Posts Tagged ‘VAT’

25 Mar

While I do hate the Argument from Authority …

Posted by freethinkingeconomist in Economics. Tagged: , , , , .

… I wish to use it on the VAT argument.     Remember that what Policy Exchange put out on VAT was not something like this:

“Did you know that if income taxes were flat and the world was like the following thought experiment then VAT would not be any different from Income tax?”

Instead, from the FT story, which influences the world’s policy makers, we have:

Policy Exchange …  said modelling and academic research showed the idea established in the 1970s and 1980s that VAT was less damaging than income tax was no longer valid.  “We found that, contrary to what is widely assumed amongst journalists and politicians, increasing VAT would be more damaging to economic growth than increases in the basic rate of income tax,” the report concluded. … Politicians should consider restructuring taxes by raising the basic rate of income tax and cutting VAT, it said.

It is a claim that their paper proves this particular point, and as such needs to be taken seriously.  More seriously, I dare say, than a straightforward thought-experiment that clearly misses out essential features of how the tax system works.   The people behind this report are very bright and honourable; they know that they need to treat the world as it is.   Empirical data on how consumption taxes affect growth may help ….

I don’t like arguments from Authority, as you may be able to tell.  People with 20 years  in academia are capable of reaching very different conclusions. Such authority is no vaccine against having badly thought-out views, but merely a great anaesthetic against the stings of criticism that are their best antidote.

But in this case, I find that referring to what the OECD has found in cross-country regressions on tax rates is rather useful.  It is not just “politicians and journalists”, as the PX press release misleadingly implies, but serious economists too.   And the paper is a recent one, not from the 1970s or 1980s.

Here is the table that justifies their view that:

The results of the analysis suggest that income taxes are generally associated with lower economic growth than taxes on consumption and property … These findings suggest that a revenue-neutral growth-oriented tax reform would be to shift part of the revenue base towards recurrent property and consumption taxes and away from income taxes, especially corporate taxes. There is also evidence of a negative relationship between the progressivity of personal income taxes and growth.

The OECD’s findings are about how things work in practise.  Economics as a profession earns its lowest reputation when it is accused of taking a “that’s all very well in practise, but how does it work in theory?” approach.  If your theory produces results that are blatantly at odds to the findings, and go against a lot of conventional wisdom, perhaps the right thing to do is question the rather-too-neat theory.

On the question of a more theoretical approach, here is my second argument from Authority: Greg Mankiw, arguably one of the most influential economists around because of his widely read textbooks, and ex-advisor in Bush’s first term.  A supply sider – someone who cares for growth more than social justice, I should think:

From a strictly economic standpoint, a VAT is great. It is essentially a flat consumption tax, like the so-called FairTax, but implemented in a way to reduce compliance problems. Because it is collected in stages along the chain of production, rather than all at the retail level, tax evasion is more difficult. If you look at the economic effects, a VAT is similar to the Hall-Rabushka Flat Tax, which many economists love. … My bottom line: If I could replace our current tax system (including the personal income tax, corporate income tax, payroll tax, and estate tax) with a VAT, I would gladly do it.

That is from an anti-tax Republican.

Let me be clear: I am not blindly pro-VAT. I recognise the social injustice, and would and will argue for these to be mitigated should it rise again.   But defending it with oversimplified analogies, a blackbox model and mischaracterisations that go against the evidence has not, in my humble view, advanced the argument.

Now back to the Budget ….

24 Mar

VAT is not the same as income taxes

Posted by freethinkingeconomist in Economics. Tagged: , , .

One of the many thought provoking ideas put out in Policy Exchange’s latest report is that VAT is really no better than income tax; both simply reduce the value of your income, either by raising the prices of the things you want to buy (VAT), or taking income directly.

To quote directly:

“Suppose a worker earns £100 and pays £20 tax on it, and there is no VAT or other taxes. Then she has £80 to spend, and her £80 goes on goods with a real vale of £80 … Suppose now that income tax is abolished and instead a flat VAT of 25% is imposed.  Then she earns £100 and she uses it to buy goods with a real value of £80 on which a 25% tax is imposed, raising the price from £80 to £100.  So the real value of her consumption is again £80″.

I think this thinking is flawed, because it ignores how income tax is not flat, and has thresholds.  I have structured the problem around how much of an incentive a person has to do some extra work under two regimes: income tax only, or VAT only.   And the tax gained is meant to be the same – no cheating by not making it fiscally neutral.

The thinking is really simple.  I have arranged the thresholds so they roughly resemble ours in the UK. There is single product (“fun”) which is going to either cost $1 or some higher number if the tax chosen is VAT.  All consumption is spent, thereby avoiding the complexities that PX admirably look at in terms of savings/deferred consumption/etc.

In each scenario, a person has a choice whether to work for an extra $5000 or not.   For the Income Tax payer, it is easy to work out the value of working more.  Just take the marginal rate at their current rate of income. For the VAT-only guy, he is considering whether to take $5000, but with a higher price for a unit of FUN*.

As you might expect, the VAT system being flat beats the income tax system, particularly when the incomes are close to thresholds.  If you make incomes very very high, then the two approximate, because the VAT required to raise the same as an income tax tends towards the 40% rate.   If you programme all thresholds to zero, you get the PX thought experiment:

I have graphed how this advantage varies with the income:

but realise that this is a slightly unrealistic way of showing things.  In the real world, there are a range of incomes and work-leisure decisions, but only one VAT rate.   So if you assume you need an average VAT rate of 20%, and then look at individual work incentives, you get a chart like this:

This is more realistic, because the upper-rate earner faces a choice between his 40% tax rate, and the VAT rate required for the whole of society to pay the income tax. So for him the incentive advantage of changing the overall tax rate towards VAT is undoubtedly good (that flat line is around 38% when the VAT presumed to be needed is 20%).  Think it through: if you earned 40k, and the VAT rate for society was 20%, pushing prices up by 20%, you would be able to get $4166 of real goods for your extra $5k of work.  In zero-vat world, you would get $3000 after paying 40% on your marginal income.

If I were really clever, or had the time, I would try to model the entire work/leisure payoff, including benefits and tax credits.  Then you might be modelling an increase in VAT that could be used to fund a lower tapering of benefits/credits.  Since the people at the bottom of the earnings face such high withdrawal rates, I would again argue that the change would greatly improve work incentives.

Now I appreciate that I have been perhaps over-influenced by an OECD finding (June 2009 Economic Outlook) that the worst taxes for growth are corporate taxes, followed by personal income taxes, then consumption taxes, then taxes on immovable property.  I often criticize others for extending results gained during non-deflationary periods into today’s crisis; I agree with Robert Reich today that with corporate profits increasing and labour income stagnant, and big companies not knowing what to do with their cash, it is ‘absurd’ to call for a tax cut for big corporates to boost recovery. So I don’t intend to use this OECD result as ‘proof’ that a rise in VAT is better for the economy – no-one should be citing piles of pre-crisis results as proof of anything right now.

But I am unconvinced that this simple thought experiment proves how VAT is really just a disguised income tax**.  Sometimes the conventional wisdom is correct.

UPDATE:  I have put the scrappy little Excel sheet here, if you want to play with the numbers.

*Note: if total income is 20k, and VAT is 15%, the VAT raised is not 15% of 20k  = 3k.   If it raises the price by 15%, 100/115 fewer units are bought.   To raise £3k from the £20k you need to choose X so that X/(1+X)*20 = 3 ….)

**interestingly, Mark Wadsworth has elsewhere complained that it is a gross margins tax.  I have a radical idea.  Maybe it is a consumption tax.

18 Dec

Why I don’t think promising a VAT hike gets us out of the liquidity trap

Posted by freethinkingeconomist in Economics. Tagged: , , , , .

In response to Tim’s very interesting idea that we could break out of a deflation-depression scenario by promising inflation through the VAT hike route.  I find this hard to accept, and possibly too good to be true: because if a VAT rise now or in the future could boost multiperiod demand, the government  could fix the economy and its fiscal woes in one leap.

Raising VAT surely hurts aggregate supply.  A producer, for any given price, is able or willing to supply less quantity of product.  So the AS curve goes up – for any Q, P is higher.

The problem as I see it is that we are in a situation like below.  I see the VAT rise promising to push AS1 to AS2.  Yes, you might get some consumption brought forward, but to the commercial sector, the mark-ups are like a supply shock: like being told that oil or electricity will double in price.  Not “let’s expand” territory.

The sloped lines are short run.  The vertical line is long term aggregate supply: what this economy can produce.

What do I think we need?  Well, this obviously: a boost to demand.  This has been, largely, a demand-shock depression, as the falling price level attested to.  People suddenly saved. So we need higher demand. The government can achieve this by using new money to buy things, broadly speaking.  It is not something I as a liberal like the idea of, and if the government can persuade other people to buy things by credibly promising to lift NGDP in the future, then that is better.  But if they won’t believe the govt, the government doing the buying is a better option.

I hope there are non-government-buying-the-stuff ways of making this happen: their targetting interventions helping ease financial pressures for smaller companies, say.

Finally, if I’m so relaxed about prices rising from AD going up, why aren’t the Right over at Coffee House or Guido or other places? Well, it is because their model of a recession tends to be more like this:

So, whenever some person (normally Conservative) explains that the problem is that we’ve lost the habit of thrift, we all spent too much, we are owed a thorough punishment for this, they are imagining we are in Iceland’s position, or that of Britain in 1980.  We need lower demand, they say.  Let prices rise to choke it off (though don’t accommodate 2nd round effects).  Then the VAT rise suggestion of Tim’s makes very good sense.  And that is why Maggie did it – in favour of lower taxes on companies to boost supply.  Look at the graph above, it makes perfect sense.

PS.  Money Growth figures look disappointing.  Note to Spectator readers: this still isn’t Weimar Germany!

PPS.  Apologies for the ugly graphs.  Microsoft Paint!  I have a real job to get on with . . .

14 Oct

VAT – a Truly Great Tax, but Regressive

Posted by freethinkingeconomist in Economics. Tagged: , , , .

. . . to paraphrase the entertaining forthright but not necessarily right Mark Wadsworth.

Across the Internet*, the argument rages about whether VAT is a good idea.  Mark’s view:

“Simple logic tells us that VAT is not a tax on ‘consumption’ (as if that were a bad thing), but either a tax on business turnover or a tax on gross margins (depending on how you argue it).”

My view:

if VAT was removed, prices would not stay where they were – they would fall, as competitive pressures would erode the (very short-lived) high margins that would pertain in the VAT-free world.  Hence the effect of there being VAT on objects is higher consumer prices.  Hence the consumer is paying it.

Now, we have the view of Greg Mankiw, an economist of slightly higher standing than me:

From a strictly economic standpoint, a VAT is great. It is essentially a flat consumption tax, like the so-called FairTax, but implemented in a way to reduce compliance problems. Because it is collected in stages along the chain of production, rather than all at the retail level, tax evasion is more difficult . . . My bottom line: If I could replace our current tax system (including the personal income tax, corporate income tax, payroll tax, and estate tax) with a VAT, I would gladly do it.

He doesn’t mention how regressive it is (which doesn’t seem to bother Matthew Parris, who is all for stealthy regressive taxes).  But as a way of collecting money without distortion or hissing, it is hard to beat.  Sadly enough for the poor, who will probably end up paying more than the small number of mansion owners now organising on the pages of Country Life to defeat the idea with bad arguments.

*well, between Mark and I

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