Value Added Tax and Price Stability in Ethiopia: A Partial Equilibrium Analysis

Abstract

Value added tax (VAT), simply an indirect goods and services tax, which was implemented in Ethiopia starting from January, 1, 2003, is currently generating much debate especially with respect to its economic impact on aggregate level of prices. This study therefore, uses the quarterly time series data covering the period of 2004Q1 – 2014Q4 to empirically examine the relationship between VAT and price level in Ethiopia. The data was sourced from NBE, ERCA, MOF, and EEA. Johansen Co-integration is adopted in this study as it allows one to explain the effect of the value added tax in isolation from other control variables in the study. The data is tested for unit root using the Augmented Dickey-Fuller (ADF) test and the Philips-Perron (PP) test, and the result shows that variables of the study are stationary in their first differences. The Johansen co integration test revealed that there is at least one co-integrating vector implying the existence of long run relationship between VAT and inflation in Ethiopia. The coefficient of estimated error correction model (ECM) revealed that the speed of adjustment for errors in the short run is 47.9 percent indicating high speed of adjustment.  The coefficient of VAT in long run is 0.188578, while it is 0.0051 in the short run enlightening that it influence price with the lower coefficient in short run. The explanatory variables accounted for 80.3 percent of the variations in inflation during the period of the study with the error term accounting for the remaining 19.7 percent. The finding of the study shows that VAT has positive and significant relationship with price in short run and long run. The positive significant impact of VAT on inflation is most likely due to the burden of the VAT on intermediate outputs. The policy implication is that well-being of the society needs to be taken into account in the process of public revenue generation. It follows that government should assure social desirability of VAT by conducting post implementation cost benefit analysis.

Keywords: VAT, Price Stability, Partial Equilibrium Analysis, Johansen Co-integration, Ethiopia

DOI: 10.7176/JAAS/65-02

Publication date:June 30^th 2020