VAT increase on restaurants and rising of imports?
Recently, having a light lunch with my wife and kids at a nice spot, Mr. Carlos the place owner whom I have known for a while, was complaining about the VAT increase on restaurants. He argued ironically that his clients would rather buy a better TV than to pay more to eat at his place.
Indeed Mr. Carlos intuition was not far from right. VAT on TVs remaining constant, a VAT increase on restaurants fully reflected on meal prices would cause a relative price increase of the menu list and a possible consequent substitution effect between meals at restaurants and the consumption of other goods (all other things equal).
But assuming Mr. Carlos’ client was financially constrained by the crisis, nothing then could be concluded with certainty about his greater appetite for a new TV: Besides the substitution effect mentioned above, the increase in price of meals would also result in a negative effect on the income of his client that would amplify even further the unwillingness to pay for a more expensive meal at his restaurant, but might also reduce the desire to buy a new TV…
Mr. Carlos understood the argument but reacted with a smile: His clients were financially in a worse situation than before the crisis, but still not at the edge of a cliff. They would not accept to feel worse because of what was happening in the restaurant business. His clients would certainly try to find a compensation elsewhere to the fact of restaurants being more expensive: they would find alternative ways to adjust their spending behavior in order to feel as well of: For Mr. Carlos “the new TV was certainly going to be bought” after all, but his business might not survive the reduction in the number of clients, meals, and average sale per customer.
But even a significant absorption of the VAT increase by Mr. Carlos was not enough to change the perception of clients that the prices had increased a lot. With less customers and lower margins he reduced the number of employees by half, and may close his family business for good, if he wants to “play by the rules”…
For Mr. Carlos, worse than the national crisis was the perception created that the prices in restaurants have increased much more than the prices of other goods. He thinks that the substitution of consumption between restaurants and other goods had a much greater negative impact for him than the general decrease in income Portuguese people are facing in general. Furthermore he thinks that his clients in particular suffer less than the average people with the crisis. He has no doubts that this policy measure is causing not only a huge increase in unemployment in his activity, but also may be contributing to rising imports by promoting a certain level of substitution between meals in restaurants and the consumption of other goods.