Economics Questions

Re: Can a sales tax increase cause price inflation?

DD5 — Thu, 24 Jun 2010 04:10:20 GMT

"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.

Re: Can a sales tax increase cause price inflation?

Graham Wright — Wed, 23 Jun 2010 23:04:14 GMT

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.

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.

Re: Can a sales tax increase cause price inflation?

DD5 — Wed, 23 Jun 2010 22:26:34 GMT

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.

Re: Can a sales tax increase cause price inflation?

Graham Wright — Wed, 23 Jun 2010 22:12:30 GMT

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.

Re: Can a sales tax increase cause price inflation?

DD5 — Wed, 23 Jun 2010 21:01:21 GMT

"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.

Re: Can a sales tax increase cause price inflation?

Graham Wright — Wed, 23 Jun 2010 19:54:21 GMT

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.

Re: Can a sales tax increase cause price inflation?

Smiling Dave — Wed, 23 Jun 2010 01:12:02 GMT

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?

Re: Can a sales tax increase cause price inflation?

Graham Wright — Tue, 22 Jun 2010 23:15:51 GMT

OK, I think I see what you mean, but I will have to sleep on this. Thanks both!

Re: Can a sales tax increase cause price inflation?

DD5 — Tue, 22 Jun 2010 23:04:06 GMT

"The immediate cost of the tax, in this scenario, is that cigarette smokers have less milk."

A VAT is not a consumption tax. I'm not sure how you want to target a VAT only on a particular good.

"so I think it is still meaningful to analyze the effects of the tax without assuming that the tax will result in decreased productivity over time."

As long as the government spends the money it taxes away, there is always a transfer of productive resources to non-productive resources. You can't assume then, no curtailment of productivity.

It's like this. There is a pool of productive resources you can tax. Once you tax and then spend, those resources that are diverted in order to satisfy the government spending are taken out of the productive pool of resources. They are no longer tax payers but tax consumers. Their income statements may say otherwise, but the economic reality is that they have contributed nothing to the pool of taxable funds. The pool must shrink as a result of any tax.

Re: Can a sales tax increase cause price inflation?

nirgrahamUK — Tue, 22 Jun 2010 22:59:51 GMT

it is a praxeological certainty; the tax reduces both the marginal productivity of labour and that of capital. by fiat, it declares all those previously profitable enterprises to be less profitable (less productive of phsycic profit to the agents)

Re: Can a sales tax increase cause price inflation?

Graham Wright — Tue, 22 Jun 2010 22:50:04 GMT

To assume that away would be to assume the cost of the tax away. And to assume that would be to assume that the tax is basically harmless or that it doesn't exist in the first place.

The immediate cost of the tax, in this scenario, is that cigarette smokers have less milk. A further cost comes when the government spends the money, when it increases the price of guns. If the tax also results in decreased productivity, then this will be a further cost of the tax. But the 'if' condition is not a praxeological certainty, so I think it is still meaningful to analyze the effects of the tax without assuming that the tax will result in decreased productivity over time.

I know that the scenario is far, far from the real world, but I am trying to create a model in my mind that will enable me to see the effects of the tax in isolation. Kind of like how Mises uses the ERE to isolate profits from interest, and clarify other concepts.

Re: Can a sales tax increase cause price inflation?

DD5 — Tue, 22 Jun 2010 22:15:25 GMT

"Over time, yes. But can we assume this away as well; assume no change in productivity? "

To assume that away would be to assume the cost of the tax away. And to assume that would be to assume that the tax is basically harmless or that it doesn't exist in the first place.

Re: Can a sales tax increase cause price inflation?

Graham Wright — Tue, 22 Jun 2010 22:06:04 GMT

There may or may not be such a visible increase due to the introduction of a VAT or any other tax because there are other forces at work that may still cause the general decline of prices. This is why the government will nearly always get away with such destructionist policies.

Totally understood. The Austrian way is to think about ceteris paribus effects, like we do when we think of changes in the world of the ERE.

VAT is basically a production cost that will decrease the marginal value productivity of labor. Like other taxes, it will initially transfer wealth by income distribution (although indirectly so) from the productive to the non-productive. The total effect, of course, will be less productivity then there would otherwise be in the absent of such a pernicious tax. Less productivity means things are more expensive.

Over time, yes. But can we assume this away as well; assume no change in productivity?

The only thing that we can conclude is that, all other things being equal, prices are more expensive then they otherwise would have been if no VAT was introduced.

Only because of the reduced productivity, yes? So if we assume that away, all that we can say is that some prices have increased, others have decreased. Whether the 'average price level' has changed depends entirely on what is included in this measure and how it is weighted.

There is no necessary change to the demand for money (which, we all agree, would cause 'price inflation' or 'a general increase in prices'), resulting from the imposition of a tax. But the decline in productivity that would likely result from the tax would cause the demand for money to decrease ("fewer goods chasing the same amount of money"), hence a general increase in prices.

Re: Can a sales tax increase cause price inflation?

DD5 — Tue, 22 Jun 2010 21:07:03 GMT

VAT is basically a production cost that will decrease the marginal value productivity of labor. Like other taxes, it will initially transfer wealth by income distribution (although indirectly so) from the productive to the non-productive. The total effect, of course, will be less productivity then there would otherwise be in the absent of such a pernicious tax. Less productivity means things are more expensive.

But when you ask about price inflation, you are basically asking about an increase in prices over time. There may or may not be such a visible increase due to the introduction of a VAT or any other tax because there are other forces at work that may still cause the general decline of prices. This is why the government will nearly always get away with such destructionist policies. The only thing that we can conclude is that, all other things being equal, prices are more expensive then they otherwise would have been if no VAT was introduced.

Re: Can a sales tax increase cause price inflation?

Graham Wright — Tue, 22 Jun 2010 20:48:26 GMT

because you are using a 'mainstream' concept of inflation, this will depend entirely on how the inflation index is populated and weighted. what do the administrators of the price index want to show ........ ?

Yes, I think you are on the right track there.

Let's make another assumption. The £5 that people now spend on cigarettes was previously spent, by everybody, on milk. That is, everyone has decided to cut back on milk in response to having to pay more for cigarettes. Now only three goods are affected: cigarettes, guns and milk. Cigarettes and guns will increase in price, milk will decrease. What will happen to the price index of cigarettes, guns and milk?

I guess it all depends how the index is weighted. Am I right in thinking that there is no such thing as an 'unbiased' weighting, because quantities of cigarettes, guns and milk are all in different units?