Changes to indirect taxes and their effect on the forecast in 2019–2021

(authors: Petr Král, Jan Šolc)

Two types of price impacts – first-round and second-round – are associated with changes to indirect taxes (i.e. VAT and excise duties). Headline inflation is affected by both types of impacts, while monetary policy-relevant inflation only contains the second-round impacts. This box explains the CNB’s approach to indirect tax changes and describes how tax changes affected the forecast for 2019–2021.

The first-round effects are the price changes stemming from changes to indirect taxes implied by full pass-through of those changes to prices. They can be either positive or negative depending on whether indirect taxes are increased or decreased. The size of the first-round effects thus depends on the direction and size of the tax change and the weights of the affected items in the consumer basket. They can therefore be accurately quantified and located in time.

In reality, though, tax changes may not pass through proportionately to prices. In such cases, (immediate) second-round effects occur. For various reasons, the movements in the prices of the relevant goods or services in a given period may not always correspond precisely to the change in indirect taxes. The immediate second-round effect reflects the difference between the actual change in the final prices of goods and services stemming from the indirect tax change and the first-round effect.¹ The second-round effect may also be positive or negative. It is positive if the increase in the price of the relevant item is higher than that implied by the tax increase or if the decrease in the price is lower than that implied by the tax decrease. In the opposite case, it is negative.² The estimate of the second-round effects of indirect tax changes provides only a simplified description of economic agents’ behaviour at the time of the tax change and its implications for immediate price movements. In a market economy, prices of goods and services change continuously (with or without tax changes) in response to changing supply and demand on the market and to changes in the overall macroeconomic environment. In most cases, it is difficult to accurately differentiate a price movement due to proportionate pass-through of an indirect tax change from the hypothetical price movement that would have occurred in the absence of the tax change. The CNB nonetheless makes informed estimates of such second-round effects of changes to indirect taxes.

The CNB applies escape clauses to the first-round effects of changes to indirect taxes. This means it adjusts the inflation outlook for the first-round effects of indirect tax changes when setting interest rates. The first-round effects are beyond the central bank’s control and have only a short-term effect on inflation in themselves, and suppressing them would cause unwanted volatility in other variables. The CNB therefore reacts to monetary policy-relevant inflation, not headline inflation. Besides standard price movements, monetary policy-relevant inflation includes the immediate second-round impacts of indirect tax changes, which may reflect, among other factors, fundamental inflation pressures in the economy and have long-term effects on inflation.

Given the advanced stage of the legislative process, several tax changes planned for 2020 have been taken on board in this forecast. The tax changes related to the launch of the third and fourth phases of ESR include the reclassification of certain services and goods (e.g. hairdressing and restaurants and water supply and sewerage collection charges) into the second reduced VAT rate (10%). Furthermore, a package of rate changes is set to increase excise duty on alcohol and implement a “harmonisation” increase in excise duty on cigarettes. All these tax measures are scheduled to take effect at the start of 2020 and will affect both market prices and administered prices. In addition, the forecast still takes into account the already approved reclassification of heat and cooling prices into the second reduced VAT rate in January 2020.

The first-round effects will be close to zero overall, but the expected significantly positive second-round impacts will affect inflation. At the end of 2020 Q1, the significantly negative first-round effect arising from the VAT rate cut is more than offset by the positive first-round effect of the excise duty increases,³ which are expected to be phased in gradually (see Chart 1). The second-round effects on inflation, which are of greater importance for monetary policy, will be positive throughout 2020, amounting to around 0.3 percentage point (see Table 1). The forecast assumes that the lower VAT rate will manifest fully in final book prices for consumers but only partially in water supply and sewerage collection charges. According to the assumptions of the forecast, the reassignment of prices of other services to the second reduced VAT rate will not manifest itself at all (like with the reduction in the VAT rate applying to restaurants in December 2016). As a result, headline inflation will not go down in early 2020, as the negative first-round effect will be fully offset by positive second-round impacts. This will cause the decrease in monetary policy-relevant inflation next year to be more gradual than it would be without these tax changes and more gradual than the drop in fundamental inflation pressures would apparently imply. The forecast expects the increase in excise duty on alcohol and cigarettes to pass through fully to consumer prices and therefore to have zero second-round effects.

Chart 1 (BOX) Impacts of changes to indirect taxes on inflation
Inflation will be substantially affected by second-round effects of changes to indirect tax next year
(year on year in percentage points)

Table 1 (BOX) Impacts of changes to indirect taxes valid from early 2020
The tax impacts will manifest mainly in market prices, but administered prices will also be affected
(impacts on CPI in 2020 Q1 in percentage points)

^a) already contained in forecast from IR II/2019
^b) e.g. water supply and sewerage collection charges
^c) e.g. hairdressing services and restaurants
^d) The impacts will appear gradually in the first three months of the year.
^e) harmonisation change

The positive second-round impacts of the changes to indirect taxes lead ceteris paribus to a higher forecasted path of market interest rates (see Table 2). The second-round tax effects in 2020 Q1 are partly expected in the forecast, so the forward-looking central bank starts to respond to them in the second half of this year. The impacts of the new tax changes on the path of domestic interest rates will peak in late 2019 and early 2020 (at 0.25 percentage point). The second-round effects of the changes to indirect taxes on market interest rates will start to fade quickly,⁴ as the forward-looking monetary policy rule will respond to inflation in 2021, by which time the second-round impacts of the tax changes will have fallen to zero.

Table 2 (BOX) Impacts of the newly incorporated changes to indirect taxes on inflation and market interest rates
Only the second-round effects of changes to indirect taxes affect market interest rates
(contributions in percentage points)

Note: The first-round and second-round effects shown in the table include only the newly incorporated changes to indirect taxes compared with the previous forecast. In line with this is their effect on interest rates, which also primarily relates to the previous forecast.

¹ The term “long-run second-round effects” is used in macroeconomics with reference to the impacts of large cost shocks (such as large and long-lasting changes in oil prices). This refers to the fundamental effect of shocks on inflation in the long run through inflation persistence, inflation expectations and changes in other macroeconomic variables (especially wages). Naturally, monetary policy endeavours to prevent such cost shocks – which are capable of posing a serious threat to price stability in the longer term – from having any fundamental impacts.

² For example, an increase in excise duties will have a positive first-round effect (and calculated monetary policy-relevant inflation will therefore be lower than headline inflation in the period under review). If the tax increase manifests itself in consumer prices with a smaller increase than that implied by the tax change, the second-round effects are negative. At that moment, monetary policy-relevant inflation decreases by an amount equal to the second-round effect, whereas headline inflation increases by the sum of the first-round and second-round effects.

³ Monetary policy-relevant inflation will thus exceed headline inflation only temporarily, at the very start of next year.

⁴ The slightly positive impact in 2020 Q2 stems from interest rate smoothing in the monetary policy rule.