Thursday, May 15, 2008

Is This Voodoo Economics?

I came across this in an Australian Newspaper:

Opposition Treasury Spokesman Malcolm Turnbull says taxes on luxury cars and some alcoholic drinks will drive up prices. Mr Turnbull has called on the Government to explain how the new taxes fitted in with the fight against inflation.

"I ask the Treasurer how can he reduce inflation by increasing prices, what kind of voodoo economics is he peddling?" he said. (ABC News)

It sounds colourful language, but is this really 'Voodoo' economics?

Increasing taxes on luxury cars and alcoholic drinks will cause an increase in the price level. However, this increase in prices is a one off. It will only affect the inflation rate temporarily. Next year, the high prices will be built into the index. Unless the tax increases are repeated next year, the effect of these price rises will fall out of the index.

Often economists look at the 'underlying rate of inflation' which excludes these temporary cost push factors such as tax increases and interest rate changes. The hope is that since they are only a temporary factor they are less cause for concern than an increase in the underlying rate (e.g. caused by rising demand)

Furthermore, it is argued that higher taxes will reduce the discretionary income of consumers and therefore lead to a fall in spending. This reduction in AD will help to reduce inflation (in fact it will reduce underlying core inflation.). Therefore, in theory, higher taxes can reduce inflation, even if they give a temporary boost, to these particular goods.

However.

  • It is possible that cost push factors like rising taxes change people's inflation expectations and therefore, the chance of inflation in the future is increased.
  • The impact of tax rises on spending is not clear cut. For example, people who buy luxury cars, may simply choose to save less and pay the extra tax without reducing their overall spending. On the other hand, people may reduce demand for luxury goods like cars quite significantly now they are expensive. An economist can never exactly predict the future effects of changes in taxes.
  • It depends which effect is greater the increase in price caused by taxes or the decrease in consumer spending
  • It depends whether tax increases get passed on. Since demand for alcohol is inelastic, higher taxes will lead to higher prices. But, demand for luxury cars is elastic, therefore, firms may not pass the costs on to consumers but suffer lower profit margins.
Conclusion - Is the Politician correct to call this Voodoo Economics?

I would say the attitude of this particular politician is unhelpful. He takes a simplistic view of the situation and seems more interested in creating a good soundbite for the press rather than understanding the economic complexities. However, we have to say, he isn't the first politician to do this.....
Also the media wouldn't be interested in reporting this depth of analysis, they prefer things in black and white.

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