Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 13 April 2012

More on tax increases versus spending cuts in an austerity programme

Using sales taxes to mimic monetary policy in a liquidity trap

                Monetary policy works by changing the real interest rate. At the zero lower bound monetary policy loses its power, unless it can influence inflation expectations. However inflation expectations for consumers will also depend on the evolution of sales taxes (indirect taxes like VAT). A pre-announced increase in sales taxes will raise expected inflation, and so reduce the real interest rate faced by consumers at the zero lower bound. In this sense changes in sales taxes can mimic monetary policy.
                I first wrote about this some time ago (for the record Wren-Lewis, 2000, but some of that discussion is a little dated now). As a result, I thought the (surprise) temporary VAT cut introduced by the UK government at the end of 2008 was a good idea (see here). Thanks to @daniel’s comment on an earlier post, I’ve now read a nice and straightforward paper by Isabel Correia, Emmanuel Farhi, Juan Pablo Nicolini and Pedro Teles, which formalises this idea in a standard New Keynesian model at a zero lower bound.
                My original piece on this suggested that a temporary but unexpected cut in VAT, like a temporary increase in government spending, could provide an effective stimulus to aggregate demand for a given monetary stance. But what are the implications for Eurozone countries that are trying to bring down government debt? They are the mirror image: it is not a good idea to use cuts in government spending, or a surprise increase in sales taxes, as a way to bring down debt in a recession. However pre-announced increases in sales taxes work differently.
                If the increase in sales taxes is announced but delayed, then this provides a stimulus before the point at which it is increased (as in the UK 2008/9 case). Put simply, people buy before higher taxes raise prices. Furthermore, if the increase in VAT is not permanent (because the intension is to bring down debt), but it is expected to end at a point at which interest rates are no longer at a zero lower bound, then the subsequent deflationary impulse can be counteracted by monetary policy. Of course, a key proviso is that interest rates have to stay at their lower bound when sales taxes are rising – obviously higher inflation will not stimulate the economy if it is offset by rising nominal rates (see here for an example).
                This suggests that pre-announced increases in sales taxes could be used as an effective consolidation device that also stimulated demand. The government announces a sequence of increases in indirect taxes, which go on increasing for as long as the zero bound is expected to be a constraint. Once the economy has recovered such that interest rates can rise, sales taxes can then be steadily reduced towards some desired long run level, achieving whatever reduction in debt is required.
                This idea is conceptually different from but complementary to the argument I have made before for using taxes rather than government spending as part of a fiscal consolidation programme. That argument was based on consumers smoothing the income effect of tax changes. The above is an additional point about the impact of taxes on inflation, which changes the incentive to consume today rather than tomorrow.
                Raising consumer prices via sales taxes increases negative incentive effects on labour supply. The optimal strategy examined by Correia et al is in fact revenue neutral, because it involves offsetting changes in income taxes/subsidies.  As indirect taxes rise, income taxes fall (or income subsidies rise). In an environment where there is no need for fiscal austerity, this is the welfare maximising plan. When government debt is excessive, then reducing debt is bound to involve either increasing tax distortions or the suboptimal provision of public goods or transfers for some time. In this case there would be no point in a tax switch: you just raise sales taxes.
                When I have asked whether this form of deficit reduction strategy was considered in Ireland, one of the responses was that there was a concern about the distributional impact of indirect tax increases relative to direct taxes. That is a whole different issue, and should ideally be dealt with by different means. From a macroeconomic point of view temporary increases in any taxes that have relatively small income effects because of consumption smoothing, but a significant impact in raising inflation, should be the preferred fiscal consolidation instrument at the zero lower bound. 


  1. Yeah I saw this VAT idea in your 2010 paper on Macroeconomics post-crisis. But i don't see really making much dent our AD deficiency, especially since absent a ridiculous super-fast economy-wide balance sheet clean-up via government/central bank intervention I don't see how it would work in our (as in UK) wretching household deleveraging crisis where sustained fiscal stimulus in the face (and in conjunction with) of zero-bound constrained monetary policy is necessary. The spectre of Japan circa 1997 with its sales tax led deficit reduction haunts me here.

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  3. There are three relevant real interest rates. One is nominal interest minus consumer price inflation -- this is the rate which should affect consumption. The other is the nominal interest rate minus producer price inflation. This should affect investment along a balanced growth path. OK also the nominal interest rate minus the rate of increase of prices of capital goods should shift the timing of investment.

    My concern is that the second real interest rate is not reduced by rising VAT. If I am deciding whether to invest, I compare my nominal revenues which depend on the price I get for my product to depreciation plus nominal interest. The fact that consumers will have to pay more does not make it profitable for me to invest.

    I admit again that if I am deciding when to invest, I will invest now when I can get equipment and building materials without paying higher VAT.

    But it still seems to me that you are thinking of a model in which real interest rates have an economically important effect on consumption. I think there is essential no evidence of any such effect (last I heard GMM estimates of the aggregate intertemporal elasticity of substitution were negative. In any case, empirical estimates of it are tiny.

    I guess that it is still true that DSGE models require reasonably high intertemporal elasticities of substitution to come close to fitting the data. But they don't fit the regression coefficient of consumption. growth on the real interest rate. Here I fear that focusing on a micro founded model which most nearly fits the data has possibly lead you to believe something about the relationship between real interest rates and consumption which is simply inconsistent with the data.

  4. Paolo Siciliani16 April 2012 at 11:56

    Wait a second, it's not just about distributional effects, when households are busy deleveraging by paying down their outstanding debt how on earth do you think they will find the resources to spend more today? To the contrary, they will anticipate further erosion of their purchasing power, since in a depressed economy salaries are likely not to keep up with expected inflation and thus react by consuming even less in order to raise their saving rates, if any! By the same token, the non-financial corporate sector won't invest more because they will anticipate this further squeeze in domestic aggregate demand. This is a vicious cycle, can't you see it?
    The only way out of this mess is to raise households' purchasing power not the reverse!

  5. Paul makes a good point - households are unlikely to be able to smooth the effects of the tax, and may become very cautious in their spending in anticipation of reduced spending power. I'd also express concern about the distributional impact - it's no small issue to be brushed aside.

  6. For what it's worth (not much) after thinking more (that is thinking at all) I am convinced that the proposed policy would definitely work. This comment is a critique of my comment above

    First the pulling forward of investment almost has to be important. The idea is that firms invest now to avoid paying VAT on equipment and such which they buy (I just paid VAT to have my research project buy a new computer -- in theory that is productive capital although I will have to work on producing something with it). The only case would be irreversible investment in capital with low resale value by a firm which is only investing at all because of extremely low real interest rates right now. The plausible case is that investment is currently low, since demand is low so there is spare capacity (or in more neoclassical theory terms the capital labor ratio is high and the marginal product of capital is low). In this plausible case, firms will invest when things are back to normal and will invest right now not later to avoid paying taxes later.

    Second, the stylised fact that the intertemporal elasticity of consumption seems to be low is based on regressing the growth rate of consumption on an econometricians estimate of the expectable real interest rate. This might mainly show that econometricians and normal people have extremely different estimates of inflation. A very clear extremely forecastable increase in prices due to a scheduled increase in VAT might have a large effect on consumption even if the econometricians' estimates generally don't have much to do with real world consumers.


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