In response to Tim’s very interesting idea that we could break out of a deflation-depression scenario by promising inflation through the VAT hike route.  I find this hard to accept, and possibly too good to be true: because if a VAT rise now or in the future could boost multiperiod demand, the government  could fix the economy and its fiscal woes in one leap.

Raising VAT surely hurts aggregate supply.  A producer, for any given price, is able or willing to supply less quantity of product.  So the AS curve goes up – for any Q, P is higher.

The problem as I see it is that we are in a situation like below.  I see the VAT rise promising to push AS1 to AS2.  Yes, you might get some consumption brought forward, but to the commercial sector, the mark-ups are like a supply shock: like being told that oil or electricity will double in price.  Not “let’s expand” territory.

The sloped lines are short run.  The vertical line is long term aggregate supply: what this economy can produce.

What do I think we need?  Well, this obviously: a boost to demand.  This has been, largely, a demand-shock depression, as the falling price level attested to.  People suddenly saved. So we need higher demand. The government can achieve this by using new money to buy things, broadly speaking.  It is not something I as a liberal like the idea of, and if the government can persuade other people to buy things by credibly promising to lift NGDP in the future, then that is better.  But if they won’t believe the govt, the government doing the buying is a better option.

I hope there are non-government-buying-the-stuff ways of making this happen: their targetting interventions helping ease financial pressures for smaller companies, say.

Finally, if I’m so relaxed about prices rising from AD going up, why aren’t the Right over at Coffee House or Guido or other places? Well, it is because their model of a recession tends to be more like this:

So, whenever some person (normally Conservative) explains that the problem is that we’ve lost the habit of thrift, we all spent too much, we are owed a thorough punishment for this, they are imagining we are in Iceland’s position, or that of Britain in 1980.  We need lower demand, they say.  Let prices rise to choke it off (though don’t accommodate 2nd round effects).  Then the VAT rise suggestion of Tim’s makes very good sense.  And that is why Maggie did it – in favour of lower taxes on companies to boost supply.  Look at the graph above, it makes perfect sense.

PS.  Money Growth figures look disappointing.  Note to Spectator readers: this still isn’t Weimar Germany!

PPS.  Apologies for the ugly graphs.  Microsoft Paint!  I have a real job to get on with . . .

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12 thoughts on “Why I don’t think promising a VAT hike gets us out of the liquidity trap

  1. I was wondering how deep we are into liquidity trap (i.e. what interests should be if they could go that low), but I’m only a layman, so I’m unsure as to how to work out something like the Taylor rule. Do you have an idea?

  2. I am not sure how straitforward it is. Prices are expected to rise; there are reasons to bring forward some consumption for this quarter. But are there reasons to invest? Investment tends to be the swingiest item of GDP. I think we need to be more bold in assuring growth for the business community, and am not sure that a 2% inflation target does it.

  3. Giles,

    This is a very good essay, and would have got an ‘A’.

    However, your failure to provide axis labels on all but your first diagram mean that I am forced to give you only a ‘B+’

    [Yes that’s right, I only remember the irrelevant parts of A-level and first year undergraudate economics.]

    [p.s. does it matter that you are holding LR AS to be completely inelastic? I understand the theory – namely, that an economy’s productive output is limited and cannot expand indefinitely (well, within a given time frame…because obvioulsy technological improvements and increased productivity mean that in the long long run AS can be increased, surely?) – but is modelling inelastic LR AS definitely the correct way to conceptualise the problems of this recession? Totally genuine question, posed from profound ignorance.]

  4. To be brief, it is a device for separating the structural from cyclical factors, I guess. There is only so much you can make your economy do by mucking around with prices; at some point, you are in the long run and need better deployments of capital and technology to get you there.

    it is a convention, sure, but I reckon a relevant one

    Microsoft Paint + 20 minutes to write this thing = bad graphs

  5. Apologies, I should have been clearer. When I proposed govt raising VAT, I was assuming fiscal neutrality, that is, that govt would recycle the money into (say) a rise in the income tax allowance.

    So you are right that AS moves left, but AD moves right (people pay less income tax). Since the two amounts are the same, the best guess is that in the short term output remains unaltered, but the price level has increased.

    Why is that useful? See my FT article: http://www.ft.com/cms/224ae9f2-fb95-11dd-bcad-000077b07658.html.

  6. It seems I spent 20 minutes knocking over a straw man! My apologies for imagining that you did not have this factored in.

    A switch from income taxes to consumption taxes – yes, that sounds like something that might well work . . . good incentive effects for work, of course . . . distributional arguments for the bottom decile (Kate Green coming into sight) but nothing that could not be fixed with targetted interventions . . . worth thinking about

    I actually had a chat with a man from the Gov about changing Bank remits. Like many in the US, I think it could be a real jolt. But I really worry what the gilt market would say. That is why I am keen on us offering more index linked debt so the markets know this is not about government default factored in.

  7. In general I prefer income taxes to consumption taxes – it is much easier to make them progressive. So as I say, I see the VAT promise as a backstop – **if** inflation is lower than a certain level (which might be zero) for non-technical reasons (i.e. more than a 12 months before rise in oil falling out of the index) then we will raise VAT as necessary. Therefore the public know that there is no chance of inflation falling below a certain level.

    I don’t think that the incentive to work argument is strong tho’ – after all, we work to spend, so the amount of goods you can buy is pretty much unaltered.

  8. While I can undestand that the last point might make people indifferent to the policy, aren’t decisions to work and decisions to consume taken discretely?

    So when I decide whether to get a job I think “How much would I keep of the money”

    and on consuming I think

    “what do I get for this”.

    VAT reduces the value of all pounds: income tax reduces the value of the ones you are setting out to earn. My brain is too tired to work this through. Have a nice w/e

  9. Your enthusiasm for a job paying £2000 a month is presumably conditional on what you can buy for £2000. (If this is not the case, and you just like working for large sums of worthless currency, I am happy to employ and pay you a large number of Zimbabwe dollars a day…)

  10. That Zimbabwean currency will have collectors value one day you know.

    I think thresholds may make a difference.

    Bloke on £25k, trying to decide whether to up his effort and do a more difficult job for £50k. For simplicity, suppose we start with income tax threshold of £25k. The government is planning to either put on a new VAT of 10%, or increase the income tax that kicks in at £25k from 0 to 20%.

    Now, suppose they do the VAT raise. The real value of his £25k salary drops so he can only buy £22.5k of stuff. As does his prospective real value if he goes to £50 – now he can buy £45k of stuff. So the decision to work harder nets him £22.5k more stuff.

    Now suppose it is an income tax raise. Now the choice is between £25k of stuff or £45k of stuff, so £20k more. So his incentives are slightly better if it is VAT

    Also, if his marginal propensity to consume is 80%, it may change things. People may be incentivized by their total take home, even if they save 20% of it which therefore escapes VAT. Then, to raise the same amount, the VAT would have to be higher, I suppose.

    My brain still tired. This is interesting stuff but I must dash or risk marital strife …. . nice weekend

  11. Giles, you are right for your example, but I promise you it is a wash in aggregate. I could make up counter examples (especially since VAT is not on everything), but take a step back: if I am wrong we can apparently get a free lunch, which is unlikely.
    MPC = 100% in the long run – people save to spend.
    Zim dollars already have collectors value. Last time I looked on ebay it cost $5 to buy a trillion Zim$ note… About 1000x its PPP value, but still not a lot.

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