I am having a debate with somebody about VAT (sales tax) and whether an increase in the rate can cause price inflation. I am sure it cannot (price inflation is always and everywhere a monetary phenomenon), but I have confused myself and I'm not sure where I'm going wrong.
I understand why an increase in the price of a single good (like oil) cannot cause a general increase in prices. Assuming no change in supply or demand for money, the increased spending on oil and oil-based products will be offset by decreased spending on non-oil products such that the general 'price level' is unchanged.
The UK government has just increased VAT from 17.5% to 20%. So people will now be spending more on products on which VAT is charged, so they will have to spend less on non-VAT products. However, unlike in the previous case, the extra VAT paid is not "sunk" but will be spent by the government. In theory, the government could spend its extra revenue on precisely those products where individuals have now reduced spending. This would mean the price of non-VAT products would not change, but the price of VAT-products has increased, so the general price level will increase.
I'm sure this cannot be right. Can somebody tell me where I am going wrong?
Government Explained 2: The Special Piece of Paper
Law without Government
OK, I think I see what you mean, but I will have to sleep on this. Thanks both!
I'll just throw in my two cents.
There is only a finite number of, say, British pounds in people's wallets. We are assuming that that number stays the same, meaning the govt doesnt print more.
OK, to make it even simpler, say one person has 100 pounds in his wallet. Usually he buys a certain basket of goodies every week, which costs a hundred pounds. Today he goes to the store and finds out that prices of some things have changed, due to VAT. So the basket of goodies he buys may be different this week, because of the new situation. Maybe he won't buy as much of item X as he used to, because buying the same amount will leave less money over for things he wants more than Item X.
Who knows what he will buy in the end? Not me. But one thing is absolutely certain. He won't spend more than his usual 100 pounds, BECAUSE HE DOESN'T HAVE MORE THAN 100 POUNDS IN HIS WALLET in the first place.
"Ah but the govt will spend more."
Well, let's look at it this way. It's the same thing as if there was no VAT, but there was a policeman at the entrance to the store, taking away 10 pounds from everyone who came in. So the guy will spend 90 pounds, the policeman will spend 10. Total 100 pounds.
As long as the number of pounds out there does not increase by money printing, it is just physically impossible to spend more than there is, right?
My humble blog
It's easy to refute an argument if you first misrepresent it. William Keizer
I see now that reduced productivity is a praxeological certainty following the introduction of the tax. To put it in terms of my scenario, the amount of milk being produced will necessarily decrease. This will lower the marginal productivity of land, labor and capital in general.
With less goods being produced, the demand for money must necessarily decrease, so prices must necessarily rise. [I think this is right, and is Say's Law, essentially "supply constitutes demand"]
So actually, it IS a praxelogical certainty that a tax will cause a general increase in prices. It's still true that (as Clayton said) a tax only causes price inflation to the extent that it changes the supply or demand for money, but the fact is that a tax will always (ceteris paribus) decrease the demand for money. So it is true that "the increase in VAT will cause price inflation". There is just an extra step involved in the reasoning.
Whether it will cause the CPI or any particular index to increase depends on the constituents and weighting of the index. But if we use a more solid definition of "price inflation" meaning "a decrease in the price of money", then it is true that the increase in VAT will cause price inflation.
DD5, I don't know what you mean by "A VAT is not a consumption tax. I'm not sure how you want to target a VAT only on a particular good." How is it not a consumption tax? And the reason I switched from VAT (applicable to some set of goods, but not all) to a tax on cigarettes is to simplify the scenario. They are equivalent, in that there is a set of goods being taxed, and a set of goods not being taxed.
Clayton, you said "I am not aware of any scholarly economic works that make a case for a link between taxation and systematic changes in the supply of or demand for money." But doesn't Say's Law do this? I mean, the link is simply (1) taxation reduces productivity, so there are (2) less goods chasing the same amount of money, which is the same as saying (3) demand for money has decreased.
"So it is true that "the increase in VAT will cause price inflation". There is just an extra step involved in the reasoning. "
No. Demand to hold money may rise, fall, or stay the same. The tax will, ceteris paribus, cause a rise in prices because the same amount of money is now chasing less goods. No requirement of change in the demand to hold money is required.
"DD5, I don't know what you mean by "A VAT is not a consumption tax. "
What I mean is that it is not the typical consumption tax where you can just tax cigarettes or liquor. it is a tax on the value added by each firm and business at every stage of production. It would be practically impossible to only tax all those stages of production that have only to do with cigarettes.
Demand to hold money may rise, fall, or stay the same. The tax will, ceteris paribus, cause a rise in prices because the same amount of money is now chasing less goods. No requirement of change in the demand to hold money is required.
Really? I thought that "same money chasing more/less goods" was like a metaphor for a change in the demand for money, alluding to Say's Law. The demand for one good is bound by the supply of all other goods. (If there was only one good in the economy, there could not be any demand for it.) So less non-money goods means less demand for money, ceteris paribus.
Or to put it another way. We know the price of money is dependent on only two variables: supply and demand for money. You say the tax will, ceteris paribus, cause a rise in prices, which means the same thing as saying price of money has fallen. The supply hasn't changed, so demand must have decreased. No?
[VAT] is a tax on the value added by each firm and business at every stage of production.
Thanks, I did not know that, I thought it was only consumer products. My difficulty here is more general than VAT, since it applies to straightforward consumption taxes as well.
If money supply remains unchanged, demand to hold money remains unchanged, and quantity of goods decreases, then prices MUST rise. No change in demand to hold money, or the money supply needs to change for prices to rise.
How preferences regarding holding money change in response to the tax is a different issue. There is no praxelogical deductive truth that we can use to determine how other preferences will change. But the point is that regarding the questions of price inflation, you don't need to complicate yourself with other factors to conclude that a decrease in production causes an increase in prices, all other things being equal. It's quite intuitive actually.
Oh I see, so the price of a good is determined by three* factors: supply and demand for it, and the quantity of goods around to demand it with. Decreased supply of goods and decreased demand for money are two separate things.
OK, here are my thoughts now.
Will there be a "jump up" in general prices when VAT is brought in? (This is what I am trying to refute)
No, because the obvious "jump up" in the price of affected products will be cancelled out by a "jump down" in the price of products not affected. In my example, cigarettes "jump up", milk "jumps down", and guns will "jump up" when the government spends the money (assume: immediately), such that there is no overall "sudden" change in "general prices" aka "the price of money". But then because less milk is being produced (and the same number of cigarettes), there are less goods chasing the same amount of money, so the price of money will fall, meaning general prices will rise.
So the tax will cause "general prices" to rise (what the mainstream calls inflation), but it won't be in the simplistic "jump up" way envisioned by laymen. It will be longer-term, as the structure of production shifts from producing something desired by consumers to producing something desired by government: guns instead of milk.
If there is a "jump up" in the CPI when VAT is increased, it will only be because the index is biased in favor of the VAT-affected products. (Or some other cause entirely, of course, since the ceteris paribus condition does not hold in the real world).
Does that all sound right?
* EDIT: Actually, it would be four wouldn't it - reservation demand for other goods would also be a factor.
"Does that all sound right?"
Perhaps. Basically the tax is a transfer of wealth. Assume the VAT applies to the entire economy. The government takes the revenue and spends it on steel. Now the steel industry will experience a boom at the expense of everybody else. The increase in revenue will more then compensate for the VAT imposed on the steel industry. Profits and eventually wages will rise in the steel industry while profits and wages will sink for everybody else. This will induce resources to shift to the steel industry. The shift of resources will cause the other industries to regain their profits at the expense of lower productivity and higher prices. The added resources in the steel industry will bring back their profits and wages back to "normal".
So in the short run, the affect on prices will be that of a shift in preferences among the different goods and services. Some will win and some will lose. In the long run, the production is less efficient due to its resources diverted to satisfy government consumption. Less efficient means higher prices. Whether the various price indexes and statistics reveal this price increase is an entire different manner.