create substitutes is different for different product categories. Households cannot themselves build high-tech goods such as electronics or vehicles regardless of how high the sales tax is, but can easily produce close substitutes for many services, such as transportation or eating out. Because of this taxes on services can reduce labor supply more than taxes on goods.
Another issue is how labor-intensive each good is. In a welfare state the social cost of unemployment for low-skill workers is higher than the social cost of unemployment for high-skill workers. Therefore it may makes sense (“second-best”) to tax goods and services produced by low-skill workers.
Based on these considerations the Swedish center-right government decided to lower the value added tax on restaurant services from 25 percent to 12 percent. The decision was made in November 2011.
Konjunkturinstitutet has evaluated the effect of the tax cut on prices. They compare restaurant prices to trend and to other Nordic countries and conclude that so far 30% of the tax cut has passed on to lower prices. The graph shows the price change in the quarter the tax cut was enacted.
I graph food prices and the prices for restaurant services from 2008. The price of restaurant services falls when the tax is cut and remains constant while inflation in food prices continues. Swedish restaurant prices appears to be 2-3 percent lower than they would have been without the tax cut.
The critique from the left was that this tax cut would not affect sales and employment and would simply be a waste of money. The left-leaning Aftonbladet editorial page writes:
“The theory behind the tax cut is that when prices fall more people will go to restaurants with higher need for hiring. But reality is not so simple. There are more things than the price level which decide if people go to a restaurant, such as habits and the availability of time”
However sales did turn out to substantially increase. Statistics Sweden reports that restaurant sales were 4.9 percent higher in June 2012 than a year before. This should be compared to retail sales growth during the same period of only 0.9 percent. Despite the economic crisis the growth rate in restaurant sales this quarter was the second highest in a decade. Only 60 percent of the restaurant sector was affected by the lower sales tax, which makes these figures even more impressive.
Though the reform has has some success, it’s interesting that prices have not fallen by the full 10 percent of prices the value added tax cut represents. It may be that some restaurants engaged in tax evasion, so that the taxes paid previously in practice were less than 25 percent to begin with.
Moreover there is a tendency in policy evaluation to be impatient. Most reforms only take full effect with a long lag as firms and people adjust their behavior. For instance the channel through which tax increases effect hours worked may be slow, generational changes in norms regulating work. In that case you may not notice the full effect of a tax increase for years or even decades, even in cases where the long-run effect is strong. The tax literature focuses on individual-level effects in the short or medium run, ignoring societal effects taking place over the long run.
If the restaurant industry is characterized by something between oligopoly and monopolistic competition a tax cut like this may require new entry for full effect on prices.The part of the sales tax cut which has not passed through in terms of lower prices raises the profitability of the industry. Over time this should put downward pressure on prices. I expect the price of restaurant services to rise less than inflation for some more time.