Impact on your business
Simple economics tells us that the higher the price, the lower the tendency for a consumer to buy. (demand). This phenomenon in economics is known as elasticity or in a simple term: The responsiveness of a buyer to a higher /lower price. The examples in the following sections illustrate a simple analysis of the impact of higher price as a result of VAT on the quantity wanted, desired and thus demanded by buyers. This is done by means of measuring elasticity in terms of responsiveness to the higher price. It is important to absorb the definition of elasticity prior to observing the working example below.
Elasticity is defined as the responsiveness of buyers to demand a change in price. Simple Economics states that in most cases, quantity demanded of a certain good or services falls if price increases; and the contrary is true as quantity demanded (wanted by buyers/consumers) increases when the price of a good or a service falls. In the case of VAT, it is also vital to mention that the price increases as a result of the value added is involuntary by the seller. In others words, the seller has no choice but to sell the good or service at a price enlarged by the magnitude of VAT. Thus, businesses in turn, may face lower demand for their goods and services involuntarily as the increase in price by an amount of VAT was not a scheduled increase by the producer, but rather imposed by the economy/government. Therefore, since VAT is inevitable and unavoidable, the best tool for businesses is to analyze how much is the fall in demand. The working example will show and assist business in their future-sales-projection based on the type of elasticity their goods and services fall under.
The introduction about elasticity aforementioned forms the basis of the impact of VAT on your business and/or businesses. It is important at this stage to mention that the impact of VAT on businesses varies country to country; depending on many factors including culture, level of wages, disposable income, and the wealth of people. Moreover and most importantly, income per head plays a role on how buyers may react to higher prices. Finally, prospects in the economy are also significant factors affecting not only buying patterns, but also indifference to higher prices. In an economy where booms are anticipated, consumers usually become indifferent about higher prices and continue to purchase even though the good or service in inflated by VAT.
Working example: Impacts of VAT on sales (Elasticity)
Initially, under this working example, the following assumptions are made:
- VAT is fixed on all goods and services. This implies that all categories of goods and services shall undergo the same value added.
- For the sake of this example only, VAT is assumed at 15%, since if we considered the actual VAT rate of 5% versus the buying power of the UAE citizens, there will be much likely no measurable medium or long term effect on the demand.
- The vital assumption that the quantity wanted by consumers will fall because of higher price upon VAT. This is a rule of demand that applies to most individuals. Collectively, buyers tend to lower their desire to purchase when the price is higher whether it is because of VAT, voluntarily increase by the producer, a result of higher customs/duties or a combination of all.
- Necessities are not included since there is no VAT imposed on such goods and services. Those may include necessary edible goods such as sugar, bread, water & electricity. VAT may also be applicable to vital services such health, fees for maternity delivery, charities etc.
- VAT will not be charged on any income, gains by corporates; thus, it is totally distinguished from income tax.
- The elasticity example applies to a distinct economy and culture since buyers in different economies react differently to higher prices because of VAT.
TYPES OF ELASTICITY:
Goods and services fall under seven types of elasticity:
- A) Types of elastic demand
- i). Elastic demand: A good or service where and when the demand (desire to purchase) falls dramatically upon a small increase in price.
- Example: Duplicate spare parts for machines and vehicles:
Original Average Price: AED 500
Price after VAT (15%): AED 575.
- Quantity demanded (desired) before VAT: 3,000 units
- Quantity demanded (desired) after VAT: 1500 units (50% drop)
- The above huge drop in demand by 50% can be explained by consumers switching to original spare parts when the price of duplicates increases by 15% VAT.
- ii). Moderately elastic demand: A good or service that falls in demand (desire to purchase) when the increase in price is substantial.
- Example: Children toys and accessories
Original Average Price: AED 60
Price after VAT (15%): AED 69
- Quantity demanded (desired) before VAT: 200 units
- Quantity demanded (desired) after VAT: 150 units (25% drop)
- Parents usually seek to satisfy the wants of their children. Thus, only a moderate number of those parents will be affected by 15% VAT increase on toys.
- iii). Perfectly elastic: A special situation, good or service where and when the consumer stops buying completely upon any change in price.
- Example: Unoriginal items, Ornaments and unnecessary decorations
Original Average Price: AED 100
Price after VAT (15%): AED 115
- Quantity demanded (desired) before VAT: 50 units
- Quantity demanded (desired) after VAT: Close to zero (No demand)
- Consumers tend to stop buying unnecessary items upon any increase in price. Hence, the increase represented by 15% VAT will prompt no purchases for those items.
- B)Types of inelastic demand
- i). Inelastic demand: A good or service where and when the demand (desire to purchase) falls by a small percentage when the price increases dramatically.
- Example: Furniture
Original Average Price: AED 3,000
Price after VAT (15%): AED 3,450
- Quantity demanded (desired) before VAT: 1,000 units
- Quantity demanded (desired) after VAT: 900 units (10% drop)
- Since the majority needs to buy furniture for homes, a 15% VAT increase in price may only decrease demand by 10%.
- ii). Moderately inelastic: A good or service where the demand on it falls insignificantly when the price increases dramatically.
- Example: Telephone services
Original Average Price: AED 300
Price after VAT (15%): AED 345
Quantity demanded (desired) before VAT: 10,000 units.
Quantity demanded (desired) after VAT: 9,700 units (3% drop)
- Telephone services are vital for all consumers. An increase by 15% may lead to a very small drop in demand for such crucial services.
- iii). Perfectly inelastic: A special situation, good or service where and when the consumer will continue to buy no matter how high the price is. An example is tobacco and luxury goods.
Example: Tobacco and the like
Original Average Price: AED 10
Price after VAT (15%): AED 11.50
- Quantity demanded (desired) before VAT: 100,000 units
- Quantity demanded (desired) after VAT: 100,000 units (0% drop)
- C) Unit elasticity
- i). A very unique situation where the percentage increase in price on the good or service leads to the exact percentage drop on the quantity demanded.
- Example: Electronic peripherals and accessories
- Original Average Price: AED 100
- Price after VAT (15%): AED 115
- Quantity demanded (desired) before VAT: 1,000 units
- Quantity demanded (desired) after VAT 850 units (15%) drop
- In the above example, an increase of price by 15% led to an equal drop in the number of buyers by 15% implying unit elasticity (steady responsiveness).