An unseen cost of shifting from income tax to GST

Following recent events it is obvious that New Zealand will do a “compensated shift” of the tax system away from income tax and towards consumption tax – removing a “flat component” of income tax and replacing it with a flat income tax.

Lovely.

However, when we think about the happiness and general welfare of society there are issues that appear given such a change.  One issue I want to focus on is timing, specifically the role of credit constraints in making GST a more “welfare damaging” tax then a tax on income.

When credit markets are imperfect (say because of information asymmetries) individuals can become “credit constrained”.  Namely, someone who expects to have a high lifetime income, but has low current income, cannot borrow to “smooth consumption” over their lifetime.  This is costly as agents who could lend to each other profitably in the perfect information case don’t, it is a market failure.

Now, if we tax consumption instead of income we are taxing the credit constrained individuals more NOW and less in the future.  As a result, their disposable income is lower now than it would have been.  As they are unable to borrow on their higher future income they are less able to smooth consumption.

The best example of people in this situation are tertiary students – in reality they should be the main people complaining about this change to the tax system.

  • kyotolaw

    I know that this inability to lend/borrow so one can spend his/her average income over the course of a lifetime is considered a classic “market failure”, but should it be?

    Shouldn’t it really be called a “physical laws of universe don’t comply with wishful-thinking economists failure” instead?

    I mean really – I can understand calling it “information asymmetries” when the information actually exists, but if we need a crystal ball or time machine to reveal the information, isn’t it asking a little too much of poor Mr. Market?

  • @kyotolaw

    Just because there is a market failure doesn’t mean that there is anything any better – it is just worse than the idealised counterfactual.

    We know that, given this market failure, a switch from a income tax to a GST rate reduces welfare.

    If we didn’t start off with an ideal case it would be difficult to identify and discuss how this failure works. I don’t see what is wrong with that.

  • If what we care about is minimizing losses though, these losses seem smaller than losses from having the top marginal rate disjoint from the corporate rate and from having too high a top marginal rate.

    Don’t tertiary students get 0% loans anyway?

  • @Eric Crampton

    “If what we care about is minimizing losses though, these losses seem smaller than losses from having the top marginal rate disjoint from the corporate rate and from having too high a top marginal rate.”

    In terms of a fully compensated shift from income to GST, the EMTR’s are no different (unless people switch to purchasing jewelry from overseas with their income). The only benefit in this case is that current and future consumption are taxed equally – of course this can be also achieved by just not taxing interest income.

    “Don’t tertiary students get 0% loans anyway?”

    Two opposite policies that provide a welfare loss don’t necessarily cancel out …

  • It’s fully compensated only for the lower brackets though, right? It’s failing to fix problems of very high EMTR for those folks (especially with no WFF changes), but not so for folks on the 38 cent rate.

    I wasn’t saying the policies cancel out; rather, that the tertiary students aren’t as credit constrained as you might be figuring on. When Labour put in the 0% loans, we asked our students how many of them were taking loans the prior year…a few hands went up; asked how many taking this year…more hands went up; we then reminded them that they could borrow the money and stick it in a Rabo term deposit and eat the interest difference…more hands shot up indeed. This isn’t a particularly credit constrained group.

  • @Eric Crampton

    “It’s fully compensated only for the lower brackets though, right? It’s failing to fix problems of very high EMTR for those folks (especially with no WFF changes), but not so for folks on the 38 cent rate.”

    It definitely isn’t fixing any of the EMTR issues. But my impression was that ALL tax brackets and rates were being reduced to compensate for the change in GST. In effect, the government is simply saying that they think GST is cheaper to administer, less likely to face tax avoidance, and they want the tax on interest to be lower – that’s it.

    Any reduction in the top tax rate has to come from the property taxes that come through IMO.

    “tertiary students aren’t as credit constrained as you might be figuring on”

    Hmmm, after fees students can borrow $1,000 for course related costs and borrow $150 a week. Rent is usually taking up most of that borrowing, and a part time job on top of full time study usually gets you about $140 a week.

    I’m still smelling a definite credit constraint there – especially when most of these people would be looking to move onto $800 a week when they get out of the place.

  • Guess we’ll have to see how they plan on running that compensation. I think you’re right that reductions in the top rate will have to come from property – there’s only rats and mice money left on GST after running the lower bracket compensation.

    There could be a credit constraint, but I’d warn against taking the proportion of students currently maxed out on student loans as evidence of anything. Of course, the problem could be solved entirely by adding provision for greater loans at market interest rates (along with a ball and chain to keep them from fleeing the country without paying debts, I suppose). Not that you’re taking those numbers as evidence. But that a majority of my students were on no loans prior to 0% suggests constraints are generally non-binding.

  • “but I’d warn against taking the proportion of students currently maxed out on student loans as evidence of anything”

    Agreed. I know plenty of people that maxed out and just put it in a savings account.

    “Of course, the problem could be solved entirely by adding provision for greater loans at market interest rates”

    Agreed. Although I would prefer it if they waited till I’d payed back a bit more of my debt 😛

    However, if I remove my self-interest I would suggest they should do it immediately.

  • Now this post illustrates what I was saying in the other comment thread: people don’t smooth consumption over their lifetime. Didn’t Thaler have a paper saying how the MPC from current income was close to 1 and the MPC from future income was close to 0? In this case, it might mean that the welfare loss is lower than you might otherwise expect.

  • @rauparaha

    Thaler …

    Lots of people have done estimates, and Thaler’s estimates were by far the most extreme. Mankiw and Barro have both written a bunch of stuff on it.

    Furthermore, we have to ask what causes the MPC from current income to be positive (for unchanged lifetime income). One of the major explanations is … credit constraints. As a result, if Thaler’s results are true it might indicate that the credit constraint is EXTREMELY binding – which would imply that the welfare cost is HIGHER.

    Party times had by all.

  • @Matt Nolan
    I have no doubt that credit constraints are part of the explanation; however, it would be rash to presume that they are the primary reason why consumption follows income over people’s lifetimes. For an obvious example you have to go no further than the huge drop in consumption when people retire.

    I’m not disagreeing with the point of your post, merely adding that there are many other considerations when thinking about lifetime welfare and consumption smoothing.

    Note also that Thaler’s estimates were based on a behavioural consumption model, so his estimates aren’t directly comparable to standard estimates of MPC.

  • @rauparaha

    “I have no doubt that credit constraints are part of the explanation; however, it would be rash to presume that they are the primary reason why consumption follows income over people’s lifetimes”

    I agree that people consumption tilt for sure, that is part of impatience 😉 . However, I also believe that people consumption smooth.

    “I’m not disagreeing with the point of your post, merely adding that there are many other considerations when thinking about lifetime welfare and consumption smoothing.”

    Also agreed. However, the welfare cost I wanted to discuss stems from the specific issue of credit constraints – hence why I focused on that.

    Furthermore, my comment was in response to you stating that “people don’t smooth consumption over their lifetime”, a statement that I believe is patently false.

    “Note also that Thaler’s estimates were based on a behavioural consumption model, so his estimates aren’t directly comparable to standard estimates of MPC.”

    Interesting. Wouldn’t mind having a look at that tbh, the methodology of behavioural models fascinates me – mainly because it feel fresh methinks.

  • “Furthermore, my comment was in response to you stating that “people don’t smooth consumption over their lifetime”, a statement that I believe is patently false.”

    I don’t think it’s patently false, just unqualified as it stands. To be more specific, I wouldn’t deny that there is SOME smoothing done, but current consumption isn’t independent of current income. No model where consumption is a function only of lifetime income can explain observed consumption patterns.

  • @rauparaha

    “To be more specific, I wouldn’t deny that there is SOME smoothing done, but current consumption isn’t independent of current income”

    No-one made that claim though – all you require is some consumption smoothing, and thereby some credit constraint, to make the result hold.

    I do not disagree that the extreme position of “all people would smooth consumption perfectly” is very unlikely to be true. However, I find the comment “people don’t smooth consumption over their lifetime” equally extreme.

    It sounds like we agree on this in the first place – but I would like to note that the assumption of perfect consumption smooth was never, and does not need to be, made anywhere in what I have said.

  • It definitely isn’t fixing any of the EMTR issues. But my impression was that ALL tax brackets and rates were being reduced to compensate for the change in GST.

  • steve

    As an alternative to the land-tax idea, I wonder if they could just impose GST on rent? Its prob about the same ammount, evens out the incentives between spending on housing and spending on all other goods, although is a little distortionary in terms of owning your own home.