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 {P₁ – P₃}), 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.