An exercise in futility: Trying to prove VAT reduces prices

An exercise in futility: Trying to prove VAT reduces prices
By Dr Clive Thomas
Guyana and the Wider World.
Article taken from Stabroek News. Sunday 8 June 2008
URL to article: http://www.stabroeknews.com/?p=14361

Every Guy-anese realizes from his or her own daily living experience since the beginning of 2007 that the introduction of the VAT and excise legislation has precipitated much of the inflation in the price level that they have had to face ever since. Nonetheless, with amazing stubbornness the Guyana Revenue Authority (GRA), GINA, other government spokespersons and technocrats employed by the state have sought to “prove” to Guyanese through the public media that the introduction of the VAT and excise tax should lead to a decline in prices and deflation, not rising prices and inflation.

As the so-called “proof” goes, the VAT and excise tax is noted as having replaced existing consumption taxes, which for most items had a higher rate of taxation. Further, the VAT tax is paid only on “value added” at each stage of the production and distribution process. There-fore, as a particular business pays higher input costs because of the VAT tax, that business can claim the VAT taxation back from the GRA as a legitimate credit. The price of the item should consequently rise by the VAT tax (16 per cent) less, the more than likely, higher consumption tax for which the VAT is a replacement.
The fallacy in this argument is astonishingly simple, yet its advocates persist in making it.

The analysis of the tax on a particular business is what economists term a “partial equilibrium analysis.”

Such analyses seek to explain how relative prices are formed. Inflation, however, is a rise in the general level of prices. In other words a phenomenon that can only be effectively explained by general equilibrium analysis.

All partial equilibrium analyses of relative prices operate on the assumption that while the analysis is taking place, other things remain equal.

That is, nothing else changes during the period of the analysis. This is usually expressed with the Latin term, ceteris paribus and this term is introduced to persons immediately they begin the study of economics, even at the high school level.

In persisting with this approach the GRA betrays a lack of understanding of the finer elements of how prices are formed in Guyanese markets and for that matter all markets.

An example

A good example of this can be gathered from the widespread increase in the price of airline travel, which most people including the airlines attribute to the rise in crude oil prices and aviation fuel.

Two considerations show how weak may be this connection. First, most, if not all regular airlines, buy their fuel in future or forward markets, because these purchases are regularly required as long as the airline remains in business. Forward purchases are geared to eliminate price speculation and other erratic trend factors that may be caused by day to day, week to week, transitory supply-demand effects on oil markets.

Second, crude oil is priced in United States dollars. The rise in crude oil prices therefore partly reflects the depreciation of the US dollar relative to other currencies. Indeed, other currencies (for example, the pound sterling and the euro) have appreciated relative to the US dollar. To this extent crude oil prices measured in these currencies have become cheaper not dearer.

What this example shows is that businesses look for opportunities (real or illusory) to seek higher profits. It is plausible, if not entirely candid, for airlines to claim that rising fuel prices have forced them to raise prices. That, in other words they are not practising price gouging!

Applied to Guyana: Trigger mechanism

When one applies this example to Guyana we see why businesses find the VAT tax, a convenient device for the realignment of prices. And, when all businesses react in a similar fashion we get a consequential rise in the general price level.

Businesses do not have to overtly collude or conspire to produce this result. Instinctive knowledge of the price formation process in Guyana leads them to this result.

Thus one cannot undertake an analysis of the effects of the VAT and excise tax on one business in a partial manner, assuming other things remain equal (the ceteris paribus condition). On the evidence, the tax has been a trigger mechanism for an all-round rise in prices.

Next week I shall provide more direct information in support of the contention that the effect of the VAT and excise tax has been inflationary through presenting data on the impact of these taxes on national expenditure and prices.

In conclusion, however, let me observe that in a free market situation, enterprises cannot be prevented from acting in the manner highlighted here. Nothing done in the example cited here is illegal. This is indeed the nature of the capitalist free market economy and the laws, rules, regulations and procedures of the Guyanese economy permit such approaches.

It is the responsibility of governments to moderate excesses. However, to be able to do so, governments must first understand and thus anticipate untoward developments.

Every presentation to the Select Committee on the VAT and excise legislation had cautioned about the potential inflationary effects of the VAT, including myself and the Institute of Development Studies, University of Guyana, where I work.

It was also pointed out that because the Guyana dollar was linked to the US dollar, which was at the time continuously depreciating in foreign exchange markets, this would aggravate the inflationary effect of the VAT as the prices of imported inputs to businesses would be rising.

Article taken from Stabroek News - http://www.stabroeknews.com
URL to article: http://www.stabroeknews.com/?p=14361