A regular reader shared with me this 2023 blog post by Tax Policy Associates (in the UK), arguing against removing VAT (Value Added Tax, the equivalent of New Zealand's GST) from sunscreen (and some other goods). The post notes that:
There are currently high-profile campaigns to scrap VAT on sunscreen, and scrap VAT on public electric vehicle (EV) charging. The proposals would waste public money, and fail to achieve their objectives.
The post then goes on to argue against the campaigns, but gets two things very wrong. Here's the first:
There’s a common intuition that a reduction in a producer’s cost (like VAT) will result in the producer lowering its prices. After all – the argument goes – the price of a product is made up of the cost of production plus a profit markup. So if the cost drops, the price will drop. And VAT is a cost, so if we reduce VAT, the price will drop...
But that’s wrong. In a market economy, economic actors charge what the market will bear.
The post uses some data on price changes over a four-year period before and after VAT was removed from e-books and tampons, and shows that the prices of those products did not fall. However, that is not a careful analysis, because it fails to account for all of the other things that might have caused prices to change. Comparing to other products where a VAT reduction didn't happen (which the write did) might be valid, but you would need to be sure that there weren't other factors at play (which the writer doesn't).
We should expect that removing an excise tax reduces the price of a product. To see why, consider the supply and demand model below. If there is no VAT, then the market would operate in equilibrium, with a price of P0 and a quantity of sunscreen traded of Q0. However, VAT, which is paid by the seller, effectively increases the sellers' costs. We represent this with a new curve, S+tax. VAT is an ad valorem tax, which means that the amount of the tax is a proportion of the price of the good. So, the S+tax curve starts off close to the supply curve, and gets progressively further away as the price of the good increases. With VAT in place, the price that consumers pay for sunscreen increases to PC. The producer receives that price from the consumer, and then passes the VAT onto the government, leaving the producer with an effective price of PP (the difference between PC and PP is the amount of VAT per unit sold). With the higher price including VAT, the consumers demand less food (QT), and with the lower effective price after paying VAT, the sellers supply less food (also QT). There is no excess supply or excess demand. Now, removing VAT moves the market from a price of PC for consumers to the equilibrium price of P0 - consumers end up paying a lower price and buying more (Q0 instead of QT). So, it is correct (at least, based on this model), that removing VAT would cause a decrease in consumer prices for sunscreen. The only time that would not be true would be if the demand curve was horizontal (perfectly elastic) - then the quantity would change, but the price would not.
Now, here's the second thing that the Tax Policy Associates post gets wrong:
The UK sunscreen market is worth £169m, implying that a VAT cut would cost about £30m.
Imagine if we could use that £30m to put high SPF sunscreen directly in the hands of the people that should use it, but don’t, and then persuade them to use it. That would be perfectly efficient, with zero “deadweight cost”. Of course real world programme to provide free sunscreen wouldn’t be perfectly efficient, and there would be material deadweight costs as we hand free suncreen [sic] to people that would have bought it anyway. However we would certainly not expect a deadweight cost of £30m.
The deadweight costs of a VAT cut are much more serious. First, a big chunk of the £30m will be kept by retailers, and not passed to consumers – on the basis of the evidence above, that’s probably most of the £30m; approaching a 100% deadweight cost right away. Even if we imagine that somehow all the benefit went to consumers, there would be an immediate £30m deadweight cost as we give a VAT cut to people who were buying sunscreen already. Only when we attract new purchasers are we incurring a non-deadweight cost, and this will almost inevitably be a small fraction of the overall cost of the VAT cut.
There is a really fundamental misunderstanding of deadweight loss here. To see why, consider what they are really saying: removing the VAT on sunscreen makes society worse off. So, applying that logic, increasing the VAT on sunscreen must make society better off, unless the current level of VAT is some magical level that maximises welfare. So, why aren't they arguing for higher VAT? It's because their argument doesn't make sense.
To see why they are wrong, consider again the diagram from earlier, and consider the areas of economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, with VAT in place, consumer surplus is the area ABPC. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, with VAT in place, producer surplus is the area PPCF. The VAT that is collected by the government, which is the per-unit amount of VAT, multiplied by the quantity of food sold) is equal to the area PCBCPP. Total welfare is the sum of the three areas (consumer surplus, producer surplus, and government revenue), and is equal to the area ABCF.
When VAT is removed, consumer surplus increases to the area AEP0, producer surplus increases to the area P0EF, and total welfare increases to the area AEF. Overall society gains total welfare equal to the area BEC, which was the deadweight loss of VAT. In other words, removing the VAT increases total welfare, and decreases the deadweight loss. There is a deadweight gain from removing the VAT. Tax Policy Associates gets this argument completely backwards.
Now, they argue that it is a bad thing that some of the gain goes to the producers. But gains to producers are part of total welfare for good reason. Producers are people too (or, rather, their owners or shareholders are people). Those gains accrue to people, even if not directly. You may not like it, but that doesn't make it wrong. [*]
There are good ways to argue against exempting particular products from VAT (or GST). The best arguments relate to the inefficiencies that would be created in the tax system generally (for example, see here). Lowering taxes does increase total welfare (within that market), but may have other social costs, and that needs to be taken into account.
Lowering an excise tax will almost certainly affect the good's price, and will not increase the deadweight loss (but will instead decrease the deadweight loss). Tax Policy Associates probably has the conclusion correct, but their arguments in support of the conclusion are wrong.
[HT: Huw Davies]
*****
[*] There is at least some consistency in these wrong arguments though. As I noted, if demand is perfectly elastic (horizontal), then there would be no price change from removing the tax. The gain in total welfare would also accrue only to the producers (because there would be no consumer surplus at all with a perfectly elastic demand curve). However, it isn't clear that this is what Tax Policy Associates is arguing. Is demand for sunscreen perfectly elastic? It seems unlikely - the estimates on this site suggest that demand is quite inelastic.
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