Using sales taxes to mimic monetary policy in a liquidity trap
Monetary policy works by changing the real interest rate. At the zero lower bound monetary policy loses its power, unless it can influence inflation expectations. However inflation expectations for consumers will also depend on the evolution of sales taxes (indirect taxes like VAT). A pre-announced increase in sales taxes will raise expected inflation, and so reduce the real interest rate faced by consumers at the zero lower bound. In this sense changes in sales taxes can mimic monetary policy.
I first wrote about this some time ago (for the record Wren-Lewis, 2000, but some of that discussion is a little dated now). As a result, I thought the (surprise) temporary VAT cut introduced by the UK government at the end of 2008 was a good idea (see here). Thanks to @daniel’s comment on an earlier post, I’ve now read a nice and straightforward paper by Isabel Correia, Emmanuel Farhi, Juan Pablo Nicolini and Pedro Teles, which formalises this idea in a standard New Keynesian model at a zero lower bound.
My original piece on this suggested that a temporary but unexpected cut in VAT, like a temporary increase in government spending, could provide an effective stimulus to aggregate demand for a given monetary stance. But what are the implications for Eurozone countries that are trying to bring down government debt? They are the mirror image: it is not a good idea to use cuts in government spending, or a surprise increase in sales taxes, as a way to bring down debt in a recession. However pre-announced increases in sales taxes work differently.
If the increase in sales taxes is announced but delayed, then this provides a stimulus before the point at which it is increased (as in the UK 2008/9 case). Put simply, people buy before higher taxes raise prices. Furthermore, if the increase in VAT is not permanent (because the intension is to bring down debt), but it is expected to end at a point at which interest rates are no longer at a zero lower bound, then the subsequent deflationary impulse can be counteracted by monetary policy. Of course, a key proviso is that interest rates have to stay at their lower bound when sales taxes are rising – obviously higher inflation will not stimulate the economy if it is offset by rising nominal rates (see here for an example).
This suggests that pre-announced increases in sales taxes could be used as an effective consolidation device that also stimulated demand. The government announces a sequence of increases in indirect taxes, which go on increasing for as long as the zero bound is expected to be a constraint. Once the economy has recovered such that interest rates can rise, sales taxes can then be steadily reduced towards some desired long run level, achieving whatever reduction in debt is required.
This idea is conceptually different from but complementary to the argument I have made before for using taxes rather than government spending as part of a fiscal consolidation programme. That argument was based on consumers smoothing the income effect of tax changes. The above is an additional point about the impact of taxes on inflation, which changes the incentive to consume today rather than tomorrow.
Raising consumer prices via sales taxes increases negative incentive effects on labour supply. The optimal strategy examined by Correia et al is in fact revenue neutral, because it involves offsetting changes in income taxes/subsidies. As indirect taxes rise, income taxes fall (or income subsidies rise). In an environment where there is no need for fiscal austerity, this is the welfare maximising plan. When government debt is excessive, then reducing debt is bound to involve either increasing tax distortions or the suboptimal provision of public goods or transfers for some time. In this case there would be no point in a tax switch: you just raise sales taxes.
When I have asked whether this form of deficit reduction strategy was considered in Ireland, one of the responses was that there was a concern about the distributional impact of indirect tax increases relative to direct taxes. That is a whole different issue, and should ideally be dealt with by different means. From a macroeconomic point of view temporary increases in any taxes that have relatively small income effects because of consumption smoothing, but a significant impact in raising inflation, should be the preferred fiscal consolidation instrument at the zero lower bound.