Tourism Taxation: No Such Thing As A Free Lunch?

Michael McMahon - Junior Sophister

Of all the sectors currently driving the economic boom in Ireland, tourism perhaps represents the strongest. Michael McMahon notes that this fact is not lost on those whose job it is to raise exchequer revenues and assesses the wisdom of applying a tourism tax. Looking at similar initiatives around the world, he cautions that the temptation to tax tourists should be resisted.

Introduction

Forty years ago tourism was effectively free of taxation. However since then, as a result of changing economic conditions, improving transport and technology, and increased globalisation of markets, international tourism has become a major industry with an impressive growth record. According to World Tourism Organisation figures, the number of international tourist arrivals has grown from 25 million in the year 1950 to almost 600 million in 1996. The growth in tourism receipts has been equally impressive, growing from $2,000 million in 1950 to over $400,000 million in 1996; and it is still continuing; it is expected to grow at the rate of four or five per cent per annum for the next twenty years.

As noted by Forsyth, governments are always looking for new tax bases and growing industries, such as tourism, offer attractive possibilities for them. In this essay I will examine how tourism can be taxed and some of the issues involved. I examine Adam Smith's canons of taxation with regard to tourism taxes. I will then focus on the levy of VAT on room rates, restaurants and bars sales; and then move to an analysis of the Irish case. I will conclude by looking at some of the current controversies associated with tourism taxes.

The attention of taxation authorities trying to tax tourists has resulted in a multiplicity of tourism taxes. The International Hotel Association (IHA) conducted a survey among its members in 1995-96 on the extent of the tax burden on hotels; the findings were published in the IHA Taxation Survey - a Comparative Survey of Taxation on the Hospitality Industry. It revealed a great disparity in levels of taxation from almost nil in Kuwait to 39% of room rate in Hungary, where 59 separate taxes are imposed on hotels.

More recently, the World Tourism Organisation Business Council (WTOBC) published its study of Tourism Taxation. It takes a broader perspective than the IHA study as it reviews all taxes which affect tourists. The types of tourism taxation which the study identified may be categorised under two main headings as follows:

Including exit formalities and taxes; entry taxes (visas); terminal charges at airports, sea ports and road borders; accommodation VAT, sales tax, hotel levy, bednight tax; taxes on transport, food & beverage, and shopping; environmental taxes and visitor attraction taxes.

Fuel tax; duties on the import of equipment used in tourism businesses; property taxes on hotels and resorts; corporation tax.

Other taxes not identified by the WTOBC study include payroll taxes, marketing levies, training levies and various licences.

The study sought to identify changes in taxation of the tourism industry during the period 1995-97. It identified nine new taxes that were imposed and twelve instances of increased coverage of an existing tax e.g. an increase in its rate or a widening of its application. This multiplicity of taxes can cause problems and complications such as possible double taxation; for example when a tourism tax is levied at a local level, a tourist might pay the tax on arrival to a hotel and again on entry to a local attraction.

There are some features of the tourism industry which make it prone to extra attention by tax authorities:

(a) Taxation can be levied on visitors to a country, thus avoiding the unpopularity which inevitably accompanies taxes which are borne by citizens; the tax is in effect exported; this is particularly significant where tax payers are also voters who elect and unelect governments.

(b) Tourists, whether international or domestic, frequently have above average incomes and can afford to pay taxes without undue hardship.

(c) Expenditure on tourism is largely discretionary and thus can be avoided if it would cause hardship.

The main concerns with respect to incidence of the tax are that of price elasticity of demand (PED) and price elasticity of supply for hotel rooms. Firstly, if demand is elastic then consumers (tourists, guests) will react to a price increase as a result of a tax by seeking other places to stay in lieu of paying the extra tax as well as the original room rate. Therefore, in some competitive situations, hotels will find it impossible to pass on additional taxes to customers and therefore the hotelier pays the extra tax. If the demand is inelastic, then the consumers will not react to price increases by substantially changing their demand and so the hotelier will pass on the cost of the tax and the tourist will bear the burden.

Forsyth also notes the difference in the incidence of a tax between the long- and short-run. He points out that in the short-run there is a fixed capacity in the hotel sector and so firms will have set the price that effectively rations the capacity. If a tax is levied on them, they have little ability to pass on the tax. However, in the long-run hotels have very high elasticity of supply and so the adjustment to the tax will be that more or less all of it will be passed on to the customers and the hoteliers will accept a lower level of output. The effect of the reduced output will depend on the PED as discussed above.

Hotel Associations have been concerned about the introduction of taxes at relatively short notice. It is not unusual for hotels to agree rates with tour operators more than a year in advance; and agreements on room rates with conference organisers can be very much longer. The contract may not allow hotels to pass on any new or increased taxes which arise after the signing of the contract and so the hotel must bear the burden.

The OECD's Council of International Tourism Policy recognised "…that tourism should be encouraged as an important generator of employment". Tourism is one of the world's foremost employers of staff generating some 262 million jobs for 10.5 % of the working population world-wide. Not only does the tourism sector create many jobs for skilled labour, but it is also the source of employment for those who need it the most such as the young, students, untrained and parents. The sector provides these people with the experience they need and opens the door to other jobs. As pointed out in the joint letter from HOTREC, EMRA and FERCO to Mr. M. Monti - European Commission lobbying for a reduced VAT Rate on hotels, restaurants and cafes; the role of the hospitality sector in social inclusion is underlined by the fact that of those people directly employed by the sector in Europe, more than 54% have only a basic education.

The idea is that a government spends the revenue it collected in taxes, on those goods/services that benefit those from whom it was collected. An example of hypothecation in the tourism sector is the use of tourism taxes to promote and market Irish Tourism through An Bord Failte. Hoteliers are suspicious of the use of hypothecated taxes; a view supported by the conclusion that in the USA only 57% of hotel dedicated taxes are being used for hotel or tourism-related purposes. Despite this concept's good theoretical objective, it is still the preferred action of governments, and the action encouraged by the IMF, to collect all revenue centrally and then determine expenditure policies.

Taxation is necessary to provide governments, both national and local, with the finance to meet their obligations in the provision and maintenance of public goods. Where these obligations arise because of tourism, there is a straightforward justification for the taxation. In this category we can put the cost of maintaining airports and immigration officers. When tourists bring their own motor cars to countries they visit, they cause wear and tear to the roads and it is fair that they should contribute to the cost of road maintenance. In some instances, tourists are heavy users of local resources. For example, in drought-stricken areas, tourists with a propensity for frequent showers are often wasteful of the scarce commodity of water. Whilst it may be difficult to calculate the share of taxation which should be borne by tourists, there can be no objection to the principle of tourists contributing their share. But objections do arise if tourists feel they are expected to pay an undue proportion of the taxation; they frequently indicate their objection by going elsewhere. And on their behalf, hoteliers protest as they seek to protect their market share.

The principles that underlie a good tax system can be traced back to Adam Smith's canons of taxation from 1776. These can be examined under four headings, namely; equity, efficiency, tax administration and neutrality.

This refers to the fairness of the tax system including the expectation that taxes are levied on those with the ability to pay. A tax is deemed to be progressive if the average rate increases as the ability to pay increases. Spengler and Uysal, based on the assumption that most of the tax is borne by the tourists and that they have the ability to pay, suggest that hotel taxes are progressive and therefore justifiable from an equity point of view. Much of the other literature on tourism taxes comes to the same conclusion. However the issue is not entirely clear-cut as one must consider whether the tax is paid by the tourists or by the hotelier which, as I have shown above, depends on the price elasticity of demand for hotel rooms.

This refers to the extent to which the tax system distorts the free market system. An efficient system is one which minimises those inevitable distortions. In the case of the tourism industry, bedroom taxes increase the price per room and thereby make such expenditure less attractive; consumers may react by spending their money on other goods or services.

Studies on taxation for hotels have produced conflicting accounts of the extent of the effect of room taxes on demand. Hiemstra and Ismail have quoted studies which showed that a 10% increase in room prices due to the imposition of a room tax would result in only a 1% decline in room sales; but these studies were conducted in the context of a low taxation regime. At a time when taxes are higher, it may be true that the price elasticity of demand is much higher. There is the celebrated case of the imposition of a 5% tax on rooms costing more than $100 in New York State in 1990. The market for hotel rooms proved to be particularly price sensitive as tourists avoided New York. In 1994, the tax was repealed.

The introduction of a higher VAT rate for 5-star hotel rooms in Madrid in 1994 caused an immediate drop in the number of such rooms from 4,016 to 1,371. This was achieved by hoteliers voluntarily downgrading to four-star to avoid the higher rate and had implications for pricing and competitiveness. The government abandoned the higher rate in 1996.

This refers to the situation where the tax rates across a range of commodities are equalised. This does not imply tax efficiency unless the elasticities across the commodities are equivalent. An aspect of this principle, which applies to the hotel industry, is the variability in VAT rates between EU member states, despite the fact that a Single Market is supposed to apply. This puts hotels in some states at a competitive disadvantage and prompts them to argue for a remedy. In the case of the hotel industry, there is concern that other industries are being treated more favourably since hotels compete with other industries for discretionary expenditure. In fact the opposite is true within the EU, since twelve of the fifteen member states apply a reduced VAT rate to room sales and eight states apply a reduced rate to restaurant sales. The EU is committed to the harmonisation of VAT rates so there is concern that the adjustment for hotels in most states will be upwards.

Another aspect is the comparative tax rate in competing countries. As tourism is highly mobile, it is important to seek the advantage of lower tax rates than one's competitors, or at least maintain equality. HOTREC has lobbied the European Commission for a reduced VAT rate to enable European tourism to compete on a more-even footing with extra-Community destinations.

This topic requires consideration of the compliance costs of tax-payers, the effective enforcement of the tax system and the elimination of uncertainty in the system. Most tourism related taxes were deemed to have low collection costs in the WTOBC study. In a number of instances such as accommodation taxes and environmental taxes, the mis-reporting of business (to minimise taxation) was thought to be a problem. Evidence that such may be happening is provided by the list of major settlements made by the Irish tax authorities with individuals and companies accused of underpaying their taxes; eleven of the top twenty seven were involved in the hotel and catering industry.

Hoteliers, in common with many small businesses, are concerned at the increasing complexity of taxation and other bureaucracy. New financial regulations issued every year and their attendant requirements for form-filling by hoteliers create the need for extra assistance from accountants, adding to costs for hoteliers as well as the direct cost of the taxes involved.

For most countries the most significant tax on the tourism industry is Value Added Tax (VAT) which is charged on gross revenue; the rates which were current in April 1998 in EU member states are set out in table 1 (see Appendix).

The table shows that VAT rates on room sales in hotels within the European Union ["The Common Market"] vary between 3% in Luxembourg and 25% in Denmark. Similarly, VAT on restaurant meals varies between 3% in Luxembourg and 25% in Denmark and Sweden.

VAT on alcoholic drinks sold in bars is generally higher than VAT on room or restaurant meals but again Luxembourg is lowest (3%) while Denmark and Sweden are highest at 25%.

An analysis of the historical relationship between VAT rates and industry growth may convince even the most sceptical of the negative effect that high VAT rates have on industry growth. In table 2, I have set out the rate of VAT on hotel room sales alongside the percentage growth achieved in international tourism receipts for the years 1990 to 1996.

An analysis of this table shows that in the EU the relationship between VAT rates and growth in tourism receipts is negative, i.e. higher rates of VAT are associated with a slower rate of growth in international tourism receipts. The correlation coefficient is -0.27 which is not particularly strong; one reason for this is that Ireland has strongly exceeded its expected performance. If it were excluded from the analysis, the correlation coefficient would be -0.54.

Alain P. Feutre's (President of HOTREC) concluding remark at the VAT symposium held in London on 18/10/97 was:

HOTREC's arguments in favour of reduced VAT Rates are mainly on the grounds that the demand for tourism is highly elastic and that even a small price cut, made possible as a result of reduced VAT, could stimulate a large rise in demand. A Deloitte and Touche study in 1995 for the British Tourist Authority estimated that the PED is as high as (-) 2.5.

The effect of the increased demand would be a growth in employment (as discussed above) but it would also impact on the demand in other sectors such as manufacturing (e.g. aircraft) and construction (e.g. hotels) through the multiplier effect.

The other arguments include the necessity for EU countries to maintain competitiveness with non-EU countries; neutrality of the taxes; and stability of state revenue. It has been argued that national treasuries need not worry about an initial tax shortfall resulting from a VAT cut as they will be more than compensated by the ensuing increases in VAT and other tax receipts due to greater activity in the sector. A number of case studies are cited to support this contention that lower tax rates can yield more income and vice versa.

In several countries there are taxes which are levied on each bednight in hotels, based on a percentage charge or a flat rate. British hotels are currently resisting a 2% bed tax which has been proposed within the ruling Labour Party. If adopted, it would enable local authorities to impose a 2% levy on all rooms in their area. The City Council of Dublin, Ireland has also floated the idea of a bed tax and suggested a charge of £3 per person per night. Both proposals have been met with alarm by hoteliers in the respective areas.

One reason for objecting to a bed tax is the elasticity of demand issue as discussed above. A study conducted by Deloitte & Touche in 1995 on behalf of the British Tourist Authority estimated that price elasticity in tourism may be as high as (-)2.5. This estimate appears high compared with the study by Hiemstra and Ismail in the USA which calculated an average elasticity of (-)0.44, though the UK figure may be higher than the US figure because the UK is more dependent on individual / family tourism than corporate travellers.

The hotel industry in Dublin has been enjoying an unprecedented boom in recent years with high occupancy rates despite the opening of 23 new hotels in one year. This provides a tempting target for a cash-strapped City Council. But the experience of New York in 1990-94 should give cause for caution; where in 1990, the state legislature brought into effect a 5% bed room tax on hotel rooms costing over $100 per night. An econometric study commissioned by the New York State Hospitality and Tourism Association of New York concluded that by imposing the tax, New York gave up $2 in related taxes for every $1 it took in from the occupancy tax. In August 1994, the tax was eventually repealed following a three-year battle by New York hoteliers. The hotel industry in Dublin could suffer similar major damage should a bed tax be levied.

The case of the Irish tourism industry is an exceptional one and one that is quoted by Hotel Associations world-wide in the arguments in favour of preferential tax treatment of the hotel sector. There are three main issues that are highlighted in the Irish case:

In the early 1980's the Irish Government increased the VAT on hotel accommodation to 23%. The effect of this was that more than 10% of hotels closed their doors. In 1985 the Irish Hotels Federation persuaded the Irish government to cut the VAT on room sales from 23% to 12.5%; in the period that followed Irish tourism grew dramatically and it has continued to grow ever since; in the six year period 1990-96 receipts from international tourism grew by 107% when the arithmetic mean growth rate in other EU countries was 36%. It should be noted however that it is impossible to prove that the reduction in tax was the direct cause of the growth in tourism; other factors such as cheaper air fares to Ireland also helped.

As mentioned above, the tourism industry is an important employer of staff in the Irish economy and the reduction of VAT has had a phenomenal impact on the level of employment in the sector. In 1985 when VAT was first cut to 10%, the hotel industry employed 22,000 people; in 1996, despite the fact that VAT was slightly higher, the same figure was 42,000 people.

Although it is accepted that the immediate effect on state revenue of a reduction in VAT rates on hotels will be a deficit for the first few years, HOTREC use the example of the Irish case to argue that in the long-term there will be a gain for national treasuries. In 1983 when the VAT on tourism was the standard rate of 23%, the tax receipts from overseas tourists amounted to IR£254m. By 1996 the VAT had fallen to 12.5% and tax take was up to IR£818m.

‘The evolution of increasingly similar patterns of taxation across EU countries is being promoted through formal EU harmonisation policy'. It is the intention of the EU to move to harmonised VAT rates in the union and hoteliers are concerned that the chosen rates should be lower rather than higher. At present there is a spread of VAT room taxes from 3% in Luxembourg to 25% in Denmark. Most countries operate at least two rates and in twelve of the fifteen states hotel room VAT rates are lower than standard rates.

As mentioned above, Governments are always looking for new tax bases and a relatively new concept of taxation is that of environmental taxes. These are allowing for greater creativity by taxation authorities and are already widely in use in those countries at the forefront of environmental issues; for example, in Denmark it is estimated that there are already more than 300 environmental taxes. Some examples of these ‘Eco-taxes' applied to tourists include the German tax on disposable packaging that applies to all sectors of the hospitality industry except fast food outlets. Externalities resulting from air traffic have also been targeted by taxes such as the French ‘noise tax' and the tax on aviation fuel applied in the USA. The most unusual eco-tax on tourism is the ‘toilet tax' levied on all visitor accommodation in the Knysma area of the Eastern Cape Province of South Africa; this requires all the owners of visitor accommodation to pay 900 Rand per toilet per year.

The International Hotel and Restaurant Association has urged its members to be environmentally responsible, to be aware of potential environmental damage caused by tourists and to seek to reduce such damage. If such action is taken speedily, it may reduce the call for legal measures which are more onerous for hotels.

The success of the tourism industry in its ability to maintain growth levels over the last forty years has definitely attracted the attention of those public servants who are continually called upon to find newer and more acceptable ways to meet the increasing demands for public goods without increasing, and even while reducing, other taxes. As a result, taxing of foreign visitors to a country may at first appear to be a ‘free lunch'. However as all economists know and as I hope I have shown in this essay, there is no such thing as a free lunch and those responsible for taxation policy must examine the distortionary effects of tourist taxes on the tourism industry in the area.

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