Global Daily – Impact of German VAT unwind on inflation

Euro Macro: German inflation to jump higher again in January – As part of an EUR 130bn economic support package, the German government decided in June to cut the standard VAT rate from 19% to 16% and the reduced rate from 7% to 5% between 1 July and 31 December 2020. The cut in the VAT rate will only have a downward impact on inflation if companies pass on the VAT cut to consumers by lowering consumer prices. Alternatively, companies could decide to use (part of) the cut in the VAT rate to support profit margins.

German inflation: impact of VAT cut, % yoy

Source: ABN AMRO Group Economics

Germany’s Bundesbank and Ifo Institute each have published research papers about the impact of the VAT cut on inflation  (see here and here). The Bundesbank paper mentions that the standard VAT rate applies to almost two thirds of the goods in the HICP basket (all energy, most industrial goods, about half of all services and about a third of food and drink) while around 15% of items in the HICP basket are subject to the reduced VAT rate (e.g. most food products, books, public transportation) and the rest is exempt from VAT (e.g. housing rents). This means that if the VAT cut had been fully passed on to consumers the HICP inflation rate would have dropped by 1.8 percentage points, with the core rate falling by a similar amount, according to the Bundesbank calculations. However, the actual inflation data that have been published since July indicate that this drop was significantly lower.

According to the Bundesbank’s calculations about 60% of the VAT cut actually translated into lower HICP inflation, i.e. it lowered inflation by 1.2 percentage points, with the impact on core inflation at around 0.8 percentage points. The largest downward impact was recorded in food prices, followed by energy prices and non-energy industrial goods prices. The smallest downward impact was recorded in the prices of services. Having said that, as the prices of large parts of the services sector have had to be imputed due to lock down measures and social distancing measures in large parts of 2020, the estimates and forecasts of these prices are surrounded by an unusually high level of uncertainty. The Ifo research paper focusses only on the changes in prices in supermarkets following the VAT rate cut. It’s results are similar to those of the Bundesbank for the prices of food.

Looking forward, all else equal, the return of the VAT rate to pre-pandemic levels in January, will push inflation higher by around 1.2 percentage points. This implies that headline inflation will probably rise to somewhat above 1% during the first months of 2021. In the second half of this year, the base effect from the cut in the VAT rate will result in a a second jump higher in inflation, which could temporarily rise to above 2.5% during the summer. Having said that, inflation will slow sharply again in 2022 as weak underlying inflationary pressures come to the fore. (Aline Schuiling)