Relative prices and GST

Over time we have been covering specific issues with how income tax and GST influence economic activity. This post was supposed to describe how an increase in GST with a proportional decrease in a flat income tax would lead to no change in consumer activity. This required the assumption that the incidence of tax on the household in both cases was equal, which will not be true.

Next we discussed the incidence of income tax in this post, which allowed us to say that some of the burden of the tax falls on labour, but some also falls on the firms that employ workers. The next step is to look at the incidence associated with a goods and services tax, and some of the inefficiencies that this issue causes for this tax type.

One inefficiency with GST taxes that we have already discussed is that, even if the whole incidence fell on the consumer, they keep relative prices the same as the original market price. Now this isn’t really an inefficiency if we can structure the rest of our tax system to take account of externalities associated with the consumption/production of goods, in fact this is usually heralded as the best point about GST. If we had a set of prices that ensured the most efficient allocation of resources, then if a flat income tax was cut, a proportional increase in a goods and services tax should not change this allocation. However, this is wrong.

This view of GST is wrong because a goods and services tax is a tax on goods and services, and difference goods and services have different price-elasticities of demand, ensuring that the incidence of tax for different commodities differs.

If this is the case, an x% increase in the GST rate will lead to different increases in the price of goods. Specifically, goods with ‘inelastic’ demand will go up in price strongly, while goods with ‘elastic’ demand will have a more significant reduction in the quantity produced. This implies that the initial GST tax will lead to a shift in resources from goods with elastic demand to goods with inelastic demand.

Now since the price elasticity of demand for a good has nothing to do with the externality associated with the good, the change in relative prices may not be optimal.  In fact, if the rest of the tax system is tailored to take account of externalities, a GST tax will create distortions to two ways:

  1. Making the price of the good higher than the social optimum
  2. Changing the relative price of goods and services

An income tax distorts the labour market, by increasing the relative price of labour to other inputs.  A goods and services tax distorts the goods market, by changing the relative price of goods and services based on their elasticities.  The question then is, what mix of GST and income taxes will be able to

  1. raise the revenue required for the provision of public goods,
  2. provide societies equity goals,
  3. and minimise the efficiency cost (distortions) to the economy?
  • CPW

    Good point. But I guess the same issues arise with a tax on labour once we stop treating labour demand as homogeneous.

    I still think the reduction in the intertemporal distortion is the strongest argument for shifting from income to consumption taxes.

    i would clarify the final question to “mix of GST and income taxes & social spending”, I’ve never been convinced that the tax system is a very effective means of achieving equity goals.

  • “But I guess the same issues arise with a tax on labour once we stop treating labour demand as homogeneous.”

    Indeed, that is a very good point. I wonder what types of workers firms have inelastic and elastic demand for (my guess is labour with specific skills vs unskilled labour), after all if demand is inelastic the firm will take on most of the tax burden, which implies that they will get the least benefit from a cut in taxes.

    “I still think the reduction in the intertemporal distortion is the strongest argument for shifting from income to consumption taxes.”

    Would you care to elaborate?