GST rates and inflation: Why Mr Peters is actually wrong

At his rates blog and his blog on stuff Bernard Hickey often has a number of insightful things to say. Sadly this piece where he forces himself to agree with Winston Peters is not one of them.

Specifically he states:

In fact, a GST cut is the perfect tax cut right now. It is a deflationary tax cut targeted at the poorest and at those with the most squeezed disposable incomes.

This is a common misconception which results from the way us economists often teach people to think of inflation. For this error I apologise. However, fundamentally, a cut to GST rates is just as inflationary as a cut to personal income tax rates. As I’ve stated here:

inflation is the rate at which prices grow – not the price level

The inflation that economists are scared off is the rate at which the price level grows. The price level by itself is arbitrary – its doesn’t impact on the true level of wealth in the economy, its only a form of measurement. However, “inflation” or the growth in the price level, is the factor that confuses us when we go shopping for goods by making all the prices change, it is the factor that increases variability in prices and destroys their ability to signal what the true value of a product is.

GST rate cuts are just as inflationary as they also “increase demand” in the economy. It doesn’t matter whether you increase someones net income by 5% or if you lower all the prices in the economy by 5%, the change in there demand for resources will be exactly the same – as a result, they are equally inflationary!  This is why the RBNZ was looking at a GST rate that increased with inflation as another mechanism apart from interest rates (an idea that many feel is silly).

Now you might state that people’s inflation expectations may fall in the face of a GST cut – this form of bounded rationality may make a GST cut preferable to an income tax cut. However, I covered this issue here. The GST cut would be anticipated so it shouldn’t influence inflation expectations. Furthermore, income tax cuts would implicitly increase the interest rate savers receive (as that is taxed as an income tax) – increasing the incentive to save relative to GST rate cuts. As a result, it is possible that a GST rate cut could be MORE inflationary than income tax cuts.

As a result, the inflation argument for GST rate cuts is wrong!

OK, but GST is regressive and we need to help the poor in the face of rising food prices!!

I understand your concern.  However, the belief that GST is regressive is not really true.  The only distributional impact a cut in the GST rate will have is to benefit those with wealth and savings (as the price level of goods is lower) and punish those with debt.

I’m not surprised that Winston Peters is raising such an issue.  He is determined to keep the baby boomer vote, and they are at a time of their lives when they are dis-saving and retiring – implying that they would like it if the price level was lower and don’t care too much about income taxes (beyond the return on investments/savings).

If they cut GST rates today I’m going to be very disappointed – and you probably won’t hear the end of it from me for a while 🙂 .