VAT Hikes And Ageing Costs

I think anyone, even those with a sceptical view on the importance of demographics, can agree that there have to be ageing costs for any society, and specifically so in a macroeconomic context. . Moreover, as a natural consequence of ageing population economies need to grow and progress if they are to be able to financially support the ongoing demographic transition. We really don’t need to be growth fundamentalists here, but it is abundantly clear that if an economy such as Germany is going to finance its current and rising old age liabilities it needs growth in output (and income); otherwise the system falters.

Of course, in the absence of growth another way to pay for ageing oncosts is through tax hikes, and in this particular context Germany has provided us with a truly wonderful experiment, since a couple of years ago (1st January 2007, to be exact) the VAT consumption tax was hiked 3 % – in part to try to secure the good functioning of German welfare institutions in the future. As I argued at the time, I found the general interpretation of this initiative strange, and so I tried to provided a rather wonkish theoretical argument to justify my opinion. Time has now passed, and as we can see in countries like Latvia and Hungary this German initiative is now being repeated (or at least the possibility of repeating it is being discussed). So what can we say about what has happened in Germany in the meantime?

Well, as we can in the chart above – which comes from Edward’s latest post – German retail sales have been steadily falling ever since and while I will certainly not take this to convincing evidence that I was totally right, it is worth thinking a bit more about this isssue, and about what we can learn from the German experience. Basically, standard life cycle theory tells us that old age consumers at some point should start to dissave as they move into retirement (although this process itself is highly complex, and I have had more thoughts about this since I wrote my original piece). But what about those, ever fewer, young consumers still trying to make a decent living. Well, first of all, it is natural to assume they are the ones directly facing any VAT hike since they are also the age group with the largest overall demand for the goods and services subjected to this kind of tax hike. The key is what their saving(dissaving)/consumption schedule looks like, and how it is affected by a tax hike such as the one introduced in Germany back at the start of 2007.

Well just to ram the point completely home, if we look at the quarterly household consumption data for the relevant period (see chart below), it is evident that the imminent arrival of a tax hike first accelerates consumption, and then sends it struggling downwards.

What I am arguing here is simply that such tax increases effectively constitute a mechanism by the which an economy imposes forced savings on its younger cohorts in order to finance the growing burden on public finances. To some extent the process may now be inevitable, but remember that the “squeeze” here is being carried out over an increasingly shrinking base (the younger cohorts) relative to the relatively increasing base (the elder cohorts) which the tax revenues are intended to support. My main point here is that this is definitely not a free lunch, and there are real economic implications which need to be weighed against the obvious benefits of having an increase in revenue to finance the deficit on the public budet.

In the first place, the tax hike has an immediate and tangible impact on the young cohorts’ consumption and thus will further skew an economy’s growth path towards ever more reliance on foreign demand, and secondly it may work as one part of a much more complicated process to push an economy into a low fertility trap, an argument which Edward presents here in the context of Latvia.

Anyway, despite the fact that there are several points I would now change, and in the spirit of recalling old arguments, and drawing AFOE readers attention to this important issue, I think it might not be out of place to go back and have a look at the article I wrote at the time, and think about the points of view which were being advanced at the time just to see what exactly holds up for scrutiny, and what does not.

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.