The pass-through of VAT to food prices at the end of 2011

The tax changes included, among other things, an increase in the reduced VAT rate from 10% to 14% as of 1 January 2012. The effect of this change on consumer prices was first incorporated into the CNB’s macroeconomic forecast in Inflation Report III/2011, where it was described in Box 1 The impacts of changes to VAT rates on the budget and inflation and their components in 2012 and 2013. The increase in food prices due to the VAT changes at the start of this year implies a first-round effect on inflation of 0.6 percentage point. According to the forecasts in Inflation Reports III/2011 and IV/2011, the VAT change was not expected – owing to subdued demand – to pass through to consumer prices in advance, as had happened at the end of 2007. At that time, more than half of the effect of the approved change to the reduced VAT rate from 5% to 9% as from January 2008 had passed through to food prices two months in advance. Given the different position of the economy in the business cycle and the different agricultural producer price situation compared to 2007, the potential pass-through of the higher VAT rate to food prices at the end of 2011 was considered in Inflation Report IV/2011 to be only a temporary upside risk to the forecast.

However, strong across-the-board growth in food prices in October to December 2011 suggested that the VAT change might again have passed through in advance to prices of food (excluding alcohol and tobacco, which are not affected by the recent VAT change). Seasonally adjusted food prices rose by 2.7% in 2011 Q4, with most food items recording increases. An econometric analysis reveals that the pick-up in food price inflation in this period can be explained to only a very small extent by the currently rising imported food prices or the weaker exchange rate (see Chart 1). By contrast, the effect of the high domestic agricultural producer prices in the past on food prices is fading noticeably. At the same time, a comparison of food price inflation in the Czech Republic with that in neighbouring countries shows that the Czech Republic had the fastest growing food prices at the end of 2011 (see Chart 2). This difference has no significant cause other than the VAT change. A similar difference between prices in the Czech Republic and other countries was observed in late 2007 and early 2008.

Chart 1 (Box) Food price factors
Food prices were affected at the end of 2011 by an increase in VAT
(annual percentage changes; contributions in percentage points)

Chart 2 (Box)  Food prices in the Czech Republic and surrounding countries
At the end of 2011, the Czech Republic had the highest food price inflation in the region
(annual percentage changes; HICP methodology)

The new forecast – just like the previous two – expects one quarter of the 0.6 percentage point first-round impact to be absorbed in sellers’ margins in the short run and to manifest itself in price increases only in the longer run. The new forecast assumes, however, that 60% of the remainder of the impact (i.e. about 0.4–0.5 percentage point of the impact on inflation) has already shown up in food prices between October and December 2011; the remaining effect will pass through to food prices in January 2012. This means that the premature VAT pass-through is similar in magnitude to that in 2007.