Thursday, May 23, 2013

GST And Inflation: Part II

I’m on a roll here (abstract; emphasis added):

The Economic Incidence of Replacing a Retail Sales Tax by a Value-Added Tax: Evidence from Canadian Experience
Richard Miller Bird & Michael Smart

A decade ago, several Canadian provinces replaced the retail sales taxes by value-added taxes. This paper estimates the effects of this tax substitution on consumer prices in the reforming provinces. Consistent with theory, we find that the resulting effective tax rate changes were shifted forward to consumers in most sectors of the economy. The overall effect on tax-inclusive consumer prices was small, albeit perhaps somewhat regressive.

This needs some explanation – we’re looking at a very similar scenario in Malaysia that Canada has already gone through. To wit, replacing a sales tax with a value-added tax and at the same time changing the marginal tax rate.

The research is particularly interesting because the shift in the tax structure was not conducted on a national level, but at a state level and only for certain states (the Canadian Federal government already levies a GST; these are state level taxes). Some states switched to a VAT, while the others retained the Sales Tax.

So what we have here is that rarest of economic beasts - a “natural experiment”. Changes in taxes and prices can be compared across provinces, thus neutralising the impact of changing economic circumstances within the national economy on econometric estimation and analysis. Some of the data can be seen in Figures 1 and 2 (pg. 93).

What these two gentlemen have found, is that changes in the tax rate was largely passed through (“shifted forward”) to the consumer – the estimate lies between 60% to 100% of the change in the tax rate was reflected in consumer prices, depending on which measure you prefer to use. What makes this conclusion more robust is that there’s no obvious incentive for businesses to cut prices if the tax rate is cut, unlike in the case of an increase.

There were some substantial differences in the different categories of consumer expenditure items (transportation for instance had a negative elasticity, i.e. the reduction in tax rate caused an increase in the final price; medical costs on the other hand had a huge positive elasticity estimate), but for the most part theory and empirical experience come together. Changing the mode of taxation from sales to VAT, and simultaneously cutting the tax rate, results in lower consumer prices.

At the risk of over-generalising, if Malaysia were to implement GST at 7% relative to the current Sales Tax rate of 10%, the likelihood then is at worse, we should not see much change in the overall price level. Using the lower elasticity estimate (60%, or to be more precise, 0.6), we should see an approximately 1.8% overall reduction in consumer prices (0.6 x (10 - 7) = 1.8).

How on earth, under these circumstances, will implementing GST be inflationary?

Technical Notes:

Bird, Richard Miller, & Michael Smart, "The Economic Incidence of Replacing a Retail Sales Tax by a Value-Added Tax: Evidence from Canadian Experience", Canadian Public Policy – Analyse De Politiques, Vol XXXV No 1, 2009


  1. Agree that GST may improve the collection of gov but BN has no credibility on managing rakyat's money. Most likely they will ismanage the money for the benefit of their cronies.

    1. About half the government's operating budget is non-discretionary spending - salaries, pensions, interest costs. A further quarter is given in subsidies to the people (mainly for petrol) and another half of that is transfers to state governments and public agencies. The development budget is primarily devoted towards improving rural and basic infrastructure (building roads and schools etc). The "crony" bit is only about RM30 billion for 2012, or about 15% of the operating budget.

      The Malaysian government is hardly alone in being inefficient - that is common in most large organisations, and in particular, most governments. BN, PR, it won't matter who's in charge. Anybody who has done large scale procurement will understand the problems.

      Case in point.

    2. If that is your argument, how would you say about both Kelantan and Kedah state economy?

    3. @anon 6.18

      I don't understand how your question relates to the topic or my comment above. Can you clarify?

  2. Salam Hisham,
    I was wondering how this GST (at 7%) would effect those households earning more or less RM3000/month. I understand GST corelation to inflation, or rather its non-corelation, however, do taxes such as GST/VAT have any profound relation to the impact it would render to lets say, salary? Should we wait for wages as salary be high enough across the board before we even think about implementing such a tax?

    Thanks in advance, love your blog btw, keep it up bro.

    Your average reader, Nik.

    1. Nik,

      Implementing GST should actually be beneficial to low-income households, because basic foodstuffs will be zero-rated, instead of 5% as it is now, and other goods will have the tax rate cut from 10% to 7%. I don't see a problem here.

  3. Hey Hisham, your blog is a nice read. I have 1 question, you talked about GST being a non-cumulative multi-stage tax, riddle me this then, in the supply chain from raw material to end user, GST is incurred in the overall cost of the product, so as the product moves further down the chain while being value-added, it carries forward its GST tax as part of the cost. At last it reaches the end user, who also pays the GST, how is this not considered cumulative? Its true the supply chain players have the option of claiming back the GST, but the cost of the product which they have already sold to whoever is next in line of the supply chain is inclusive of the GST already. Please help me understand this as simple as possible, I'm a simple man.

    1. It's non cumulative because all the tax paid along the supply chain are recouped, resulting in the effective GST being the GST on the final product price.

      E.g. , Miner sells RM 10 raw material, Factory sells RM 50 finished goods, and Supermarket sells RM 100 retail price.

      Thanks to GST the goods are sold for RM 10.70, RM 53.50 and RM 107 respectively.

      Tax paid to government is RM 0.70, RM 3.50, and RM 7.00 respectively.

      Tax rebates claimed back from government is RM 0.00, RM 0.70 and RM 3.50 respectively.

      Total tax paid throughout this chain of supply is (RM 0.70 + RM 3.50 + RM 7.00) - (RM 0.00 + RM 0.70 + RM 3.50) = RM 7.00.

      Ergo, the total tax paid throughout the chain of supply, no matter how long, is not cumulative. Only the final tax imposed on the consumer is actually going to be received by the government, i.e. in terms of tax burden, it is no different from a SST of 7%.

      The difference between GST and SST is that GST uses a form of Game Theory to manipulate members of the supply chain to keep track of each other, making it difficult for any single business to evade tax. This is a good thing in principle.

    2. hi Hisham

      I like your simple explanation and calculation. it does give a good theoratical picture. Go deeper and think about the factory, buying the same goods at 10.70 now an increase of 0.70 cents, not just this. all of it's other services which was not even part of the product chain like cleaning services, phone bills all increases by 7%. why do you think they will still sell at 50.00? if they are they must be making over 30% margin currently which not alot of business es do. so selling it higher than 53.50 of their costs because 53.50 is only their direct costs, is very likely higher than 60.00.

      now taking a step back to the miner, who used to sell at 10.00 now needing to pay all it's basic costs again like water, electricity, rent, other services at a higher rate of 7%, wouldn't they too would increase their product from 10.00 to 11.00 perhaps.

      we have to drill deeper and of cos, if we assume all things remain constant your simple calculation works. but practically things are never constant, if miner increases it's costs slowly but surely over time, factory too will do the same.

      Results - you and me, unless u are the miner we will all suffer because our pay are not getting the same amount of increase.

    3. oops just realized the example is not yours Hisham but I am sure your thoughts are along the same line

    4. @anon 11.08

      Thanks for the help.

      @anon 11.36

      The key point here is that under GST businesses do not have any tax liability, they only act as collection agents. Any GST paid by businesses for raw materials, services and utilities can be claimed back from the government. That in fact is one of the whole reasons for the shift from SST to GST, the fact that GST is neutral with respect to the production and distribution process.

    5. back to the same example, wouldn't now the factories' costs is higher? not just from products alone but other costs have increased. thus from a pricing perspective selling price is upwards resulting in inflation.

    6. on the product the factory produced, it will no longer sell at 53.50 because if the taxes that's been collected overall will be greater, so 53.50 is no longer reasonable. hope you get what I meant.

    7. @anon 10.13

      What you're looking at and describing isn't the impact of the change in tax regime, but inflation generally, which is a different matter. The imposition of a new tax has a one-time effect on the price level, not a continuous one i.e. if you impose a new tax of 10%, costs will rise 10% across the board. But that doesn't mean it will increase 10% every year after.

    8. price increase I agree should be one off, but not at all times everyone increase costs at once. effects maybe delayed, that is supplier A increasing price, affecting B, in turn affecting C and so on. if process and impact is not immediate, results is increase of prices is delayed, that was why my view is this will cause inflation and not just a one off increase.

    9. @anon 1.54

      Whether the price increases takes one period or two or three or four is irrelevant. It does not change inflation dynamics, just the mechanical calculation of inflation which dies off after the effects of the tax propagates through the system. Most empirical research into this question find that such effects only last 2-4 quarters, i.e. just the base effect.

      There is little evidence of "second-order" price effects, which would be necessary for the higher inflation to be sustained. For there to be an increase in inflation beyond this from the tax, the tax rate itself would have to be increased every year, which is obviously not the case here.

    10. I see where you are coming from and thanks Hisham. one last question, and needed to back track to the miner factory example. do you agree that miner after GST introduction would price it's product higher than 10.00 as he has to pay for other costs now or like you said passing on the tax to the consumers? and the same goes to the factory if it's purchases is now higher and other expenses of factory includes GST, would it too needed to pass it on and price it's product now higher than 50.00?

    11. I tried to google and found a research paper on Australia's introduction. there were numbers and data and it did show an impact to inflation by GST implementation. you may want to have a look:

    12. One other example I have, if say food is zero-rated, wouldn't also the seller needs to price it's food higher since it's costs would increase as a result of gst it needed to pay on other expenses?

    13. @anon 10.22

      From the abstract:

      "We found that GST had a significant but transitory impact on inflation only in the September quarter of 2000 when this new tax system was implemented."

      That's consistent with a one-time increase in the price level, not an increase in inflation per se.

      You might want to read this.

      @anon 10.31

      No, any increase in costs from GST is refundable from the government.

  4. Hi there, silly me replied in your first post, but it seems more appropriate to post here instead.

    Essentially, you are ignoring the fact that the introduction of GST widens the tax base and eases enforcement, roping in many business who (legally or otherwise) are not paying SST. Since you agree that the evidence is that the cost of taxes are passed on to consumers, it necessarily follows that a business which was previously not paying SST, but which now has to pay GST, will pass on said tax to the consumer, resulting in a one off rise in prices.

    This is not an objection to GST of course. My own personal feeling is that GST will cause a one time increase in prices, and will then reduce inflation until the government decides to cut income taxes.

    1. @anon 10.46,

      Yes, the change in the base complicates analysis considerably, especially relative to consumer expenditure. However, consider that even with the introduction of GST, the expansion of the base doesn't amount to much. The current yield from SST is RM15 billion, while the estimate of GST is RM27 billion. In a RM1 trillion economy, that amounts to a difference of just 1% of final sales.

  5. At the risk of over-generalising, if Malaysia were to implement GST at 7% relative to the current Sales Tax rate of 10%, the likelihood then is at worse, we should not see much change in the overall price level. Using the lower elasticity estimate (60%, or to be more precise, 0.6), we should see an approximately 1.8% overall reduction in consumer prices (0.6 x (10 - 7) = 1.8).

    hisyam i really need ur help..please explain that figure..

    1. @anon,

      "What these two gentlemen have found, is that changes in the tax rate was largely passed through (“shifted forward”) to the consumer – the estimate lies between 60% to 100% of the change in the tax rate was reflected in consumer prices, depending on which measure you prefer to use."

      The calculation is just 60% of the change in the tax rate from 10% sales tax to 7% GST.

  6. If you know mathematics well, yes = GST at 7% will balloon the cost hike to more than 20% at end user. If you are living in a GST country, you will know. About fair taxation, there will be the same loopholes. If the government is corrupted, they will sure find ways to corrupt. Najib and BN never keep any promises they made. Now they promise this, later they change it to become worse. To be exact, if BN dont suck dry all of our blood now, when can they do it? Wait until the other party take over and profit? BN is now monopolized by all those ex-PMs. So all the ex-PMs will push their next generations to become PM again. This is so unfair, corrupted and never end!

  7. i'm working on my thesis abt GST..sighhh wish i can ask u personally..