The International Monetary Fund (IMF) warns governments against cutting VAT to combat inflation.

In response to rising inflation and the global cost-of-living crisis, the IMF has urged countries to refrain from cutting VAT.

As global inflation soars and countries grapple with a worsening cost-of-living crisis, the IMF has advised governments against cutting VAT on food and energy products.


The IMF warned in its June 7 report that lowering VAT rates risks depriving governments of much-needed tax revenue. According to the IMF's Fiscal policy for mitigating the social impact of high energy and food prices report, "a general reduction in taxes…results in the loss of significant revenues when these are most needed."


Inflation, combined with lower price elasticity of demand for food and energy, would increase government revenues, according to the Washington-based organization. In the long run, this would allow countries to provide targeted assistance to vulnerable households.

Matthias Luther, an EY associate partner for indirect tax and a lawyer in Hamburg, agrees with the IMF's assessment. VAT reductions, he claims, can be an administrative burden for businesses.


"We just had a temporary VAT cut in Germany, which was a huge burden on entrepreneurs and tax authorities with limited effect on the economy," Luther says.


Businesses are already stretched trying to deal with economic headwinds, he says, and increased VAT compliance is the last thing they need.


"Changing their invoicing system setups or pricing due to reduced tax rates does not help. It only adds to the complexity of the tax law ," Luther says.


The IMF acknowledges that lowering VAT and excises is a fiscal tool that many governments have used to protect their citizens from rising prices.


Given the current global economic situation, the IMF's advice to governments appears to be somewhat unconventional. In a survey, the organization discovered that since January 2022, most countries have announced at least one VAT or excise reduction measure.


Advanced economies have led the way, with 26 of the 31 countries announcing tax cuts. Developing countries have lagged behind, with 45 of the 103 emerging economies lowering their taxes.


The report noted that "the fewer announcements in emerging and developing economies likely reflect continued reliance on existing energy and food subsidies while limiting adjustments in domestic prices, less fiscal space, and lower ability to quickly scale up [social security nets] SSNs."


According to the IMF, VAT and excises accounted for 42 percent of announced tax cuts in developed economies, while they accounted for 24 percent of all reductions in emerging economies.


The head of tax for an Indian pharmaceutical firm says he agrees with the IMF's advice to governments not to cut rates.


"From a macro-economic point," he says, "the current governments [fiscal] budget does not give it much elbow room to reduce GST. Look, the government is fighting inflation, general elections are also due in the near future, so we don’t expect any changes to GST rates anytime soon."


He also claims that because VAT is a domestic tax, he does not expect the Indian government to reduce GST rates in response to international pressure or trends, as it did previously with corporate taxes.


"Any cut to GST would be hypothetical at this time," he says, "although there have been discussions about this, but it is unlikely."


Given VAT's high share of total taxes collected, a tax professional at a global technology company in London understands why some governments are hesitant to reduce it.


"They [governments] collect so much [VAT]…  ," she explains.


She does, however, believe that a VAT reduction would be beneficial to the economy and businesses. Because it would only be an internal IT rate amendment, implementing VAT changes would not be too difficult.


"It [VAT reduction] does help with cashflow and for big companies like ours, having [good] cashflow is very important especially given the tough pandemic and economic situation we’re facing… it helps a lot," she says.


Not all tax executives agree that governments should defer VAT reductions. Businesses benefit from indirect tax cuts because they help to boost or maintain demand.


High taxes and high inflation, according to Vikas Garg, director and head of indirect tax at Siemens in Mumbai, result in lower consumer spending, which hurts businesses.


"Quite often, to keep the consumption levels high, businesses tend to absorb the higher input costs on a short-term basis, but that may not be sustainable long term," says Garg. 


Some businesses believe that if inflation is not controlled, it will have a negative impact on trade, despite increased government revenues, as the IMF has stated.


According to a tax professional at a global technology company in London, lowering VAT has clear economic and business benefits.


The impact of difficult economic conditions is felt by everyone, not just businesses. The COVID-19 pandemic and inflation have wreaked havoc on government balance sheets in recent years.


A tax expert at a toy company in the United Kingdom questions whether governments are interested in long-term VAT reductions.


"“I am fascinated to see whether there’s appetite from the rule makers at Treasury to reduce their income streams…with growing inflation and when we’ve borrowed billions to pay for COVID-19," he says.


He claims that balancing government budgets is difficult enough in normal times without adding the complexity of an economic crisis.


There may be a divide in the global south between richer developed countries and emerging markets. The former can afford VAT reductions, whereas the latter may prefer to keep as much revenue as possible for social programs.


There will be little room for governments to avoid criticism, regardless of the strategy they choose.

By fLEXI tEAM