Tuesday, May 28, 2013

GST And Inflation Part IV: Some Theory

I wonder how many people have figured this out?

If, as the reports say, GST will yield greater tax revenue than SST, that implies an increase in effective taxation. But all other things equal, greater taxation isn’t inflationary – it’s deflationary. At the very least, it’s dis-inflationary.

The Macro Perspective

Intuitively, taxes reduce household disposable income or corporate surpluses that can be used for private consumption and investment. This lowers private demand for goods and services, and thus demand-side pressure for price increases.

A higher aggregate tax yield – and it doesn’t matter if the “burden” falls on consumers or businesses – would therefore reduce aggregate demand in an economy. If firms operate in perfectly competitive markets and are profit-maximising, their ex-tax prices have to be cut. In fact, you can drop the perfectly competitive part, and the conclusion still holds true.

In a closed economy, with little to no trade, higher taxes would thus put downward pressure on prices; in an open one, the impact could be felt on either prices or imports or both.

But whichever situation you are in, the one thing that shouldn’t happen is an increase in upward price pressure. As per my previous post, the fact that GST will raise prices on previously untaxed goods and services is beside the point – in looking at inflation, it’s the slope that matters.

The other thing that does happen is that, even if the GST is ostensibly borne completely by consumers, companies ironically end up paying for it too, and I don’t mean just the cost of compliance.

The Micro Perspective

Here’s how:


In the simple chart above, the horizontal axis is quantities, while the vertical axis is prices. D is the demand schedule – what quantities consumers will buy at any given price. B is the supply schedule – what companies are willing to supply to the market at any given price. P2 and X2 are the prices and quantities at which these preferences coincide, which is the original market equilibrium.

Let’s say the government imposes a tax on all goods, such that the actual prices consumers face follow schedule A (the distance between A and B is the tax rate). Here, supply and demand coincide at P1 and X1. Quantities bought and sold are now less than before, but prices are higher.

The point here is that price P1 does not fully reflect the extent of the tax increase. The difference between P1 and P2 is not the same as the difference between A and B, which should be given by the difference between P1 and P3.

So while consumers pay the notional amount of taxation (given by X1 x {P1P3}), companies suffer too, as gross revenue falls from P2 x X2 to P3 x X1.

Summing Up

The conclusion then is that the imposition of a tax, even one purportedly borne wholly by consumers, is in actuality borne by both buyers and sellers – the former through higher prices and lower quantities, and the latter by lower profits. The only exception to this would be in the case where demand is perfectly inelastic (a vertical line), where the full tax burden is borne by consumers and companies maintain their profit levels regardless of changes in the tax rate.

Now since GST will be replacing SST, the extent of the tax increase/decrease will be much less than the headline rate implies. Also since GST is neutral to costs in the supply chain, that implies cost savings that may offset any revenue loss to companies. Given that we’re looking at an economy wide tax change, with many different goods, services, and market structures, figuring out which way the frog will jump is going to be pretty hard if not impossible ex-ante.

Nevertheless, the important point here is that changes in tax rates, especially one that increases the tax yield, will likely dampen price pressures in an economy, not increase them. A second related point is that, despite being a pure consumption tax, some of the economic cost of a higher GST tax yield will be borne by companies as well, though not in the form people expect.


  1. I've always thought the same, hence my view that GST will actually reduce inflation until income taxes are cut.

    I think we will be seeing differentiation between different industries, where the taxes on basic goods and services with inelastic demand can be pushed to the consumer leading to price rises, whereas the prices on luxuries with elastic demand (e.g. fancy hair cuts) will be pushed down to partially absorb the tax increase, and to deal with reduced consumer spending power, thereby leading to price falls or stagnation.

  2. Whether a consumption tax is inflationary or otherwise, that depends on elasticity though. Low elasticity means it can be inflationary (or at least, one time jump). People will just buy pretty much the same quantity given the price.

    Furthermore, through the lens of tax incidence, extremely low elasticity of demand would mean taxation burden would fall on consumers. So, luxury goods may see disinflation. I'm not too sure about other goods/services. Prepaid telco stuff is one thing that I see consumers are effectively paying the current taxes, even if telcos are absorbing the taxes.

    The fact that basic foodstuff have been proposed to be exempted from the GST may support the "no inflation" case. But I'm sure there's a lot of goods/services with low demand elasticity out there.

    And then we haven't played with the expectation game yet.

    1. re: luxury goods, I assumed it has high demand elasticity. Come to think of it, rich people probably have low elasticity when it comes to those goods anyway. But this is a minority case given the income distribution in Malaysia. So, best ignore the luxury goods remarks.

  3. 1. Yawn.......zzzzzzz.... an obviously irrelevant prattle akin to bludgeoning a visibly dead horse to more deaths, a samsara of death and rebirth , if you like!! What more it sounds preachy redundant especially when directed at the stupid intelligentsia suffering from thought amnesia! In fact, such is the idiocy that GST=inflation has been minted as a new canard, set to join the likes of money illusion, informed choice, democrazy and other ill informed conceptions. Provided they understand its imposition,, everyone sane bar my pet tiger should know that GST is a transient fart with no lasting or long run impact on inflation except for its “anticipatory effects” :



    But then most Malaysians nowadays are too stupidly clever for their own intelligence that no matter how one puts it, it won’t get through all that density as stupidity is not something you can legislate away anyway. So for a final nail in the coffin:

    “Tait (1990) examined measures of inflation two years before and after the adoption of a VAT in 35 countries. He found that the VATs in 29 countries (83 percent) could be categorized as having no impact on the consumer price index (CPI) or having only a one-time increase in the CPI. Countries falling into this category included France, Germany, and the United Kingdom. The other six countries were characterized as having some acceleration in the rate of inflation. In most cases, however, the VAT was a substitute for existing “sales” taxes, in which case significant forward shifting would not be expected. He further concluded that in six cases where VAT rates were increased substantially only one country showed accelerating inflation two years after the increase. This experience is more relevant if the U.S. adopts an add-on VAT. A final point made by Tait is that even if the overall inflation rate was not affected by VAT adoptions or rate changes there were important changes in relative prices. In an earlier discussion of lessons the U.S. may learn from the EU experience in adopting VATs, McLure (1987) concluded that “... introducing an American VAT would probably result in an increase in prices, especially if the VAT were a source of additional revenue, but this could be a one-time event that would not lead to further inflation if the transition were handled properly”’

    2. Strictly off topic but insightful as to the impact of policy responses in inflation management:

    Razzak, Weshah A., The Inflation-Output Trade-Off: Is the Phillips Curve symmetric? A Policy Lesson from New Zealand (January 1997). Reserve Bank of New Zealand Discussion Paper No G97/2. Available at SSRN: http://ssrn.com/abstract=321806 or http://dx.doi.org/10.2139/ssrn.321806

    3. Maybe it is time to move on:


    but I kinda like this one better, especially after reading the book:

    RSA Animate: The Truth About Dishonesty

    Definitely a must see for all the Chingkie hypocrites out there, the ones who can think of course!

  4. As a addendum to my earlier comment at 2.45pm, here is how Malaysian perceive and receive the proposed GST, especially the chronically irrational middle classes aka the nattering nabobs of negativity


    Some cautionary tale for both Najib's and Jala's arse, I reckon. And Not surprising that Palil and Ibrahim's findings is mirrored in some of the silly comments here.

    By the way for another take on GST and inflation, here is one from Nzee


    1. A belated thank you for the links. :thumbs up:

  5. Everything have to be systematically done.