Question

Do you agree that inflation causes higher consumption tax? Elaborate the answer.

Answer 1

Yes, We Agree

The relationship between inflation and consumption taxes is bidirectional. Changes in the price level affect the tax revenues by influencing the tax base. A higher than expected rise in inflation results in an inflation premium, also called inflation tax, allowing for an improvement of the budget balance. Inflation is therefore called the “silent ally of the government”. Unexpected changes in inflation can cause fiscal loosening or tightening. The inverse relationship between consumption taxes and inflation consists in the fact that changes in tax rates shape the prices. The fact that consumption taxes shape the prices can result in inflation phenomena

There are two indicators that enable the study of the impact of changes in indirect taxes on prices: the producer price index (PPI) and the harmonised consumer price index at constant tax rates (HICP-CT). PPI does not include indirect taxes, hence it reflects only the changes of prices determined by the producers at different stages of production. The advantages of PPI as an alternative measure of inflation have led some economists to suggest basing the direct inflation targeting strategy on this indicator.

The harmonised index of consumer prices at constant tax rates (HICP-CT) is considered to be the best – although not flawless – measure for investigating the impact of changes in indirect tax rates that affect prices. The principles of their calculation are standardised in all EU countries and that enables comparability between countries. HICP-CT is defined as the ratio, which measures the changes in prices of consumer goods and services excluding the impact of changes in tax rates in the same period.

HICP-CT data is broken down into categories of the European classification of individual consumption by purpose (ECOICOP), which enables the creation of sub-indices.

Basic pieces of information necessary for their calculations are: a) purchase prices of products, b) characteristics that determine the product price, c) information on taxes and excise duties levied, d) information as to whether a price is fully or partially administered, e) weights reflecting the level and structure of the consumption of the products concerned.

This measure is interesting from a cognitive point of view, it is, however, hypothetical, as it assumes an immediate impact of changes in indirect taxes on prices. The methodology ignores the time delays. Furthermore, in reality, an increase in VAT rates can make the sellers increase the prices of goods and services to a lesser extent than it results from the increase in rates, due to the competition on the market. Hence, the HICP at constant tax rates helps to identify the potential impact of tax changes on product price index, setting its upper limit.

In the modern economy, the state (government) has limited impact on prices. This impact, however, is possible through the use of administered prices and changes in indirect taxes. The experience from the last crisis shows that changes in indirect taxes in some countries shaped, to a large extent, the growth rate of prices. It resulted in increased or decreased inflation, and in the case of some countries in reduced deflation. Reconstruction of the tax system towards an even distribution of taxation between direct and indirect taxes would help reducing inflationary pressures. Limiting the phenomenon of fiscal illusions that occur with indirect taxes would be an additional advantage.