Economic Efficiency and GST

We’re less than two weeks away from GST going live, so it might be appropriate to look at the economic arguments in favour of it.

On the WCI blog, Frances Woolley reviews the textbook arguments (excerpt):

The case for taxing basic groceries

Economists frequently argue that taxing basic groceries is a good idea - for example, see these papers/posts making the case for taxing food in the US, Canada, and New Zealand.

The equity argument for taxing groceries is straightforward. Suppose everyone spends $500 a month on groceries. If groceries were taxed at 10 percent, everyone would pay about $50 in tax (or slightly less, if people cut back on their food expenditures when the tax is introduced). If part of the revenue raised by taxing groceries was used to give every low income individual a $60 tax credit, the tax on groceries would actually increase the well-being of the worst off members of society. Any additional revenues raised could be used either to decrease other taxes, leading to greater economic efficiency, or to provide needed social or infrastructure programs, further enhancing efficiency and/or equity.

This equity argument is the one emphasized in, for example, Michael Smart's recent paper. Yet it begs the question: why groceries? Why not increase the top rate of income tax instead, or raise capital gains taxes?

The heart of the economic argument for taxing basic groceries is that it increases economic efficiency.

There's a short version of the efficiency argument and a long version. The short version goes something like this: "If groceries aren't taxed, but other goods are, then people's choices will be distorted. They will substitute groceries for other goods, hence the economy will devote too many resources to producing food and too few to producing other goods. Economic efficiency will be compromised…."

It’s a long post, with lots of graphs and (gasp!) not a lot of math, so should be fairly easy to follow even without a microeconomics background. It’s essentially the same argument against energy subsidies, though in this case, it’s about differential taxation. The Canadian case is pertinent because Canada is one the very, very few examples of countries which have done what Malaysia is going to do – switching from a sales tax to a value-added tax.

The second argument is that, contrary to other forms of taxation, consumption taxes like GST actually boost growth (again from the WCI blog; excerpt):

Taxation and Economic Growth

I had a bit of an intellectual crisis this evening as I pondered the conventional wisdom in economics regarding the choice between reducing consumption taxes or income taxes. Briefly put, the simple conventional wisdom is that taxes on consumption are preferred to income taxes because they encourage saving and long-term capital formation and economic growth. Income taxes, on the other hand, distort the labour-leisure choice and can reduce labour supply and therefore reduce economic growth.

Yet, as I thought about the Canadian economy and how well it seems to have weathered the global economic downturn, one thing that stuck out in my mind is that the federal government reduced the GST rate just prior to the Great Recession....

...I’m afraid I don’t have an answer to that specific question for Canada. However, it should be possible to see if countries with greater reliance on consumption taxation have better growth rates than those that were less reliant. What I did do was quickly collect data from OECD Statistics for the 34 OECD countries on the annual average growth of per capita GDP in US PPP dollars over the period 2007 to 2009, the share of GDP accounted for by taxes on goods and services in 2008 and the share of GDP accounted for by taxes on income and profits in 2008. I then proceeded to plot the tax to GDP shares against the growth rates as shown in Figures 1 and 2 with a linear trend. The results show a positive correlation between growth in per capita GDP and the share of GDP accounted for by consumption taxation and a negative correlation between growth and the share of GDP accounted for by taxes on income and profits….

Two papers were also linked to in the comments (here and here).

Now, I can see the loopholes in this – higher growth doesn’t necessarily imply that this growth is inclusive. Lower marginal tax rates would increase the post-tax return for those at the top of the income distribution, and nothing is stopping individuals from incorporating themselves to take advantage of lower corporate taxes. Nevertheless, a bigger pie allows for bigger redistribution.

There’s a hierarchy of taxes in relation to growth – consumption and property/inheritance taxes are the most beneficial (actually, the least distortionary), while income taxes slow growth down. Of course, this depends on the level of taxation, and I think that income taxes in Malaysia (both personal and corporate) are low enough that raising them wouldn’t necessarily reduce growth. For the more technically inclined, I think we’re on the part of the Laffer curve where reducing income taxes just reduces government revenue without boosting savings, investment and growth.

But I think the most important reason for backing GST is that its the one instrument that can raise enough revenue to properly fund the required social transfers to make a real dent in inequality (excerpt; emphasis added):

Revisiting Robin Hood's agenda: Be less concerned about taking from the rich and focus on giving to the poor

...As a matter of statistics, it's perfectly true that people who are in (say) the top 10% have received the lion's share of gains to national income. But people who are at the 90th or even the 95th percentile could fairly object to such a broad brush, because they - like the people at the median - haven't seen much in the way of increases in income either....

...I like the idea of a surtax on the top 1% or the top 0.5%, but I view it as a sort of a speed bump to slow a worrying trend; it's not likely to generate much in the way of revenues....

...And now we return to Ed Broadbent's question: how do places like Finland, Sweden and Denmark do it?...

...The remarkable thing about this graph is that the redistributive effects of the tax systems of all of these countries are approximately the same, and are pretty small at that. I've made this point before, and it's worth repeating: the countries that have been the most successful in reducing inequality don't have particularly progressive tax structures. The real gains in reducing inequality are achieved by means of well-designed transfers....

...successful social democracies have learned that the goal of the tax structure is to generate as much revenues as possible with the fewest distortions as possible….

…It's true that these tax instruments probably won't do much in the way of redistributing income, but as we've seen, that's not the point. They are an efficient way of generating tax revenues that can be in turn redistributed in the form of transfers.

Successful social democracies have learned to worry less about taking from rich and to focus on giving to the poor.

Higher marginal tax rates, capital gains taxes, inheritance/estate taxes all have their place – but their job is really to limit gains at the top. The Malaysian tax base is so narrow, that what they can’t and won’t do is really address the structure of inequality itself.

We can’t make achieve any meaningful reduction in Malaysia’s Gini coefficient without addressing the middle and the bottom of the distribution too. BR1M is a start, but its too poorly funded and too stretched thin to make a real impact. The post-BR1M reduction in Malaysia’s Gini number is almost lost in statistical noise. Multiply it by a factor of five (e.g. by earmarking all GST revenue for social spending and transfers), get it better targeted (I’ve seen estimates that a third of BR1M payments are “leakage”), and then we might get somewhere.