Both measures were presented as extraordinary and temporary and were intended to curb the impact of the price shock on essential goods and thus moderate the rise in inflation. But if at the beginning of this year the zero VAT on food was definitively ended (after a three-month extension from the original schedule), the subsidy of fuel prices carried out through taxes remains and the governments (the current and the previous one) seem afraid to withdraw this support once and for all.

On the one hand, it costs a lot of money (one billion euros per year in round figures), it is contrary to energy transition policies (because it fuels fuel consumption and car use) and has already earned Portugal criticism from international institutions. On the other hand, there are few measures more unpopular than increasing the tax burden on fuels, as was evident when the news of this possibility (published in the Jornal de Negócios) generated reactions from Chega and questions from socialist deputies. It was the PS government that introduced this support in 2021 and that two years later still maintained it, unlike Spain which, at the end of 2022, limited the discount of 20 cents per litre to some sectors, when it had become a widespread discount.

Brussels warns Portugal to end widespread support for fuel prices

In Portugal, the partial unfreezing of the carbon tax, with an increase of three cents per litre that came into effect last week, reverses a small part of this aid that has been slowly withdrawn, seeking favourable low tides in international prices to cause the least possible shock.

However, the budgetary impact of this aid is strong and there is pressure from various sides to withdraw the aid: external through the European Commission but also internal, as a result of the need to include other major tax-cutting policies in the budget balance, such as IRS Jovem or the reduction of the IRC.

In 2023, fuel subsidies will cost €2 billion, according to the proposed State Budget for 2024, which is three times more than the cost of zero VAT on food. In the first seven months of the year, the budget execution points to an expenditure of almost €600 million, a figure that does not include the effect of the partial freezing of the carbon tax.

The decision on support will probably be made in the next state budget proposal, given that the AD economic programme, which served as the basis for the main tax-cutting measures (from IRS Jovem to IRC) did not provide for the withdrawal of these supports. And the invariant policy framework sent to Parliament by the Ministry of Finance also does not identify any budgetary savings resulting from a possible elimination of this support.

Pensions, civil service salaries and new measures (from the Government and the opposition). The budget for 2025 already includes 5.8 billion in new expenses

First came support for fuels…

The reduction of fuel taxes to counter rising prices began before the war in Ukraine, at the end of 2021, and with slight cuts, but gained momentum in 2022 when the government of António Costa, re-elected at the beginning of 2022, but this time with an absolute majority, used the tax on oil (ISP) to reduce the tax burden on this good after failing to convince Brussels to accept the reduction of VAT to the intermediate rate of 13%.

In addition to this significant and unprecedented reduction in the ISP for petrol and diesel – 11 cents per litre – two other mechanisms were introduced in parallel:

• The return of the profits that the State was making from VAT on fuels, induced by the increase in prices, to the oil tax, through additional reductions;
• And the suspension of the annual update of the carbon tax.

At the height of this policy, fuel tax subsidies exceeded 20 cents per litre and were unable to always offset weekly price increases that exceeded double digits during the first months of the conflict in Ukraine in the first half of 2022. The situation only calmed down at the end of that year with the stabilisation of international markets, but by then it was already clear that inflation, initially seen as a temporary phenomenon in response to demand in the post-pandemic phase, was going to have a longer-lasting effect on Western economies.

…and only then the meal

Energy prices (the war in the east further affected natural gas prices, which in turn polluted the electricity sector) were one of the main culprits. But not in isolation. The agricultural commodities sector also suffered severe supply chain disruptions, and rising prices reached food.

Inflation in Portugal peaked in October 2022, reaching 10%. Part of the acceleration is explained by the sharp rise in natural gas bills that only reached domestic consumers that month, but food was the structural factor that pushed prices up the most. And several countries have started to reduce VAT on food.

Interview with Medina. VAT on food is not falling because the money could go to the shareholders of the distribution group and not to those who need it

The then Minister of Finance still resisted such a measure during the preparation of the State Budget for 2023. Fernando Medina feared that the margin generated by the VAT reduction would be appropriated by companies, rather than being reflected in consumer prices. But he ended up changing his mind and in April 2023 the Government moved forward with a zero rate on a basket of 46 essential products for an (initial) period of six months with many warnings to navigation (in this case to distribution) to pass on the effect on the final price. The measure would end up being extended until the end of that year (at an estimated cost of 550 million euros).

The Bank of Portugal validated the impact of zero VAT on the negative variation in the prices of these products in 2023, although a drop in inflationary pressure on food products was already felt, concluding that items with zero VAT had a more pronounced drop in prices.

Despite Medina’s fears, supermarkets (for real) brought Zero VAT to families

But despite the positive effects it had on inflation control, and particularly on food prices, the Socialist government finally ended zero VAT in January this year. This abrupt halt had an impact on inflation, but only to a limited extent, and did not call into question the downward trend of inflation, which in July stood at 2.5%.

Energy price shock has strongest impact on food

In another analysis published in the June economic bulletin, the Bank of Portugal analysed the impact of the energy price shock on the evolution of the consumer price index and its transmission to inflation.

The analysis considers the direct and indirect effects on the prices of other goods and services (the most obvious example being transport) which in turn affect food and core inflation (a measure that excludes energy and unprocessed food). It concludes that energy has a stronger impact on food prices than other factors, with fuels accounting for around 50% of energy prices.

If we analyse the peak inflation reached in October 2022 (10.6%) and, according to the estimated model, “the direct impact via the price of the energy component was around 1.9 percentage points, while the indirect contribution was 2.4 percentage points. 1.5 points via food and 0.9 points via core inflation”. The conclusion is that “the total impact of energy goods explained 41% of the (year-on-year) inflation observed that month”. The analysis of the Bank of Portugal also points to “the persistence of the indirect effects of the price of energy on the price of food and other goods and services, which remain positive”.

The Bank of Portugal also highlights that the “impact of the increase in the price of energy goods on the dynamics of food prices is, on average, four times greater than the impact of the dynamics of underlying inflation” (which does not include the most volatile prices). This means that the contribution of energy to food inflation is particularly relevant. And food accounts for about a quarter of total inflation.

It was during the time of the socialist government that fuel prices fell to the levels they had before the increases caused by the war. And several times during the last two years. However, a new geopolitical crisis with its epicentre in the Middle East (Israel’s war against Hamas) and the increased risks it brought to oil prices contributed to maintaining the support of prices.

António Costa, who saw the first government of the scheme cling to the reputation of taxing oil, did not want to go too far in recovering tax revenues. In 2023, the Socialists began a path of fiscal recovery, but focused on the partial unfreezing of the carbon tax, which last year increased (gradually and taking advantage of favourable circumstances of low international prices) by 8 cents for diesel and 7 cents for petrol.

The Government wants to recover (increase) 6 cents in the carbon tax on fuels in 2024

The 2024 State Budget predicted that this gradual recovery would continue this year, but political instability and elections interrupted the process. The new government took office in April, but only in August did it resume unfreezing the carbon tax, taking advantage of the margin provided by a sharp drop in international prices. The additional CO2 charged in the oil tax rose by 3 cents per litre and will have to rise by another 3 cents to complete the update of the rate based on international carbon market prices.