Seeking Knowledge Not Hype

"Opinion"

08/29/2010

Paul Munnis


Looking at the threat of further recession one asks what might be a preventative and a cure? There are not a lot of options open to us. The Federal Reserve wants to buy up more American debt thus creating strength in our currency. A stronger currency will be of help to us but will stress the global economy, especially Europe with its huge debt load and poor investment climate.

One area undergoing close scrutiny right now and engendering debate among economists is the role of taxes in America; especially as they apply to the upper class. Many see the return of taxes to the 2001 pre-Bush level as providing a cushion to help pay down the national debt while others claim it to be a drag on our economic growth. The models that I have seen from the CBO show it will help to narrow the gap but by itself it is not a silver bullet that will solve American debt matters.

My opinion is that the debate and the urgency to do something about the economic stall are propelling us towards a fast path to adopt a “Value Added Tax.” This will return the American Corporation towards paying a larger share of the tax burden while combined with a Pay-As-You-Go legislative ethos then that should return our economy to the performance profile of a pure market driven engine and still be progressive at the same time.

I could be wrong of course too and so what I am seeking is someone that has created econometric models that cycle the three scenarios and can disclose to us which is the optimal solution.

It is unconscionable that such models are not being publicized to give us quantitative answers to our dilemma. By not quantifying these matters it is left in the hands of economic and political dispute when it is actually a matter of quantitative analysis and choices.

Where are the economists when they should be delivering to us answers instead of opinions? Where are the University Professors and the Think Tanks when we need them? Why isn’t the CBO further enlightening us?

All seem on holiday at a most crucial time in American history.

When I search the Internet for answers I find that the British are looking at an increase of 20% on the VAT and I suspect that handing more money to government merely encourages it to be spent by government and it then creates demand for more and more money and that one could get onto a tread-mill of unintended consequences. But frankly I do not have an econometric model to support my suspicions.

In Britain they do have an econometric model and they have executed it with the following findings of the consequences of a 20% increase in the existing tax rates:

• At 17.5% the UK currently has the lowest standard rate of VAT and the only 0% rate on food of any major EU member state - Norway, Denmark, and Sweden pay 25%, while the European average currently stands at 21.3%1
  
  
• Impact on consumers: A VAT increase to 20% would cost each of the UK’s 26.2 million households an extra £1.16 per day or £425 a year, reducing spending power by an average 1.25% per annum and increasing the annual VAT bill by 13.9%
  
  
• Impact on the retail sector: The retail industry employs 3 million people and accounts for 25% of national GDP - a slowdown in the sector could lead to a further 0.5% decline in economic growth over a twelve month period
  
  
• Benefit to Government: A 2.5% VAT rise would generate an additional £11.4bn for the treasury, bringing total receipts from the tax to £91.29bn from £80.15bn
  
  
• Hike in price of goods: VAT increase would see cost of petrol rise by 2.5p per litre, cigarettes by 12p per pack, and a pint of lager or a glass of wine increasing by 7p on average
  

Impact on low income groups

• The report finds that the impact of any change in VAT would hit lower income groups most severely, given that they tend to pay above average levels of VAT as an indirect tax on spending.
  
  
• During the last fiscal year, the bottom quintile of earners paid 28% of their gross income in indirect taxes, with VAT payments representing more than 12% of their disposable income. This compares to the average household in the UK which paid 14% of their gross income in indirect taxes, and 7.4% on VAT.
  
  
• High income earners paid 10% of their gross income in indirect taxation and VAT represented 5.9% of their disposable income. However, to put this into context, the top quintile still paid 175% more in VAT than the bottom quintile (£6.6bn compared to £2.4bn).
  

Repercussions for the retail industry

56 of the UK’s major retailers were interviewed to assess the impact that a 20% rate of VAT would have on their businesses. Almost 77% of retailers felt that the impact of a 20% VAT rate on their profits and cash-flow would be ‘very negative’ or ‘quite negative’, and 73% thought that it would have a negative impact on overall sales.

The report estimates that a VAT rate of 20% would raise £36bn from the retail industry including £4.5bn in additional tax, although it would also cut retail sales growth by 0.64% - potentially leading to a 1.6% reduction in retail staff or 47,360 employees, and resulting in the closure of around 9,480 stores nationwide.

On the other hand, online retailers were less likely to pass on the entire VAT increase and were more positive about the commercial opportunities it presented. E-commerce is forecast to grow by around 12.4% in 2010-11, but this may rise to 15-17% if VAT-induced price increases in traditional stores result in consumers going online. In stark contrast, the report estimates that a VAT increase would reduce growth in overall retail sales to a little over 1%, instead of the projected 1.7%.

Impact on the economy

With the retail sector employing 3 million and providing 24.8% of the UK’s GDP, the performance of the industry is vital to the economy as a whole. The Government’s pre-budget Statement in 2009 forecast growth in real terms of 1.25% in 2010 and 3.5% in 2011. However, the recent announcement from Office of Budget Responsibility (OBR) confirms that this is now unrealistic and 2011 growth is likely to reach just 2.6%2. An increase in the proceeds provided by VAT receipts may increase confidence in the general prospects of the UK economy in the long-term, but in the short-medium term, increasing taxes by £11.4bn could make growth forecasts unrealistic. If consumers follow a combination of reduced and postponed spending following a rise in VAT, the reduction in GDP could be approximately 0.5% over the 12 month period following the introduction of the VAT increase. Furthermore, the impact of higher prices could also lead to an estimated increase in the Consumer Price Index (CPI) of between +0.6% to +0.8%.

Thus I can see the areas of impact and I can also see that the amount of the VAT tax controls the amount of societal impact and that the impact is spread over a large distribution base and thus is not terribly bad for their economy although it is inflationary and it will put pressure on the social welfare component of government.

What I can’t find is a control to manage checks and balances on the future VAT tax for indeed we do want American Business to remain competitive and we do want positive results ranging from an end to the income tax filings to reduction in deficit spending. This leaves me suspecting that there are no controls and that without them then inflation can creep into a VAT taxed society as a function of politics and that is most undesirable.

I also suspect that Britain is seeking solution to the lack of such a check and balance mechanism.

Could A VAT Tax Be Floated?

Perhaps there is a way to float the VAT tax rates so they are counter-cyclic to the economy. That is to say that in time of inflation the VAT taxes increase to cool the economy and in time of recession the VAT taxes ease to heat up the economy; and if such controls were to exist then the consequences to debt levels require a control. Thus borrowing could be permitted in times of high GDP output but restrained in times of recession. Maybe these could be automatic controls and not in the hands of politicians?

Again these are mere suspicions in need of quantification from the use of an econometric model. Such a model would be sensitive to world trade figures and also sensitive to currency exchange rates.

Both Model Surplus and A Vacuum of Knowledge

IBM used to produce such an econometric model and iterate it to produce forecasts valued by banks and fund managers. When Nancy Teeter was IBM’s chief economist she had models that some said were so good then they had the effect of creating a self-full-filling prophecy as a result of their forecasting strength and influence. I am not sure whether IBM still produces such an economic forecast mechanism or not but I suspect they do for they do business around the world and thus need to understand cause and effect relationships to profits. Indeed it’s hard to imagine any multi-national corporation that can exist for long without an understanding of cause and effect of policy to profit. So I will premise that the models exist, that the Administration needs to smoke them out, needs to get them turning with a view towards understanding the consequence of choices open to us and also needs to report the result. Maybe the CBO also needs to get to work and obtain them and start updating them.

A search on the terms: “U.S. Econometric Model” produces a flood of data on macro economic models that exist and could lead to economists using them to in effect create grid-lock by implying that your data sucks and that I have the facts to prove it. We can’t progress with modeling wars. We need an official best-of-breed model that we can all trust and agree upon. I think that is the job of the CBO and I think they need to produce it soon for use.

Conclusion

We are needlessly living in a mushroom factory where we are being kept in the dark and fed manure. This must end if we are to have recovery of this economy.