Question

We have learned in class that tax distorts market equilibrium price, reduces the quantity purchased/produced, and induces deadweight loss. Although tax revenue is indispensable for any country’s financial sovereignty, governments sometimes cut taxes as a stimulus for economy growth. In 2009, when financial crisis hit Europe, household spending was greatly dampened because people were concerned about their income perspectives. To revitalize the economy, many European governments decided to intervene by providing economic stimulus packages. Among these measures, the French government delivered a policy cutting the value‐added tax (VAT) for food items in the country’s restaurants from 19.6% to 5.5%, although the VAT for alcohol would remain at 19.6%. Restaurant trade groups welcomed this policy change. They agreed to create more jobs using the increased revenue and pledged to cut prices of many menu items by 11.8%. Nonetheless, restaurants were not obligated to cut prices. Despite skepticism, for a time, the policy seemed to be working. At least some of the restaurants passed the VAT cut through to diners, which encouraged people to spend more and dine out more often. However, three years into the tenure of this policy, the French government was considering raising the VAT again. This was largely motivated by “a damning report to France's National Assembly on the tax‐lowering measure found restaurants largely failed to honour their part of the bargain.” Starting from January 2014, the VAT in French restaurants has been raised to 10%. The French story is not an independent case. Recently in UK, more than 40 pubs and restaurants launched a campaign to cut prices by 7.5% on Wednesdays. This was a lobbying effort from the restaurants hoping to convince the government that cutting VAT would lead to reduction of prices and spur consumer spending. 1) As a restaurant manager, how would you decide on how much you are going to cut the prices and which items’ prices to cut? 2) What kind of restaurants would cut their prices deep and what kind of restaurants are not likely to pass any benefit to consumers? Please elaborate with graphs and examples.

Answer 1

Tax cuts is a part of expansionary fiscal policy. This move incentivizes customers and sellers. Customers spend more as good/service becomes cheaper. However, it should be noted that when demand is inelastic, customer bears the burden and when supply is inelastic then seller bears the burden. In this case, eating out is not a necessity and has elastic demand and hence sellers can affect the demand by changing prices.

1) As a restaurant manager, how would you decide on how much you are going to cut the prices and which items’ prices to cut?

As discussed earlier, the eatables having high elasticity would be price cut and inelastic like alcohol will be charged the same. It can also be an effective strategy to decrease alcohol prices to lure the customers and charge prices on food items. Alcohol has inelastic demand as shown in fig. d, Price paid by customers earlier was P* and quantity was Q *, but tax put raises price to Pc and Quantity changes to Qt. But it is seen in the diagram that price change is large but Quantity change is small. Hence, hotels may charge high on alcohols. Govt. stands a chance to collect more revenue. As demand for food is increasing more jobs will be generated.

Food items are having elastic demand as shown in fig. C. for a small change in price(In case of tax cuts, price goes down from Pc to P* and quantity changes highly from Qt to Q*). This shows high revenue for hotel owners and also govt. stands a chance to collect revenue.

Example- It can be any normal food dish which people prefer.

2) What kind of restaurants would cut their prices deep and what kind of restaurants are not likely to pass any benefit to consumers?

Premium luxury restaurants may not decrease its food and service prices as premium pricing is also a strategy to differentiation. Lower and middle budget restaurants will cut prices to attract day to day customers and increase sales revenue. People also prefer low budget hotels to eat out. As shown in fig.a, many small hotels have inelastic supply and they cannot change immediately as they have to rely on customers response daily. Tax reduction will bring prices down from Pc to P* and they will change supply from Qt to Q*, which makes customers to buy more and as hotel owners do not have to pay tax and hence they also receive price higher from Pp to P* . (Fig. b)Premium hotels will have a small effect of tax cuts as they have premium customers and tax reductions will increase their sales but their budgets are still out of middle income customers.

The diagrams are as mentioned below.