This blog post by John Pagani about removing the GST from fresh fruit and vegetables has raised an interesting issue about value-added taxes like the GST and how well understood they are. Pagani comments; “I doubt there is anyone who would support a GST of 20 per cent with no exceptions; that would be inhumane”. Well, I don’t think of myself as inhumane, but if we had a 20% GST I would still be in favour of it applying as broadly as it does now. In fact, I would make the opposite claim to John: No-one, no matter what their political perspective, their desire for income redistribution, their concern about unhealthy eating, their belief in the efficacy of price signals as a way of changing eating habits, or even their basic level of humanity should every be in favour of muddying the GST by removing it from particular categories of goods. The key word in this sentence is “should”. I am convinced that the reason there are differences in opinion on this issue is misunderstanding about the GST.
In this post, I want to point out some aspects of a GST that are not as well understood as they should be, and in a subsequent post I will explain why commonly stated justifications for giving special treatment to some goods just don’t hold water.
The first thing to note is that a clean GST is equivalent to a labour income tax at a flat rate with no tax on capital income. By example, imagine an economy with a 20% flat-rate income tax on labour income and no tax on capital income. Now replace it with a 25% clean GST. This implies that 20% of the cost a product is the GST, hence the equivalence to a 20% income tax. In the income tax system, consumers who save have 20% of their income taken off at the point they earn it, and their savings then grow at the market rate of interest. With the GST, nothing is taken off at the start, the full value of their income grows at the market rate of interest, but then 20% of the total value is paid as GST when the income is finally consumed. Either way, consumption is reduced by 20% by tax. In short, the two systems are identical in the impact on consumer’s consumption possibilities and in government revenue.
Second, it is a basic mistake in tax policy to examine the efficiency and equity aspects of a single tax in isolation, rather than considering the effect of the overall tax system. For instance, the distortionary effects of a tax on a particular class of goods depends on whether there is also a tax placed on the goods that people might substitute too. Similarly, the equity implications of a GST depend on the income tax system that exists at the same time. Consider the tax system we had for most of the period of the 1999-2008 Labour government: a 12.5% GST, and income tax rates of 19.5%, 33%, and 39%. Now consider a change to a 20% GST. To maintain the same level of progressivity (and humanity) in the overall system, all that is needed is to increase benefits by 6.6%, and reduce the respective income tax rates to 14%, 28.5%, and 35%.
Finally, it is important to distinguish in a value-added tax like the GST between exemption and zero rating. The idea of a value-added tax is to tax final consumption but not the use intermediate goods. (If all sales were taxed, we would create a tax incentive for massive vertical integration, probably at a cost of bureaucratic inefficiencies.)
One can try to tax final consumption by guessing which purchases reflect final consumption (such as a retail sales tax), but this will not catch all final expenditure and will catch some intermediate-good purchases. A value-added tax works by having all sellers add the tax to the price of their goods but having them subtract off the tax already paid on intermediate goods. In this way, it is only the seller’s value-added that is taxed at each point in the production chain, but consumers will face the full value of the tax wherever they purchase.
Let’s work with a simple example with a 10% GST. A miller produces $10 bags of flour, to which it adds $1 GST, giving a cost of $11 to bakers and final consumers. A baker combines that $10 of flour with $10 of labour to produce $20 of bread, to which it adds $2 of GST. The baker, however, only pays $1 to Inland Revenue as it subtracts off the $1 already included in the price of the flour and paid by the miller. Finally, a café combines the $20 of bread with another $10 of labour to produce $30 of sandwiches to which $3 is added. The café subtracts off the $2 tax already paid by the miller and baker, and sends the final $1 to the government. The price to consumers of any of these three goods ($11,$22, or $33) includes a full 10% of tax.
Zero rating is typically applied to a category of good rather than to a category of seller. Using the same example, let’s imagine that bread is zero-rated, but flour is not, and nor are café sandwiches. The miller seller sells flour to the baker for $10 + $1 GST. The baker combines the flour with $10 of labour to produce bread worth $20. It places no GST on this, and sells it for $20 but claims the $1 paid by the miller back for a tax bill of -$1. The café still adds $3 to the price of sandwiches, but as the bread had no tax applies, it can deduct tax already paid and so remits the full $3 to the government. Consumers therefore pay the full 10% tax if they buy sandwiches or flour, but not if they buy bread.
Exemption works differently, and in New Zealand it is typically applied to the seller rather than the good. Exemption means that you don’t have to add GST to the price, but you also can’t claim back the GST already paid. Exemption is done to reduce compliance or implementation costs rather than to materially affect the price of a particular good. For instance, small businesses with turnover of less than $100,000 can choose to be GST exempt, although for some there is an advantage to registering for GST anyway. In our example, if bread were exempt, but not flour or sandwiches, the miller would charge $1 for the flour. The baker who added $10 of labour would then have to sell the bread for $21, so that bread-buying consumers would still be paying an effective 5% tax. And the café adding $10 of labour to $21 bread to create sandwiches would have to charge 33.10 for the sandwich, being unable to claim back the implicit $1 of tax paid by the miller, so that the implicit tax rate on sandwiches would be 10.33%.
This difference between zero-rating of goods and exemption of sellers, is the key to understanding why New Zealand’s clean GST has far lower compliance costs than the typical value-added tax. When completing one’s GST return on-line, one can simply enter two numbers: Total sales to domestic buyers, and total purchases from GST registered sellers. Because there is a single rate of GST, that is sufficient to calculate the GST component of your sales and the GST already paid on purchases. When some goods are zero rated, the fraction of the price paid on goods that is GST will depend on the proportion of each purchase that was for a GST-rated good. Filling out returns then means adding up the GST component of every single purchase separately. It is true as Pagani says that “the purity of a flat rate is good, but it’s not the whole enchilada.” Maybe this increase in compliance costs would be tolerable if abandoning purity brought other benefits. But the putative benefits of exclusions are illusory, based on mis-understanding the above points.
More on that tomorrow.