Journal Issue
Finance & Development, June 1981

Is the introduction of a value-added tax inflationary?: Not really, according to data from 31 countries

International Monetary Fund. External Relations Dept.
Published Date:
June 1981
  • ShareShare
Show Summary Details

Value-added taxes (VAT) are, as the name implies, levied on the increment in the value of a good (or service)—that is, on the difference between its selling price and the cost of the inputs to the seller—as it proceeds from initial production to distribution and final consumption. The main difference between a VAT and other taxes is that it is, in principle, a way of “fractionating” the liability of taxation. A VAT usually extends to the retail stage of virtually all sectors, including services, and the retail selling price represents all “fractions” of value added through the production chain. Thus, a 10 per cent VAT yields the same as a 10 per cent retail sales tax but is collected at each stage of the production and distribution process instead of at the final stage. Being more comprehensive than other sales taxes, a VAT covers more taxpayers; it is adopted by many countries as a device to increase revenues, particularly when the rate of sales tax rises to about 10 per cent. Denmark, for instance, successfully used a VAT to increase total tax revenues by over 6.2 per cent in fiscal year 1967/68. But because it is so comprehensive it also often increases the burden on the administrative structure of the tax system, and policymakers have to take this into account when planning to introduce it. (This is one reason why many developing countries avoid it.) Aside from its effectiveness as a device to increase and secure revenues, the VAT is frequently used to shift the tax burden from incomes to expenditures as a way of managing aggregate demand—it was used for this purpose in the Netherlands and in Norway in 1968/69 and 1969/70, respectively.

Readers interested in a much more extended treatment of the data and the discussion are invited to write directly to the author.

Whatever the reason the authorities consider using a VAT, probably the most controversial argument advanced against its introduction is its effect on retail prices. From proponents of the tax who maintain it has no effect on prices to Belgians, who, in 1971, applied its initials TVA (taxe sur valeur ajoutée) to the slogan tout va augmenter (which means “everything goes up”), all commentators confront the possibility that the tax will increase prices and aggravate current inflation. Yet there have been no studies showing conclusively what the effects of such a tax on inflation actually are.

The major reason is not because of disinterest but because it appears too difficult (even impossible) to disentangle the changes in prices attributable to VAT from other influences on prices. “How can we know the dancer from the dance?” This article summarizes the conclusions of a detailed analysis that attempted to isolate the effects on prices of the introduction of VAT. The experience of the 31 countries using the tax was analyzed over the period the tax was introduced, allowing enough time in advance of the introduction to capture anticipatory as well as subsequent effects.

The analysis itself was made at two levels. At one, the relevant data were examined—on the consumer price index and on wages and credit before and after the introduction of the tax. At the second level these data were set in the context of a more detailed review of the situation in each country over the relevant period. Other influences on prices were analyzed, and their effects were isolated as far as possible from those of the tax. Thus, in many cases where the data seemed to show that the VAT had triggered inflationary price increases, more detailed study indicated that the rises were a result of a general uncertainty over prices or pressure for higher wages. The overall conclusion of the study was in fact that the introduction of VAT had a major impact on inflation in only 4 of the 31 countries under review.

Results of data

Data on prices can in theory show the effects of the introduction of a VAT in four ways:

  • There may be a single upward shift in the consumer price index clearly associated with the period when the tax was introduced, but with an unchanged, or little changed, rate of increase in prices, if the tax increases government revenue and if traders pass forward the increase. This is called the shift case. If inflation is defined as a continuing general increase in prices, the tax that results in a once-and-for-all price change cannot be inflationary by itself.

  • There may be an increase in the rate of change of the index, as a result of the introduction of the tax. This is called the acceleration case.

  • The acceleration may be combined with a shift in the overall price level. This is referred to as the shift plus acceleration case.

  • There may be no discernible effects at all, if the tax substitutes perfectly for the one it replaces or if the authorities can offset any accompanying pressures to increase prices.

Theory would suggest that if trend lines were fitted to the price indices before and after the introduction of the tax for the pure shift cases, the slope of the price graph should be approximately the same before and after, even though price levels would differ substantially. The data were examined assigning the shift to the quarter before the tax was introduced (to cover anticipatory buying and widening of margins) and to the quarter when the tax was actually introduced. The chart shows an example (for Denmark) of this behavior and Table 1, column A, categorizes the effects of VAT on consumer prices.

Table 1.Countries allocated to categories according to the effect of VAT on consumer price indices
Allocation on dataAllocation on broader
Price shift upwardBolivia
Shift plus accelerationHonduras
United Kingdom
Little or no effectAustriaArgentina
Costa RicaBrazil
Germany, Fed. Rep. ofChile
Ivory CoastColombia
KoreaCosta Rica
MadagascarGermany, Fed. Rep. of
Ivory Coast
United Kingdom
Source: IMF data.

The data on the 31 countries were examined over four years (two before and two after the introduction of the tax). Out of the 31 countries, 6 pure shift cases can be identified. Honduras and Norway were shift cases that also had clearly accelerating inflation. Ten of the remaining countries fell into the acceleration category, and for the rest no effect could be identified from the data.

Price shifts

To flesh out the background of each case to evaluate whether the results shown by the data were genuine effects of the tax on prices or were due to other concurrent circumstances, a more detailed examination was made of each country. This examination took into account such other causes of simultaneous price rises as changes in relative tax burdens, uncertainty, or rising wages. It also accounted for factors that might have suppressed price increases so that no effect of the tax could be discerned from the data alone; these factors included any offsetting policies to control incomes or prices or to reduce other taxes. This evaluation suggested some reallocation of the countries, shown in Table 1, column B.

Denmark VAT introduced July 1967

(Third quarter 1967 = 100)

The conclusions of the more detailed analysis did on the whole, however, corroborate those of the data regarding the countries where prices simply shifted upward as a result of the introduction of the tax—and where the effects of the tax could therefore not be regarded as inflationary. Six countries fell into the shift category on the basis of the data, and further examination confirmed that this was the appropriate place for five of them.

The experience of Denmark with the tax is fairly typical of the shift cases (see the chart). The introduction of VAT in Denmark at a rate of 10 per cent was designed to have wider coverage than the 12.5 per cent wholesale turnover tax it replaced and to yield about DKr 2.1 billion more in a full fiscal year. However, the complete tax changeover was more complex than the introduction of the VAT; higher tax-free allowances for wage and salary earners, high tax thresholds for low incomes, increased children’s allowances, and transfer payments to those not liable for income tax were all attempts to compensate for the anticipated increase in prices. These offsetting measures were estimated to have cost about DKr 1 billion in revenue forgone, so the net revenue increase was still over DKr 1 billion. The effect of the introduction of the VAT on relative prices was complicated further by the taxation of food and services, items that previously had borne little tax.

Large wage increases, just before the introduction of the VAT, also helped to compensate workers for price increases. Generally, the study conducted by the Monopoly Board of Denmark concluded that, “with few exceptions, businesses changed prices by amounts close to the tax differential and did not use the VAT introduction as an opportunity for unwarranted price increases.” Prices rose by 8 per cent between April and October 1967 and the wage regulation index (which excluded taxes) rose by 3.1 per cent; thus, the VAT was regarded as probably responsible for a rise of almost 5 per cent in prices. However, the rate of change for wages before and after the introduction in July 1967 of the VAT increased from 2.3 to 3.8 per cent a quarter. Despite the same trend of prices before and after the introduction of the VAT, the shift acted as a trigger for wage increases, and credit was expanded somewhat to accommodate this (see the chart).

Denmark indisputably introduced its VAT to increase revenue, and in this it was dramatically successful—taxation on private consumption was 19 per cent higher the year after the VAT than before. Although the resulting once-and-for-all shift in prices acted as a trigger to increase wages by more than the price increase, the Danish authorities were able to contain the potential for explosive price increases immediately following the VAT introduction. This success should probably be attributed to those offsetting adjustments in income taxation which, combined with substantial wage increases (continuing a previous trend), more than compensated labor for the VAT-induced price shift.

Thus, in Denmark and the other countries in the shift category, the effect of the VAT on inflation may have been modified by direct government intervention. But in Honduras and Norway, the data showed not only a shift but also a marked increase in the acceleration of prices, as the shift fed a greater price-wage increase than in the other countries, which in turn led to greater increases in prices after the VAT than before it. The reason appears to have been anticipation by the public that the tax change was going to increase prices and that the adjustments in income taxation would give them insufficient compensation.

Closer examination shows that the data for Honduras are misleading. A general ring tax was replaced by a VAT in January 1976. (A ring tax applies to transactions between registered and unregistered traders—between those inside and outside the ring. Small traders are unregistered, as is the general public.) The revenue from domestic sales taxation as a percentage of private consumption increased by 12 per cent but the effect on prices was relatively minor. The rate of the VAT was only 3 percent (as the ring tax had been) and the increased revenue must be ascribed to better tax administration for checking evasion. The rate of increase of prices was trivial and is more appropriately attributed to the accelerating credit expansion than to the introduction of the VAT. Honduras can be transferred to the “little or no effect” category.

Table 2.Impact of introduction of VAT on prices
DesignedPercentage CPI

change in quarters

before and after VAT


on revenue
General1Attributed to VAT2Other concurrent tax changes
ArgentinaJanuary 1975Equal yield37.2minorProvincial tax changes
AustriaJanuary 1973Equal yield2.4nilLower income taxes
BelgiumJanuary 1971Equal yield2.6nil
BoliviaOctober 1973Equal yield9.5nilNew luxury tax rates, increased excises
or increase
BrazilJanuary 1967Equal yield15.8nil
ChileMarch 1975Increase146.7minorTaxes on gasoline, incomes & property
ColombiaJanuary 1975Increase12.9nilIncome, property, capital gains taxes
Costa RicaJanuary 1975Increase5nilIncreased excises
DenmarkJuly 1967Increase8.05.0Lower income tax
EcuadorJuly 1970Increase8.7(7.1)Mining taxes reduced
FranceJanuary 1968Equal yield2.11.0Tax exemptions abolished & income tax
Germany, Fed.January 1968Equal yield1.50.6
Rep. of
HondurasJanuary 1976Increase1.0nil
IrelandNovemberEqual yield5.5nilSome tariff reductions
IsraelJuly 1976Increase17.9(9.0)
ItalyJanuary 1973Equal yield6.3nil
Ivory CoastJanuary 1960Equal yield
KoreaJuly 1977Equal yield4.1minorChanged excises
LuxembourgJanuary 1970Equal yield3.5nil
MadagascarJanuary 1969Increase3.2nil
MexicoJanuary 1980Equal yieldLower border VAT of 6%
or increase
MoroccoJanuary 1962Equal yield2.4nilChange in corporate & production taxes
NetherlandsJanuary 1969Equal yield6.21.5Lower income tax
NicaraguaJanuary 1975Equal yield5nilReduced customs duties
NorwayJanuary 1970Loss7.85.8Reduced income & property taxes
PanamaMarch 1977Increase5.0(3.1)Stamp taxes reduced & increased
PeruJuly 1976Increase27.1(13.5)
SenegalMarch 1961Equal yield
SwedenJanuary 1969Equal yield1.6nil1% payroll tax to offset lost revenue
United KingdomApril 1973Loss4.90.7Selective employment tax removed
UruguayJanuary 1968Equal yield66.3(53.0)
Source: IMF data.… Indicates data not available.
Any otherPriceNew VAT
concurrent changescontrolsTaxes mainly replaced3rates4
Utility rates increased, devaluationYes, but relaxedWholesale sales tax16
Strict credit controlYesCascade wholesale tax8, 16
Increased wagesMonitored &Cascade wholesale tax6,14,18,
some control25
NoMultistage ring system5,10,15,
NoState sales & municipal industrial taxes12
Utility rates increased & rent controls relaxedNoCascade turnover tax20
Many incentives abolishedNoSimpler VAT4,6,10,
NoMultistage ring system8
Increased transfers & increased wagesNoWholesale tax10
DevaluationNoVAT was a new tax, some turnover4
taxes on mining & manufacturing
Increased wagesYes, after VATSimpler VAT6.4,13.6,
MonitoredCascade retail tax5,10
Rapidly expanded creditNoMultistage ring system3
MonitoredWholesale and retail sales tax5.26,
Increased wages & tax allowancesNoVarious sales taxes0,8
Increased wagesNoCentral & local government sales tax3,12,18
NoManufacturers VAT8
Proposed VAT rate of 13% reduced to 10%Yes8 sales taxes representing 40% of revenue0,10
NoCascade wholesale tax2,4,8
NoCascade production tax6,12
NoCascade production taxes10
NoCascade production tax5,12
Increased wagesYesCascade wholesale tax0,4,12
NoMultistage ring system6
Increased transfers & wagesYesSales taxes on 65% of consumption20
Increase in utility ratesNoWholesale tax5
NoCascade production tax3,20,40
NoManufacturers VAT
NoRetail sales tax11.1
NoMultirate wholesale tax0,10
NoManufacturers, wholesale & retail taxes5,14
Source: IMF data.… Indicates data not available.

Accelerated inflation?

The next set of cases involves those countries where the data appear to correlate the introduction of the VAT not with a single increase but with an acceleration in prices. However, as shown in Table 1, column B, an examination of the particular circumstances in each country suggests that only in Israel, Italy, and Peru could the acceleration be genuinely attributed to the VAT.

The Israeli VAT can be used to illustrate what happened. Introduced in July 1976, it was designed to yield additional revenue, even though a number of sales taxes—mainly on food and clothing—were simultaneously abolished. The base of the VAT was wider than the taxes it replaced and sales taxation was extended to services, including financial services. The rate of change of prices accelerated from 5.2 per cent per annum before the VAT to 10.5 percent after. Some of the increase in prices in the first half of 1976 before the introduction of the VAT (and therefore included in the pre-VAT trend figure of 5.2 mentioned above) was attributed to speculative purchases in anticipation of VAT-induced price increases that permitted the transfer of higher costs into final prices. As in many of the other countries studied, wage increases accelerated more sharply, as did credit creation.

The Israeli experience with the VAT suggests that the new tax may have allowed traders to pass on cost increases and justified cost-of-living increases in wages, both of which triggered an increase in the rate of change of prices. However, the expansionist policies of a new government in the second half of 1977, including a sharp increase in government expenditure and wages, and an exchange rate reform that increased the capital inflow and expanded the domestic credit base, seem to have had more impact on prices than the VAT. Nevertheless, Israel is regarded as an acceleration case in Table 1.

In France, too, the data show an acceleration in prices of 2.1 per cent concurrent with the VAT introduction. However, probably less than 1 per cent of this was due to the tax. The main problem was the uncertainty caused by the change in taxes. The French VAT is, of course, the original from which all others evolved. Its modern form, introduced in January 1968, was a direct revenue replacement for the old tax (domestic taxes on private consumption represented 20.4 per cent compared with 21.1 per cent before VAT) but it did involve an extension of the tax to most wholesale and retail transactions. At the same time, under the new VAT many exemptions were abolished, and various anomalies and forms of double taxation (for example, on buildings and furniture) were removed, while the number of tax rates was reduced from seven to four. Moreover, there was a major change in the financing of local authorities; the changeover abolished the main taxes earmarked for the local authorities and substituted the revenue from the employers’ payroll tax; this caused a net loss in revenue to the central government. Although the overall sales tax revenue involved an equal-yield substitution, adjustments (partly to compensate for anticipated price changes) in the lower-income and middle-income brackets also cost 700 million French francs in revenue.

Prices rose somewhat faster after the tax changeover, and wages and credit increased sharply. But the picture is distorted by direct intervention later in the year to reinforce price controls through program contracts covering industrial prices, supervision of wholesale and retail trade margins, and a price freeze for services. At the same time (November 2, 1968), rates of the VAT were increased.

So the 1968 French VAT reform might be characterized as one which, while nominally an equal-yield change, involved changes in coverage and in rates, with offsetting adjustments in other parts of the system. Although the direct effect of the VAT on prices was probably less than 1 per cent, the uncertainty induced by the tax changeover may have accelerated the rate of increase in prices. Wages increased sharply but the vicious circle of wage-price increases triggering each other was contained (only partially) by price controls. The French example should probably be transferred to the “little or no effect” category.

Little or no effect

From the data, the introduction of VAT appeared to have no (or very little) effect on the rate of change of prices for 12 countries. Further analysis added 9 countries to the “little or no effect” category, making 21 in all.

The Federal Republic of Germany is the country most frequently used to show that the introduction of a VAT need not affect prices. The changeover in January 1968 from a 4 per cent cascade turnover tax (a tax on turnover at each stage of production, extending to the retail level) to an equal-yield 10 per cent VAT (and a 5 per cent rate on foodstuffs and agricultural products) was estimated at the time to have increased prices by 0.5 to 1.5 per cent. Even this increase was anticipated only because those sectors where prices could be expected to fall might prove more reluctant to pass forward tax changes than those where tax liabilities rose and because some services were taxed at higher rates.

This moderate impact of the tax is widely ascribed to the timing of the tax changeover, which came when the rate of German expansion had slowed and firms were reluctant to raise prices. In addition, the Lander (districts) operated a price monitoring system and no further control on prices was deemed necessary.

The experience with VAT in Costa Rica was similar to that of the Federal Republic of Germany in that the introduction of the tax coincided with a recession, and traders did not pass the tax on to consumers in the form of higher prices. In January 1975, the Costa Rican general ring tax of 5 per cent was transformed into a VAT of 8 per cent. It was estimated to have increased revenue by 50 million colones (and 1974 revenue from the general sales tax was

217 million), not through an expansion of the tax base but because of higher effective rates. In the event, the sales tax revenue in 1975 was
298 million and the revenue from this tax rose from 11.6 per cent to 13.6 per cent of total tax revenue. In addition, the introduction of the VAT was associated with increases in the rates and coverage of consumption taxes that were expected to raise another
100 million. This might have shifted prices upward and caused an acceleration in inflation, had it triggered a wage-price reaction.

However, it appears that the introduction of the VAT coincided with a marked slowing down of growth in Costa Rica that seems to have been more effective in restraining prices than the VAT was in stimulating them. The annual average rate of growth of domestic product in 1971-73 was 7.5 per cent, falling to 5.4 per cent in 1974 and to 3.4 per cent in 1975. The growth of manufacturing output declined from 10 per cent in 1974 to 2 per cent in 1975. The increase in consumption taxes seems to have choked off demand and an increase in interest rates to have stimulated private savings. With the depressed economic conditions and a substantial drawdown of inventories, merchandise imports actually declined.


In Korea, the rate of inflation accelerated as a result of the VAT, but the increase was controlled by direct government intervention. The VAT, introduced in July 1977, was a complex equal-yield substitution; that is, eight taxes (all at different rates) representing about 40 per cent of central government revenue were replaced by a single-rate VAT. This change was accompanied by the introduction of excises on 29 categories of consumer goods and services with rates ranging from 4 per cent to 160 per cent.

In an attempt to meet widespread uncertainty about the effects of the VAT, the authorities reduced the initial proposed single rate from 13 per cent to 10 per cent just before the introduction of the VAT and increased the scope of price controls. The Government had control over the prices charged by monopolies (enterprises with 30 per cent or more of any product market) and oligopolies (where three firms have 60 per cent or more of the market) and control over ceiling ex-factory and wholesale prices for 251 items. There was a huge campaign to publicize recommended retail prices for a wide variety of consumer goods. This was an interesting example of a sharp, short-term, widespread price control to cover the introduction of the VAT and to curb any price increases that might have occurred through uncertainty, increased business margins, and profiteering. Within a few months these controls were relaxed.

Although the rate of price increase was somewhat higher after the introduction of the VAT, the price control appears to have been successful in dampening the price-wages nexus for inflation. As a result, the introduction of the VAT does not, broadly speaking, seem to have had a major impact on the rate of price increases.

Little impact on prices

After considering the circumstances of each country in detail, in 21 of the 31 countries where the effects of introducing a VAT on prices were evaluated, no major impact could be identified. That is, in 68 per cent of the countries the introduction of the VAT can be said to have had little or no effect on prices. In four countries, the VAT could have contributed to an increase in the rate of inflation—although this was associated in each case with expansionary wage and credit policies. In six countries (19 per cent of the total) the introduction of the VAT is associated with a highly defined once-and-for-all shift in prices, but in only one of these countries (Norway) could this be said to have contributed to an acceleration in the rate of inflation.

Clearly it is possible to introduce a VAT (sometimes even to increase revenues) without shifting, or increasing the rate of change of, prices. If anything, the assumption should be that an equal-yield VAT substitution will have no effect on the rate of change of prices and that even if an increased yield is derived and prices increase, it will not necessarily accelerate inflation.

Moreover, the analysis showed that in a wide range of situations direct government intervention can be used effectively to offset any potential price increases from a VAT. Government policies to inform the public and traders about the expected effect of the VAT on prices, the use of price controls (particularly in Austria, France, Korea, the Netherlands, and Norway), offsetting adjustments in other taxes, the correct timing of the tax changeover, and generous provisions to ensure full credit for previously paid taxes on business assets and inventories were a few of the more important government decisions that helped to contain any potential inflationary effect the introduction of the VAT might have had.

Other Resources Citing This Publication