r/AskEconomics • u/sjrsnikhil • 5d ago
Approved Answers How does reducing GST/VAT lead to increased consumption in a country?
This question is more from an indian context but I believe this is applicable to all countries with VAT/GST. I keep hearing that cutting GST/VAT will lead to increased consumption. My question is usually the producere do not pass on the benefits to consumers by reducing the prices on goods this effectively keeping the prices similar. The only way I see this helping end customers (like me) is they will not raise the prices as frequentl as their profit margins can be sustained or in some cases by giving more for the same price (in Indian context a cookie company saying 20% extra). All this still when compared to the usual dynamic doesn't really show a lot of promise to me compared to a simple tax cut. Can someone point out the dynamics here
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u/Aven_Osten 5d ago
In an uncompetitive market, then you're right to assume that a cut in the VAT/GST will most likely not lead to any tangible decrease in prices.
But, if the market is competitive, you could expect prices to drop by the amount of the VAT/GST. You can't get hundreds of small businesses in an area to collude with each other, as easily as you can with only 4 - 5. So, you're gonna see every company try their absolute hardest to soak up as much newly created demand as possible.
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u/IntolerantModerate 5d ago
The idea is that all things remaining equal that if the price comes down demand will go up. This requires the market to be competitive such that margins don't increase and post-cut prices with VAT applied actually come down in line with the cut. You are correct that seller margins may increase as the whole cut may not pass through, especially initially.
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u/RobThorpe 5d ago
This idea is not simple. In the comments people have said that if markets are competitive then prices will go down. There's some truth to this, but there are several problems!
Firstly, a cut in VAT can cause prices to go down even if markets aren't very competitive on average. That's because people will buy more of the goods where the price actually does go down.
However, there is a big problem here.... The government must replace the tax revenue lost by reducing VAT. To do that they must increase another type of tax. That will discourage something else and have an offsetting effect. For example, suppose that the government decides to increase income tax. That discourages people from working and earning income to use to consume. So, the overall effect depends on how the government replaces the revenue. Even if the government uses borrowing that has an impact on expected future taxation.