Why Austerity Measures Do Not Work in Greece

In his seminal work, Lucas (1976) argues that economic models should reflect the fact that economic agents operate under optimal decision rules that vary with policy changes.

As a result, the effect of introduced reforms can neither be evaluated nor quantified without considering the response of affected parties. This “critique” of static economic models becomes particularly relevant in the case of Greece, as it provides an explanation for the failure of austerity measures over the past years.

Indeed, the recent Greek reform programs provide countless examples of implemented measures that failed to yield the expected outcomes, because policy-makers ignored the reaction of affected parties. For example, the increase of vehicle registration fees resulted in massive de-registration of cars and motorcycles, inducing a negative fiscal outcome for the government budget. Similarly, anticipation of additional wage cuts for government employees, which aimed to reduce public spending, led to a movement towards early retirement, which in turn put pension funds under terrible strain.

Especially when it comes to tax reforms, large discrepancies between forecasts and realized results suggest that policymakers fail to factor in the response of taxpayers to new policies. This reaction tends to induce Laffer-type outcomes that render the changes introduced partially or totally ineffective. In light of this observation we apprehend the reduction of tax revenues that resulted from the upwards tax equation of heating and fuel oil. The upwards tax equation led to the collapse of demand for heating oil, producing results similar to those instigated by the tax rates increase on alcohol and tobacco, which motivated increased smuggling activity.

However, the Greek restaurant industry provides perhaps the most evident example of how this adaptation happens. In September 2011, the VAT sales rate for restaurant services increased from 13% to 23%. In contrast to initial forecasts for 1 billion euros in additional tax revenue per annum, the tax rate increase yielded just 160 million euros. In August 2013, the rate was lowered back to 13%; again, contrary to predictions of 140 million euros in revenue loss, collected taxes declined by just 69 million euros until the end of the year. These large differences between forecasted and realized values imply that firms“adjust” the level of evasion to tax rate changes, and that policymakers continue to ignore this adaptation.

The study “VAT Rates and Tax Evasion: Evidence from the Restaurant Industry in Greece”1 examines the effect of VAT rate changes on tax evasion, by exploiting a unique macroeconomic setting, in which opportunities for tax shifting are very limited. In particular, the initial rate increase observed was implemented at the peak of the financial crisis (2011), thus significantly limiting the margin to pass the tax burden on consumer prices. Consequently, when the change was reversed in 2013, the effect on prices was also minimal, as restaurants had already absorbed the prior increase. As a result, the effect of the tax rate on evasion was to a great extent naturally isolated. In the study, changes in evasion are estimated by observing changes of the ratio of reported sales over reported inputs around tax shifts, using as the control group large fast-food restaurants, which record their sales mechanically.

Empirical findings indicate that changes in the VAT rate result in sizable and significant changes in under-reporting. Firms tend to increase under-reporting upon a tax rate increase, both due to greater motive to evade and due to lower probability of being detected. The reverse holds for tax rate reductions; firms increase compliance and “uncover” hidden sales. For the VAT rate decrease of 2013, we conservatively estimate the average reduction in under-reporting across industry to be around 12%. The effect is more pronounced for small firms that exhibit greater flexibility in under-reporting and firms will low percentage of alcoholic sales that are less exposed to policy changes. Similarly, the VAT rate increase resulted in an increase of under-reporting of at least 9%.

Figure 1: Sales Ratio and VAT Rate Reduction}

The graph presents the median percentage change of the Sales ratio (reported sales over reported inputs) for small and large firms, and the control group (large fast food restaurants).The rate decrease was implemented in August 2013 (Q3).

Turning to industry-wide figures, the VAT rate decrease was followed by a decline of just 69.8 million euros in tax revenues for the last six months of 2013 — almost half of the amount anticipated. The limited losses in VAT revenues are due to the increase in sales reporting (+15.2%), which predominately originates from small firms (+19.2%). Additionally, the overall cost of the rate reduction for the government budget becomes even smaller, if we consider the impact on direct taxes. Restaurants report an additional 352 million euros in sales for the last two quarters of 2013 compared to the previous year; even if a portion of this amount of “uncovered” sales, which do not involve additional production costs, is reflected on profits, then the additional direct taxes (given the 26% corporate tax rate) can offset the realized losses in VAT revenues.

The aforementioned results have direct implications for policymakers. In environments of pervasive evasion and in industries where enforcement is difficult, the increase of tax rates does not necessarily lead to higher revenues, as market participants adjust their evading activity to new conditions. In contrast, lowering tax rates tends to reduce under-reporting, which in turn limits the adverse effects on tax revenues. These effects are further amplified if we consider the impact of increased direct taxes that result from higher reported sales.

The (limited) final cost for the government budget should be weighted against the long-term benefits for the industry, which are generated by a reduced tax rate environment given the importance of the tourism sector for the Greek economy. A low tax rate is essential for the industry to remain competitive with respect to foreign peers; during the period of the high VAT rate (23%), restaurants in neighboring countries were subject to significant lower tax rates, ranging from 5.5% in France to 13% in Italy. Additionally, since a lower VAT rate is shown to increase compliance, it also improves horizontal equity and competitiveness within the industry. Thus, it creates a more friendly environment to entrepreneurship, which facilitates entry and motivates investment and employment in the sector.

Finally, the findings also indicate that enforcement is more challenging for small firms, which do not rely on paper-trail as intensively as larger firms. Thus, the pervasive nature of evasion seems to be related to market structure, at least partially. Even though under-reporting by entity might not seem important for small firms, evaded amounts become considerable in the aggregate, due to the high population of small establishments. Thus, enforcement efforts on indirect tax evasion should be focused where paper-trail intensity is low, via targeted audits directed by the use of ratios of economic activity (as the Sales ratio), as these prove highly effective in detecting non-compliance.

1 The complete study is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2585147

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