Flat Rate VAT on All Goods?

A number of necessary goods in the UK have zero VAT and an analysis of applying a flat rate of 20% tax on such commodities should be conducted in terms of welfare. A value added tax [VAT] is a percentage tax on value added at each stage of production. However, price elasticities of demand of such commodities, which is the absolute value of the percentage change in quantity demanded to the percentage change in price (Rosen and Gayer, 2014), ought to be taken in consideration to assess improvements in efficiency and greater inequality. A Pareto improvement in welfare can occur if there is some action that can be taken to improve the utility of one individual without worsening the situation of the other. Efficiency, in this context, would refer to the loss of welfare above and beyond the tax revenues collected or the excess burden.

Imposing a VAT would cause a shift of the supply curve from  S to S1, which would then change the equilibrium point of the market from (Q*, P*) to (Q1, P1). This occurs for both figures 1 and 2. However, the efficiency differences reside within a lower deadweight loss when demand for the commodity is inelastic when compared to the demand being elastic. The deadweight loss is indicated in the shaded area of the triangle. A price elastic demand for a commodity would create a bigger behavioural response to the tax as a result of a larger decrease in quantity demanded in figure 2 compared to figure 1. Consumer tax burden in figure 1, of an inelastic demand would, however be larger than the producer’s, this is the opposite in figure 2.

Linear and nonlinear commodity taxes attempt to address the progressivity and regressivity of tax policies. Figure 3 presents impacts of different tax systems on income tax paid. As commodity VAT taxes are consumption taxes, they are deemed regressive to lower income households. This is because as the propensity to consume decreases with the rise in income, lower income families spend a larger proportion of their income on necessities and consumer goods (Carlson, 1989, pp. 339). Intuitively, exempting food and necessities is one way to reduce the regressivity of the tax system. However, a study in Japan concluded that even though an exemption of VAT on such necessities under both a tax credit and subtraction method reduced the tax burden across all incomes, it did not reduce regressivity (Tamaoka, 1994). Yet, this argument is weaker when consumption is considered from a lifetime view, if people consume all their earnings at some point in their lifetime (Mirrlees, 2010, pp. 275-422).

Adam Smith’s Four Canons provide a basis into the assessment of changes to the UK taxation of commodities (Rosen and Gayer, 2014). Efficiency in this context would refer to the tax policies ability to enforce small costs of collections and avoid distortionary effects on taxpayers. Measures such as the inverse elasticity rule would regard that for efficient taxation the ratio of the tax rates applied to two commodities should be inversely proportional to their elasticities. The second canon of equity, which attempts to address rising inequality is fairness with respect to contributions. Cross price elasticities are also taken in account through Ramsey’s rule, which states that efficient taxes would be set such that the percentage reduction in the quantity purchased of each good would be the same (Atkinson, 1976).

In production efficiency, it would be optimal not to affect the prices of goods and services used in production—such that there should not be taxes on transactions between producers within a supply chain. Atkinson and Stiglitz (1976) note that it may be better to address equity concerns through the benefit and income tax system, where it exists, than through commodity taxation. This could suggest an argument for the commodity tax system to be neutral, which could avoid the inefficiencies linked with tax exempt goods. Mirrlees Review proposed several reforms to the UK tax system, one of which addressed how broadening of VAT for a flat-rate tax can be carried out in a non-regressive manner (Mirrlees, 2010, pp. 216-230). It was found that applying uniform rates to commodities would increase consumer welfare through a decreased distortion of their spending choices. Although its reform package would raise the cost of living, certain compensations through the direct tax and benefit system would be distributionally neutral and would not worsen work incentives.

A Hall-Rabushka flat tax is, in essence, a modified VAT, yet takes advantage of its administrative convenience. It would comprise businesses paying a flat rate VAT on their sales minus any purchases from any other firm and also subtracting their wage payments to employees. There would also be a family-level exemption, which would allow for some degrees of progressivity, yet raising the same amount of revenue as a standard VAT would. An important element is that capital income and corporation profits are not taxed (Rabushka, 1985). It has strong investment incentives considering consumption taxes do not put taxes on investment.

Atkinson and Stiglitz (1976) work on uniform commodity taxation suggests that upon the possibility of the government redistributing income through income taxation, and if the “utility function is weakly separable between goods and leisure”, then commodity taxes to be optimal should be uniform. Production efficiency findings by Diamond and Mirlees (1971) contribute to these findings in a way that suggests a progressive (non linear income taxation system) is enough for inequality measures and redistribution. Governments should keep the commodity market efficient. However, a reexamination of these studies presents that if the production side of an economy is taken into consideration, a Pareto improvement in welfare is still possible under nonlinear commodity taxation and a nonlinear income tax system (Naito, 1999). 

Assessment of tax commodities in the UK may not only reside within its impacts on welfare in terms of its price elasticities but also in terms of efficiency. Hall Rabushka and reforms in Mirrlees Review provide some possible implementations to decrease the regressivity of current tax systems. Their findings are supported by Atkinson and Stiglitz, yet, may lack further research into the role of production efficiency in commodity taxation.

References

Atkinson, A., & Stiglitz, J. (1976). The design of tax structure: Direct versus indirect taxation. Journal of Public Economics, 6(1-2), 55-75. doi:10.1016/0047-2727(76)90041-4

Diamond, P., & Mirrlees, J. (1971). Optimal Taxation and Public Production I: Production Efficiency. The American Economic Review, 61(1), 8-27. Retrieved January 11, 2021, from http://www.jstor.org/stable/1910538

Carlson, G., & Patrick, M. (1989). ADDRESSING THE REGRESSIVITY OF A VALUE-ADDED TAX. National Tax Journal, 42(3), 339-351. Retrieved January 11, 2021, from http://www.jstor.org/stable/41788804

Naito, H. (1999). Re-examination of uniform commodity taxes under a non-linear income tax system and its implication for production efficiency. Journal of Public Economics, 71(2), 165-188. doi:10.1016/s0047-2727(98)00052-8

Mirrlees, J. A. (2010). Broadening the VAT Base. In Dimensions of tax design: The Mirrlees review (pp. 216-230). Oxford: Oxford University Press. Retrieved 2021, from https://www.ifs.org.uk/mirrleesreview/design/ch9.pdf

Mirrlees, J. A. (2010). Value Added Tax and Excises. In Dimensions of tax design: The Mirrlees Review (pp. 275-422). Oxford: Oxford University Press. Retrieved 2021, from https://www.ifs.org.uk/mirrleesreview/dimensions/ch4.pdf

Rabushka, A., & Hall, R. E. (1985). The route to a progressive flat tax. Cato Journal, 5(2), 465-480. Retrieved 2021, from https://www.cato.org/sites/cato.org/files/serials/files/cato-journal/1985/11/cj5n2-6.pdf

Rosen, H. S., and T. Gayer. 2014. Public Finance. 10th ed. Maidenhead, UK: McGraw Hill Education.

Tamaoka, M. (1994). The Regressivity of a Value Added Tax: Tax Credit Method and Subtraction Method – A Japanese Case. Fiscal Studies, 15(2), 57-73. doi:10.1111/j.1475-5890.1994.tb00197.x

Arman ZavaryanLeave a comment

Lockdown vs. No Lockdown

The ongoing pandemic has brought concern over whether or not certain policies should be implemented to combat the growth of COVID-19. Certain textbook and classical economic measures have been used as a benchmark to evaluate the effectiveness of a lockdown across Europe and most of the world. While some such as Norway and Sweden differ in the way they have enforced these policies, the evidence is clear that more research into the trade-offs between economic activity and health should be conducted.

A cost and benefit analysis [CBA] of a lockdown in terms of welfare would have three implications (Rosen and Gayer, 2014). One of which would interpret costs and benefits as social costs and benefits. Appropriate social prices would be taken in consideration as it may not be the same as a market price, however, as it is apparent with the lockdown, there may be no specific price to begin with. Lastly, it is vital to identify an appropriate discount factor, yet this is clear that doing so for a national lockdown, isn’t so practical. The group of individuals that are clear to ‘lose out’ from a lockdown are the younger generation and those who are less vulnerable to the COVID-19. This is due to certain losses of liberty and even employment opportunities. Those that are struggling within quarantine confinements, or are experiencing increases in domestic violence, or depression are also part of that group. On the contrary, vulnerable groups who are mostly the elderly or those with preexisting conditions are benefiting from a lockdown.

A CBA should be considered under a “with” or “without lockdown” manner rather than “before” and “after lockdown” to ensure correct features are captured. Any economic costs of a lockdown should be taken in comparison with alternative policies (Harford, 2020). In other words, alternative measures should be compared in a time frame where the “fear” of the virus already existed, as to make this the status quo—this is what Wren Lewis was attempting to elaborate (Lewis, 2020).

Figure 1: Policy Frontiers of Lockdown and Relevant Measures (Initiative, 2020)

Figure 1 depicts policy frontiers and bundles in which a government can choose between welfare preserved against lives saved. Any movement to the right of the policy frontier shows an improvement in the policy proposed, and vice versa. This presents policy makers with a “menu of policy options”. Although it quantifies the relative better bundles of each frontier and their constraints, the model doesn’t take into account [VSL], the value of a statistical life. This is in order to determine not only consistency in the decision-making process of better policies but also respective desirability of different points on the frontier (Initiative, 2020). The concept of VSL is incorporated into OECD economic policy analyses as a measure to determine the benefit of relevant measures, and the amount the society is willing to pay in order to prevent an infection (Coast, 2020).

Tim Harford (2020), states that, “if an economic lockdown in the US saves most of these (2 million) [vulnerable] lives and costs less than 20$tn, then it would seem to be value for money”. The usual approach resides within focusing on the valuation of lives that are “statistical” or unknown. However, this may not hold in policies relating to COVID-19 because of the different effect it contains towards varied age groups. Lockdown as a policy, has impacts, “on lives and life expectancy more broadly across the population”. Therefore, the value of a statistical life year [VSLY] than simply a VSL can help address these distributional factors. This, in return, might alleviate weight in terms of importance to policies preventing COVID-19 deaths and more significance to policies that target the general population’s health instead (Coast, 2020). Covid-induced uncertainty in the market causes loss of business confidence, which in return impacts consumption and investment components of GDP (Baker, 2020). CBA analysis may, in tangency, also address implications in the contribution of an individual’s life to GDP growth. It may be perceived that the younger distribution, those who are less vulnerable, may consume more and therefore increase economic growth. However, this wouldn’t then support the aims of a social welfare economist, that doesn’t measure success through increases in gross national income (Initiative, 2020). 

Intuitively, it is possible to say that those who benefit and those who do not can be both compensated through the fact that lockdown measures prevent them from infecting one another. While one is better than the other, the second person may be compensated through an increased likelihood of a healthy life. Is it possible to use VSL to assess the benefits and compensations of those who lost out? A simulation by Adler (2020), attempts to determine whether or not the use of social distancing policies can prevent fatalities caused by COVID-19. Under 3 versions of VSL, it is clear that social distancing measures (with lockdown) would be better than the status quo (without lockdown). However, flawed guidance in the use of VSL-based CBA proves methodological deficiencies. VSL-based CBA can deviate from the Kaldor-Hicks criterion as the approximation of an individual’s willingness to pay becomes larger as a change in fatality risk from a given policy increases. Therefore, such methods used to assess policies that involve significant changes to a person’s risk, are favourable to policies that are not Kaldor-Hicks efficient (Adler, 2020). 

Due to the high degrees of uncertainty and complexities, some economists now believe that a full CBA is not the most appropriate measure of analyzing lockdown measures. Instead, it is believed that it is more efficient to adopt the approach to recognize the key trade-offs between the two extreme outcomes as a method to guide public policy. In this way, the compensation may be more vivid and visible to the general public, reducing the uncertainties that arise from the ‘fear’ of the virus. Some interventions discussed include workplace rotation schemes, subsidized workplace testing and even reopening schools (Initiative, 2020).

While classical CBA provides a benchmark into analyzing lockdown measures to address the spread of COVID-19, such as in a “with” or “without lockdown” manner, methodological changes should be optimized to further enhance the credibility of an assessment’s findings. Time as a constraint, a combination of different policies could be the future to sustain not only the health of the general public but also the economy.

References

Adler, M. D. (2020). What Should We Spend to Save Lives in a Pandemic? A Critique of the Value of Statistical Life. SSRN Electronic Journal. doi:10.2139/ssrn.3636550

Baker, S., Bloom, N., Davis, S., & Terry, S. (2020). COVID-Induced Economic Uncertainty. doi:10.3386/w26983

Coast, J., & Sanghera, S. (2020, October 5). Valuing statistical lives: How should such metrics inform pandemic policy-making? Retrieved 2021, from https://www.coronavirusandtheeconomy.com/question/valuing-statistical-lives-how-should-such-metrics-inform-pandemic-policy-making

Harford, T. (2020, April 3). How do we value a statistical life? Financial Times. Retrieved from https://www.ft.com/content/e00120a2-74cd-11ea-ad98-044200cb277f

Initiative, T. (2020, August 14). Economic Aspects of the COVID-19 Crisis in the UK. Retrieved January 11, 2021, from https://rs-delve.github.io/reports/2020/08/14/economic-aspects-of-the-covid19-crisis-in-the-uk.html#fnref:2

Lewis, S. W. (2020, June 15). Fear of coronavirus, not lockdown, is the biggest threat to the UK’s economy. The Guardian. Retrieved from https://www.theguardian.com/commentisfree/2020/jun/15/coronavirus-fear-lockdown-recession

Rosen, H. S., and T. Gayer. 2014. Public Finance. 10th ed. Maidenhead, UK: McGraw Hill Education.

Arman ZavaryanLeave a comment