Besides, the government could offset the negative re-distributional effects that put pressure on low-income households due to the full application of the VAT tax rate, by using transfers or tax reliefs in other areas to return additional tax revenues to the households. This is the key result of a study conducted by the Centre for European Economic Research (ZEW), Mannheim, on behalf of the Federal Ministry of Finance (BMF).
The ZEW study confirms that low-income households do, indeed, spend an above-average share of their income on goods with a reduced tax rate and would thus be most severely affected by the abolition of VAT reductions. However, the spending structures of low and high-income households hardly differ, which weakens the argument for keeping the reduced VAT rate to support low-income households. High-income households benefit from the reduction almost to the same extent. The VAT reduction is thus a very inaccurate instrument of re-distributional policy.
But how can legislators avoid financial disadvantages, in particular, for low-income households while abolishing the VAT rate reduction? The EU tax harmonisation calls for a minimum VAT rate of 15 per cent. Therefore, it is impossible to replace Germany's differentiated VAT rates with a uniform tax rate at a medium level ranging between the current rates of 7 and 16 per cent. That is why the ZEW study examines scenarios, in which the additional tax revenues resulting from the abolition of reduced VAT rates are used to fund transfer increases and income tax or social security deductions in the form of a revenue-neutral tax reform. A smart choice of compensation measures leads to scenarios, in which all households are better off than before the reform. To maximise the positive effects of such a comprehensive tax reform, the government should use the additional VAT revenues to reduce social security contributions. Decreasing the marginal tax rates of the income tax could also be considered a suitable re-distributional instrument, whereas an increase in income tax exemptions was proven to be less effective.
The ZEW analysis suggests that the inaccurate nature of the value-added tax makes it an unsuitable instrument for distributional policy-making. Therefore, differentiating the VAT rate cannot be justified by means of distributional policy. Direct transfers or changes to the income tax rate promise significantly stronger effects in this context.
Sector-specific effects of tax rate differentiation are of much greater importance. A revenue-neutral abolition of the VAT reduction can lower the demand for goods that have so far been offered at a reduced VAT rate and increase the demand for products that have been offered at a full tax rate. The VAT reduction thus acts as sector subsidies disguised as distributional policy instruments. Policy-makers should discuss them as what they truly are.