Home > Economics > Is it the VAT?

Is it the VAT?

A commenter ‘Alex’ over at Interfluidity directs me towards Paul Krugman, debunking the idea that the UK inflation has been worse than the US when you take into account the change in VAT. Here is the graph Krugman shows:

But what happens if you extend this graph back to 2009*:

What you have to remember is we initially cut VAT before we increased it (and had stimulus before we had austerity). And so you can see my point about how to interpret the recession as a whole. Many thanks to all those who have made comments and provided links about debt dynamics. I will read, ponder and get back to you. But for now I’m sticking to my contention that (given tracking NGDP with the US) the UK experienced a real as well as a nominal shock. As Steve Waldman has pointed out in the comments below at my previous post, the effect this would have on real wages would exacerbate the problems caused by a desire to deleverage on the part of UK households, and of course these two stories are not mutually exclusive.     

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*File under: Department of Yikes

Categories: Economics
  1. asdasdasd
    April 29, 2012 at 1:17 pm

    Sure, CPI-CT was high in 2009, but why is that important?

    All that shows is that Darling’s 2009 VAT cut allowed the BoE to keep monetary policy easier than it otherwise would have been (you don’t hear many people arguing that monetary policy was too tight in 2009, after all headline CPI hit 1.1% in August 2009.)

    So in 2009 looser fiscal policy (lower VAT) allowed more expansionary monetary policy, both monetary policy and fiscal policy were acting in the same direction.

    In 2010 and 2011 there have been a series of tax rises that have raised headline CPI. In 2010 headline CPI was above 3% for the entire year. But as your chart above shows, CPI-CT was below 2% for whole of 2010. So in the counter-factual universe in which Darling did not raise taxes, headline CPI would have been much lower and so monetary could have been more expansionary.

    In 2011, Osborne increased VAT again, so headline CPI remained above the BoE’s 3% upper limit.

    But in the counter-factual universe in which Osborne did not raise VAT, the BoE’s monetary stance would have kept headline CPI at 2%+-1 for all bar 3 months of the period.

    Monetary policy was tighter throughout 2010 because of tax rises to address the deficit. Tighter fiscal policy caused tighter monetary policy. This is exactly the opposite of what would have occurred had the Chancellor decided to increase income taxes or limit transfer payments. So two ways of changing government spending, of equal magnitude, can have very different effects on the monetary policy target, and on the monetary policy reaction.

    Does it make sense for a central bank to target headline CPI? Mankiw implicitly argued against this a decade ago. By targeting headline CPI, the central bank is forced to react to one time changes in the price level that are due to tax changes. Are there any models of central banking that suggest this would be a good idea?

    Even if the BoE uses discretion, and ignores tax induced price rises, and allows CPI to rise above their target, they will still be judged in the media against their 2% target. The BoE is getting a lot of bad press, but most of it says that monetary policy is currently too loose, very little argues that monetary policy was too tight in 2008-2010.

    p.s. when I say VAT I mean all consumption taxes subtracted to calculate CPI-CT. To my knowledge this does not include payroll taxes, which were also increased by Osborne, so even CPI-CT will include price rises that, in the counter-factual “no tax increases” universe would not have occurred. I.e. your graph above understates the true difference between actual headline CPI and CPI given no tax rises.

    Thanks for the posts, they are way more thoughtful than most of the analysis of monetary policy published in the press.

  2. david
    April 29, 2012 at 1:56 pm

    If you want to contend that there was a real shock, identifying one is not difficult: the economy of the City is heavily involved in finance.

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