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, MOFEC, and EEA. Partial equilibrium analysis through 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 DickeyFuller (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 Values added tax and inflation in Ethiopia. The coefficient of estimated ECM revealed that the speed of adjustment for errors in the short run is 47.9 percent. 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 both periods. The study also found that VAT Granger causes inflation and unidirectional causality runs from VAT to inflation. The positive significant impact of VAT on inflation is most likely due to the burden of the value added tax on intermediate out puts. The policy implication is that a very detailed post VAT cost benefit analysis and careful assessment of social desirability of VAT is essential.