The Economics of the German VAT Hike

I am very happy to be back here at AFOE, if not only, for a brief one-stop guest post about the economics of the German VAT hike and more specifically how market commentators and analists might just be reading the German economy somewhat falsely at the moment in the sense that they are not taking into account the implications of the sustained and evolving process of ageing in the German society. Indeed as Edward noted just a few days ago here at AFOE we might actually be talking about a clash of paradigms or at least a clash between two ways of looking at and interpreting the economic data coming out of Germany and indeed of the entire Eurozone. There are consequently many venues on which this diagreement is fielded and an important one of these is the German economy and more specifically the significance of the VAT hike and below the fold I will give my view on this topic.

The German VAT Hike

I think the first important point here is to note the underlying reason as to why the VAT hike (16%-19%) was enacted in the first place. As such, the need to get the federal budget in order is primarily, I would argue, driven by the ongoing changes in the German society as a result of the process of ageing as the old age dependancy ratio increases and the labour force decreases. More practically of course the fiscal demands of monetary union are of course more imminent as an impteus. However, ageing costs and as an economy with expensive embedded pension and health care schemes like Germany’s you have to generate income and change the strucure of if the government receipts relative to the economic structure and reality.

However, what we really need to talk about here is the (expected) reponse by the German economy towards the VAT hike and here there has been much debate amongst market and economy commentators. A recent piece in the FT mirrors this as it notes how the VAT gamble has paid off. What underpins this statement is the perceived notion that the VAT hike was suppose to speed up inflation as companies passed on the tax hike to consumers. The fact that this does not seem to be the case is taking to heart as evidence that the Germany recovery is strong and longlived as ever. In essence the relationship between a rise in value added tax and inflation is not easy to discern in a German context but looking at the inflation rate figures from 2006 in Germany it the inflation rate is not exactly worrying I would argue. Based on my rough calculations of the y-o-y figures the annualized core inflation rate in 2006 should come in around 1.7%. Turning to the monthly inflation fluctuations and thus the notion of how consumers would push forward purchasing of durable goods to escape the VAT hike before January 1st 2007 the inflation figures only show partial signs of this phenomenon. In the last two quarters (Jul-Dec) of 2006 the core inflation rose at an average of 0.15% a month but with a notable rise in December of 0.8% relative to November which at least to some extent merits the notion of forward pushing of purchases. However, the perplexing question remains here in my opinion? Why should we expect the VAT hike to be inflationary in the first place? I mean consumer confidence continues to constitute the ever missing link in the Germany recovery and on the back of the persistently sluggish data on consumer confidence and spending why should we not in fact expect the VAT hike to be somewhat deflationary in the sense that this should only deter consumers more from shopping? Or is it indeed as many are claiming that the German economic recovery indeed is so strong that the VAT shock as it has been desribed has been well weathered by a strong German economy are we indeed witnessing what many commentators have been referring to as a goldilocks recovery?

Deflation Anyone?

Actually, economic theory might help us a bit here. Consequently, students of applied microeconomics learn to distinguish between the point of impact and point of incidence of a tax. The former constitues the party who actually levies the tax towards the government whereas the latter denotes the party who actually supports the tax. In the case of a value-added tax (an indirect tax) the point of impact would then be the consumer who (through an intermediary; e.g. a retailer) levies the tax towards the government. However, it is much more interesting in this case to discuss the point of incidence of the tax that is who actually supports the tax. In order for us to do so we need to introduce yet another economic concept, namely supply and demand elasticities of the tax hike. Consequently, the party with the highest relative elasticity (i.e. flexibility) towards the tax will also avoid supporting the lion’s share of the tax increase. What this means in the concrete case of the German tax is of course very difficult to asses. Yet, since for example consumers’ demand elasticity in this case can be operationalized as the relative fraction of disposable income which is consumed and saved (i.e. the MPC and MPS) we might actually be able to sketch a framework which suggests why the VAT hike in fact should not have been expected to rapidly push up inflation in the first place. The point would then be that the consumers’ demand elasticity towards consumption and thus flexibility towards avoiding the tax relative to businesses would be positively correlated with the marginal propensity to save. In essence, the higher the MPS the more likely it is that consumers choose to spend less relative to the increase in prices as a result of the VAT hike and as such the businesses will support lion share of the VAT hike thus resulting in relatively less inflation than was first expected. In fact, we should perhaps ask whether in fact not the VAT hike could have a deflationary impact as the decline in consumption as a result of the VAT offsets the increase in prices thus pushing inflation down. Remeber the inflation figures cited above which are not exactly signs of rampant inflation. As such, I am inherently sceptical about the ‘rule-of-thumb’ calculations suggesting that the VAT hike would increase German inflation by as much as 1.4 percentage points, this figure has later been downgraded to about 0.7 percentage point. Once again, the relationship between the MPS and MPC is important and also crucially is the evolution of this relationship and I think this has not been adequately accounted for in this case.

And now as they say the plot thickens and the gizzilion Euro question is subsequently mounting because what are in fact the structural drivers of the evolution of the marginal propensity to consume and save in a German and indeed more general global context? I am sure you now have some kind of idea of where I am going with this and although demographics indeed are not destiny we should not I think neglect the importance of this in this concrete case. As such the hypothesis about how the life cycle component affects consumption and savings behavior as an economy ages serves as an important entry point to argue that we migth need to look at this differently in the German case where the population after all is one of the oldest on the planet and moreover further rapidly ageing. In the German case however there migth be other factors in play in terms of perhaps a relatively high degree of consumer scepticism and thus consumer risk aversion which is reflected in a somewhat high structural propensity to save.

What I have offered above cannot hardly be said to be en empirically founded economic analysis but that does not in my opinion make it any less pertinent. My point is that the recent debate on Germany’s economy and how the recovery is strong as ever and furthermore how the VAT hike would largely be shrugged off misses some important points. First of all is the question on inflation and where commentators are hailing the lacking inflation as a result of the VAT hike as a sign of a broad based economic recovery I am a bit worried. I am worried because the lack of inflation as a result of the VAT hike shows to me that consumer spending in fact risks becoming very depressed in 2007. Indeed, I am now more worried that Germany will see a more sustained dip in inflation as oil prices recede and the ECB stays hawkish. What underpins this worry is that the last thing Germany needs at this point in my opinion is deflationary pressures in the domestic economy as it will only further push Germany’s growth path into one structurally tied up in the export sector. As such, we should also remember here that the German growth path already is driven by exports which accounted for two thirds of growth in the economy from 1999-2005 and as such I think the German economy is beginning to look increasingly more like Japan with the notable exception of course that Germany will have to endure a hawkish ECB on the top of it all. As such, I fear that the ECB’s single-interest rate policy will exacerbate Germany’s (and Italy’s) structural transition into a growth path driven largely by exports and where the domestic economy becomes detached and bypassed from contributing markedly to growth. My view is of course anchored in a somewhat long term perspective but what perhaps worries me the most in a general sense is the lack of awareness of this issue.

10 thoughts on “The Economics of the German VAT Hike

  1. So, tax hikes are good for the economy.

    That the German economy was able to absorb the, by any standard, does indeed show the resiliance of that economy…. but the argument cannot be used to say that high tax rates are good for the economy, quite the reverse.

    Do you really think deflation is a remote possibility… certainly not with these tax rates.. stalling of the economy is much more likely.

    I cannot trust any notion that proposes high tax rates are a good thing – perhaps a necessary evil for a short time, but do not ever suggest that this is or ever should be the normal state of affairs – high taxes, in all quarters are ruinous, and only belong in decrepit socialist states that cannot manage their economy.

  2. Hi Bryan,

    I don’t think I ever said that tax hikes were necessarily good for the economy neither in general nor in the specific case of Germany. However, as you say yourself tax hikes can be a necessary evil and in Germany’s case this is where we are at I am afraid. As I point to there are two imminent reasons; the first is that Germany needs to abide to the fiscal demands of monetary union and secondly the sustained process of ageing is putting the German government budget under strain. In this sense you can do a number of things and one of the things is to impose tax hikes in order to finance the increased cost burden as a result of the increasing old age dependancy ratios.

    ‘Do you really think deflation is a remote possibility… certainly not with these tax rates.. stalling of the economy is much more likely’

    I am not sure I agree here, at least not in principle. The point is that the domestic economy migth very well as you say stall as a result of the continuing downtrend of consumer spending and as such the domestic economy could come under deflationary pressures. So why is this a problem? Well, currently the CPI rate in Germany is running along at around 1.7% but the ECB is still vigilant mind you and if I am right in terms of the effects of fiscal tightening where is the floor at this point. Oil prices are of course volatile and will probably go up again but they are also falling at the moment so I am just pointing to the underlying dynamics here which all imho point to a downtrend in inflation rather than an increase.

  3. Hi Bryan,

    I don’t think I ever said that tax hikes were necessarily good for the economy neither in general nor in the specific case of Germany. However, as you say yourself tax hikes can be a necessary evil and in Germany’s case this is where we are at I am afraid. As I point to there are two imminent reasons; the first is that Germany needs to abide to the fiscal demands of monetary union and secondly the sustained process of ageing is putting the German government budget under strain. In this sense you can do a number of things and one of the things is to impose tax hikes in order to finance the increased cost burden as a result of the increasing old age dependancy ratios.

    ‘Do you really think deflation is a remote possibility… certainly not with these tax rates.. stalling of the economy is much more likely’

    I am not sure I agree here, at least not in principle. The point is that the domestic economy migth very well as you say stall as a result of the continuing downtrend of consumer spending and as such the domestic economy could come under deflationary pressures. So why is this a problem? Well, currently the CPI rate in Germany is running along at around 1.7% but the ECB is still vigilant mind you and if I am right in terms of the effects of fiscal tightening where is the floor at this point. Oil prices are of course volatile and will probably go up again but they are also falling at the moment so I am just pointing to the underlying dynamics here which all imho point to a downtrend in inflation rather than an increase.

  4. Claus,

    What I’m missing in your and Edward Hugh’s analysis is the causal link. Why exactly would an ageing population have a higher marginal propensity to save and a lower marginal propensity to consume? As far as I can see, the low consumption rate of the German economy might more plausibly be caused by the long period of rather extreme wage moderation (people didn’t get more money, so they didn’t spend more), with an added contribution of economic uncertainty caused by the (until very recently) high unemployment rate and increased volatility on the labour market. I haven’t investigated the problem at great length, so perhaps you could explain if and why these don’t suffice as an explanation.

  5. Germany hasn’t yet aged to being a nation of retirees: it has aged (median age 42) to being a nation of people who are thinking about retirement, a nation in which much of the earnings that are being paid are being paid to people who rationally expect to be earning less in the future than they are earning today, and so are saving them.

  6. _’What I’m missing in your and Edward Hugh’s analysis is the causal link. Why exactly would an ageing population have a higher marginal propensity to save and a lower marginal propensity to consume?’_

    Ok, this is important and obviously it is difficult to quantify totally. However, there is a fairly strong theoretial foundation to be found of this in Modigliani’s life cycle hypothesis on savings and consumption. In fact, life cycle theory which deals with income and saving decisions of individuals during their life time is the key theoretical instrument here. Basically it stipulates as Cyrus emphasises that elderly people tend to save more than in their younger years.

    So what I am in fact arguing is indeed a bit like Cyrus is describing it. However, I don’t think Edward and I are fundamentalists 🙂 and there might be a lot of other reasons as to why people tend to (all things equal) save more or perhaps even to save ‘excessively’ from a macroeconomic perspective. What you say about Germany and wage moderation might indeed be an explanation as well. But we also need to think about how consumption is financed these days and debt is an important issue here and since modern capital markets (with great differences though) allow people to consume on debt in the ‘young’ years we might expect some volatility in the life cycle behavior with a more heavy relative bias towards saving as a country ages.

    Another thing about ageing and its impact countrywide and indeed globally from a life-cycle perspective is that this in fact is a global phenomenon and crucially that no-one knows how far this can go. This of course brings us right smack into Alex’ point and I think this indeed will become an issue at some point but as always it is the path up until this point which is important and it is here that we argue (Edward and I that is) that the life-cycle component of saving and consumption is important.

  7. “One would think, after all, that the retirees would be dissaving, not saving.”

    Well this is an interesting point, obviously.

    Firstly there is the interesting detail that Milton Friedman (now I know you don’t like him Alex, but just bear with this pragmatic point) modified Modigliani (who the perspicacious will realise was a Keynesian) by incorporating a bequest motive element, so this to some extent explains saving mania.

    But there is another point here, relative generation size and relative wealth.

    Now on the generation size, the think generations are the boomer ones, and they are just coming up to retirement, so they outsave everyone else really.

    Secondly, each generation is richer than the one before it (or has been up to now, I need to be careful here I think), so obviously the 55 – 65 age group is saving of a rather bigger income base than the 75 – 85 generation may be dis-saving off.

    So this is what we have at the present, but given that the younger generations are both going to be asked to do some forced saving (in the form of Vat and other taxes to pay for the old paygo systems) and be asked to save for themselves in the new pension schemes, one way or another a lot of saving is likely to be going on, and of course this is what we are seeing in the data.

    So it isn’t exactly as if Claus and I are shooting arrows into the void here, we are providing an explanation for (or account of) the existing data. Plausible? That is for you to decide, but I’d like to here some alternative accounts to make a comparison of plausibility.

    Incidentally Alex, your view is what everyone was imagining was going to happen. All the models through to 2050 incorporate this idea, and it may happen, but first we need to think about what happens between now and 2050, this was the point about Keynes’s in the long run we’re all dead bit, you need to thing abbout the short and middle runs to be able to get through to the long run.

  8. “As far as I can see, the low consumption rate of the German economy might more plausibly be caused by the long period of rather extreme wage moderation (people didn’t get more money, so they didn’t spend more)”

    Incidentally Nanne, this is a fair point. Since this debate is now moving along at a fairly rapid clip, and beoming something a bit more serious than a simple amicable dispute between bloggers, I think Claus and I do need to define our terms a bit better.

    What we have is a hypothesis, and obviously there are rival hypotheses. You mention one, which is normally termed the global labour arbitrage theory.

    Clearly nothing yet is irrefuteably demonstrated.

    What Claus and I are drawing attention to are a number of interesting empirical correlates. We are not simply talking about Germany here. The situation in Japan is also now pretty clear, and it is becoming reasonably clear in Italy. Finland may be going the same way, and Switzerland could be another case. Now what all these countries have in common is their comparatively high median ages.

    Switzerland is an interesting example since it is also becoming a source of the carry trade due to the low interest rate environment which is a by-product – as in the Japanese case – of the weak internal demand issue. What is the carry trade you may ask? Well see Claus or Brad Setser’s blogs for this, and I will try and post something here later in the week.

    Now, what Claus and I do have is a theoretical model which offers a causal explanation, and then we have empirical backing in the data. This isn’t a bad start for a hypothesis I feel.

    The global labour arbitrage hypothesis could handle most of the phenomena I have mentioned, but what I feel it cannot handle is why other countries (which just happen to have rather lower median ages) don’t experience the same effect. The reason why they don’t have the effect is essentially due to the fact that people are much more prepared to borrow in these societies – the US, the Uk, France, Ireland, Spain etc – yet they are exposed to exactly the same forces on global wages.

    So until this theory can crack this particular nut I would say that Claus and I have it, but then I think at the end of the day this is for others to decide.

    There is one last interesting detail for those of us pursuing the demographic hypothesis, which is the question as to just why we are getting the global labour arbitrage effect at this particular point in time. Basically this is to do with the rise of places like China and India. But why are these countries taking off economically at precisely this moment in time? A complete explanation of the process requires that this topic be addressed.

    Well, of course, we do have some sort of explanation, since we would argue that these countries are precisely in this moment at the stage of the demographic transition where they start to feel the full impact of the demographic dividend.

    This point isn’t accepted at all by, for example, the guys and gals over at the Economist (see last week’s issue), and that is why the debate which Claus and I are forwarding here in Europe is being mirrored by a similar debate which Nanubhai Desai and I are fielding out in India (go see the posts on the India Economy Blog, which are really causing something of a stir in India).

    So if you want to apply something like Occam’s parsimony principle, then we could also argue we have some support in the simplicity and level of generality of the model.

    Of course none of this means we are right. Here only time will tell.