Supply and Demand Determinants of Heterogeneous VAT Pass-Through

Abstract We investigate the substantial variation in the extent to which a rise in value-added tax (VAT) is passed on to consumers. We first extend existing theory to characterize the roles of imperfect competition and product differentiation, then investigate these relationships empirically using a panel of 14 Eurozone countries between 1999 and 2013. We find that consumers pay a larger share of VAT increases when producers face more competitive upstream markets: the higher tax reduces final demand, but this lower demand does not in turn reduce input prices when upstream markets are competitive. Greater scope for quality differentiation also increases pass-through, by reducing the relative price elasticity of demand. JEL: D43, H22, H25