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, firms pass most of the higher tax on to consumers, so the prices of most goods and services rise.
indirect tax · incidence
indirect tax · incidence
Assumes: Firms pass the tax on in full.
But: Where demand is price elastic or competition is fierce, firms absorb part of the tax in lower margins.
2
This means the general price level rises and measured CPI inflation jumps, as when VAT rose from 17.5% to 20% in January 2011.
cost-push inflation · CPI
cost-push inflation · CPI
Assumes: Many goods carry the standard rate.
But: Food, children's clothes and books are zero-rated, so the rise in CPI is smaller than the change in the rate.
3
Consequently, annual inflation is higher for twelve months, then falls back once the rise drops out of the year-on-year comparison.
one-off rise in the price level
one-off rise in the price level
Best link to attack
Assumes: There are no second-round effects.
Assumes: There are no second-round effects.
But: If workers win higher wages to make up for the price rise, firms raise prices again and a wage-price spiral can make the inflation last.
4
At the same time, higher prices cut real incomes, so consumption and AD fall, easing price pressure later on.
real income
real income
Assumes: Households cut spending.
But: Households may run down savings to keep spending, so the fall in AD is small.
End
Inflation rises temporarily.
Evaluation chain
- E1However, whether inflation stays higher depends on whether the one-off price rise triggers second-round effects.
- E2If workers expect prices to keep rising, they bargain for pay rises to protect their real wages.
- E3As a result, firms facing higher wage costs raise prices again, and the higher inflation feeds on itself.
- E4So the VAT rise has only a temporary effect on inflation as long as inflation expectations stay anchored, for example because the Bank of England's 2% target is credible.
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Questions this answers
- Explain how an increase in VAT might affect the rate of inflation.
- Assess the macroeconomic effects of raising VAT.
- Discuss whether an increase in indirect taxes is an effective way to reduce a budget deficit.
Diagram
AD/AS: SRAS shifts left, so the price level rises and real output falls.
Reverse and related
VAT cut → prices fall for a year → inflation temporarily lower (as with the 2008 cut to 15%).