Automatic smoothing with VAT/GST?

Via the Money Illusion I see that there is a suggestion to make consumption taxes an automatic stabiliser for a given economy.

Russ Abbott, who is a computer science professor at Cal State LA, sent me an ingenious plan for having the Fed use fiscal policy to stabilize the economy.  It involves sales tax rebates when times are bad and tax surcharges when times are good.  It would be easiest to implement in an economy that already had a VAT, and/or state sales taxes.  I see it as analogous to my proposal to makes cyclical adjustments to the employer-side payroll tax rate.  These plans tend to work best when the central bank is targeting inflation.  Of course an even better policy is to directly target NGDP expectations.

The entire paper is only 2 pages, a model of clarity and concision.

I can not access the article, so just have to discuss it in terms of a concept.  It also remember that the RBNZ has discussed the issue before, but I said this on the blog before I got into the habit of hyperlinking everything … I will find a link at some point.

The way I see it, expectations regarding the relative price of consumption now to future consumption are incredibly important – which is why we need to think about these very issues in terms of expectations.  This raises four things to keep in mind when thinking about a proposal like this:

1. How do we determine the cycle,
2. what timing is there between data on the cycle and when the tax change occurs,
3. Given information about what the cycle is, and regarding any lags in timing, what does the change in VAT/GST do to relative prices for consumption in current and expected future periods,
4. Is this necessary with inflation targeting?

So, in answer to point 1 we would determine that we are on the upswing of a cycle when we are a certain % above some trend per capita – it may not be perfect, but it works in an operational sense.  Very good.

In answer to point 2, we would know whether we were above this point with a lag of about a quarter (three months) in New Zealand.  A similar lag would likely exist overseas, as they wait to have sufficient data finalised.

So, when it comes to forming expectations, people in the economy will already know if we are near a point where the consumption tax is going to be hiked (due to this being a some cycle), and they will have partial data from other economic indicators for the three months after the end of this quarter – as a result, if it seem sufficiently likely that taxes are going to be hiked, consumers will foresee it and lift their consumption now.  Similarly, on the downside if people start to expect that a cut in VAT/GST will happen at a near time in the future (due to expectations of a downswing) people will cut consumption now.

In other words, by making the level of VAT/GST depend on the perceived point in the cycle we are at, we make any expectations of a downturn or upturn self reinforcing.

However, this is not the full impact.  When activity is below trend, then consumption taxes will fall, when activity is above trend they will rise.  Although the timing does cause some cyclical elements, the existence of the tax would likely smooth out the magnitude of any underlying cycle that happens to exist in economic activity (if the cycle is sufficiently larger than the deviations from trend that are targeted with the change in VAT) – in many ways it can be justified in the same way as an interest rate target for smoothing economic activity, as both involve changing the relative price of consumption based on where we are in the economic cycle.

Do we need this

Well no.  With inflation targeting, we have a natural built mechanism for dealing with cyclical changes in economic activity.  Furthermore, without having to rely on some arbitrary trend estimate we don’t have to worry about a supply shock knocking the fiscal position into a perpetual deficit/surplus.