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.
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.