GST does increase the incentive to save

In a recent Herald article (found on interest.co.nz, where I find it easier to read straight from the screen) Bernard Hickey discusses the increase in the goods and services tax and savings. The article makes a number of good points, but I do not agree with the conclusion.  For my thinking read below 😀

In the article Bernard Hickey makes two exceptional points – points that really need to be kept in mind following the increase in GST and reduction in income taxes:

They are ignoring what is potentially the most damaging impact that will not be compensated for. New Zealanders had NZ$153 billion worth of savings in term deposits, debentures, bonds and savings accounts at the end of December, Reserve Bank figures show. Inflation erodes the purchasing power of all of these assets.

Now keep in mind that the increase in GST isn’t “inflation” in the textbook sense – it is a one-off increase in the price level.  This is a big point for economists.  However, as Bernard says an unexpected (as in when some bought the asset this change was not anticipated)  switch from income tax to GST will imply that people invested in assets they weren’t intending too.  Furthermore, the fact that future consumption is being taxed and previous income (used to buy the asset) was taxed implies that people who own assets/have saved will lose out.

As a result, the switch from income tax to GST is a transfer from people who have saved to people who have borrowed!!!  When making the change, we have to realise that people who have net positive savings have lost from the tax change, while those who are net borrowers have won!

Bernard also states:

One of the great injustices of our tax system is that the government takes tax on the inflation component of interest earnings on savings.

This is true as it implies we are taxing term deposits at a higher effective rate than other assets.  Treating asset classes differently, without some justification, is usually poor policy.

However, Bernard ends with the statement:

The final irony is that one of the aims of the budget was to encourage savings and reduce the incentives to invest in other assets where tax is not paid on capital gains, such as property. This inflation hit does just the opposite.

Now the one off bump up in the price level will have a positive impact on house prices – and it will do so in relative terms (compared to term deposits) given the tax on interest – sure.

However, switching from income tax to GST still does increase the incentive to save.  In essence, taxing consumption more and income less implies that we are now taxing interest at a lower rate than we were previously.  As a result, the gap between what a saver receives and what a borrower pays has been narrowed – implying that there are more situations where mutually beneficial lending can take place.

Furthermore, it is important to think about what saving and borrowing is.  A tax on interest increases the relative price of consumption in the future, by lowering the rate of return.  Cutting the tax on interest reduces the relative price of consumption in the future and given that future consumption is equal to savings, we know that such a change leads to proportionally greater savings out of current income!

Cutting income tax and increase GST does the following two things:

1. It transfers funds from people who have saved to people who have borrowed
2. It lowers the tax on interest, thereby leading to proportionally greater savings.

So it does increase the incentive to save – it just has the nasty side effect of hitting those who saved in the past.