ChainWhat it assumes · how to break it
Start
The government raises the standard rate of VAT, for example from 20% to 22%.
1
As a result, the prices of most goods and services rise, so households' real disposable income falls.
real disposable income · indirect tax
real disposable income · indirect tax
Assumes: Firms pass the tax on to consumers.
But: Where demand is price elastic, firms absorb part of the rise in their margins, so prices rise less, though their profits fall instead.
2
This means households can afford fewer goods and services, so consumption, the largest component of AD, falls.
consumption
consumption
Assumes: Households cut spending rather than use savings.
But: Households may run down savings or borrow to keep up their spending for a time.
3
Consequently, AD shifts left and, through the multiplier, real output falls by more than the first fall in spending.
multiplier · aggregate demand
multiplier · aggregate demand
Best link to attack
Assumes: The government uses the extra revenue to cut borrowing rather than to spend.
Assumes: The government uses the extra revenue to cut borrowing rather than to spend.
But: If the revenue is spent on public services or investment, the injection offsets the withdrawal, so AD may barely fall.
4
Therefore, firms facing weaker sales cut back on investment, slowing the growth of the capital stock and of LRAS.
accelerator · investment
accelerator · investment
Assumes: Firms expect the weaker demand to last.
But: If the VAT rise is part of a credible plan to cut the deficit, business confidence may hold up and investment may fall little.
End
Real GDP growth slows, at least in the short run.
Evaluation chain
- E1However, the fall in growth depends on what the government does with the extra revenue.
- E2If the revenue is spent on public services or infrastructure, the extra government spending is an injection that replaces much of the lost consumption.
- E3As a result, AD falls by much less, and spending on infrastructure may also shift LRAS right in the long run.
- E4So a VAT rise slows growth most when the revenue is used to cut borrowing during a downturn, and much less when it is spent.
Another way to attack it: VAT rose from 17.5% to 20% in January 2011 as part of fiscal consolidation, and UK growth was weak in 2011 and 2012, though the euro area crisis and high inflation also held it back, so the VAT rise alone cannot explain it.
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Questions this answers
- Assess the impact of an increase in VAT on economic growth.
- Discuss whether raising indirect taxes is a better way to reduce a budget deficit than cutting government spending.
- Evaluate the effects of contractionary fiscal policy on real GDP.
Diagram
AD/AS: AD shifts left and real output falls. Some treat VAT as a cost to firms, so SRAS may shift left too, raising the price level.
Reverse and related
VAT cut → prices fall → real incomes and consumption rise → AD and growth rise, as intended by the temporary cut to 15% in December 2008.