The case against a dirty GST: Illusory benefits of exclusions.

John Pagani, in the blog post that motivated my post on the GST yesterday, suggests four reasons for supporting the exculsion of fresh fruit and vegetables. In short, these are that it would mitigate the regressive nature of the GST, that it would promote better nutritional outcomes, that we already exclude a number of products from the GST so it is already dirty, and that the best thing about the policy is that everyone gets the same break. Let’s take each of these in turn.

1. Excluding fruit and veg is a way of making the tax less regressive.

Actually, John didn’t exactly make this claim, but it is implicit in his analysis, and it is a common mis-concpetion. First, please shout if from the rooftops: The GST is not a regressive tax. Steve Landsburg had a good post last year , which I won’t duplicate here, explaining how a flat-rate labour income tax with no tax on capital income (which is equivalent to a clean GST) implies a flat rate of tax. Adding in taxation of capital income results in double taxation. You can argue that a clean GST is undesirable because it doesn’t have the double taxation of capital income (compounded by inflation), and such double taxation is a good thing given that the rich earn a greater fraction of their income from interest and other capital income than the poor, but don’t say that a clean GST is regressive. Furthermore, if you want to argue that a clean GST is bad because it doesn’t imply double taxation of capital income, please don’t also advocate Kiwisaver or other tax incentives to encourage retirement saving. You can’t have it both ways.

More important, when one considers the overall tax system rather than just the GST in isolation, it becomes clear that excluding a class of goods from the GST is a lousy way to achieve income redistribution. To illustrate, consider an economy with a broad-based GST, but one that includes an exemption for a particular class of goods done for equity reasons rather than to encourage consumption of those goods. Now consider an alternative system in which the exemption is removed, and the extra revenue earned is returned as a negative poll tax to every adult in the country. Such a redistribution would be easy to implement. It simply means bringing the implementation of the benefits (dole, superannuation, DPB, etc.) into the same system as income tax, and then either increasing benefits or reducing the tax liability by a fixed amount. This policy will eliminate the distortions implied by having differing rates of tax, and would eliminate the compliance and enforcement costs that come from having different tax rates across different goods. And the impact on equity? As long as the rich spend a greater absolute amount on the good that had been zero rated than the poor, even if the good is a necessity that takes up a smaller fraction of their income, this policy will see the tax bill of the rich being raised by a greater amount than the poor while all receive the same rebate back. That is, removing a GST zero-rating would be a distortion-free way of taking from the rich to give to the poor! Only if the good in question were one where poor people spent a greater absolute amount than the rich would removing the zero-rating not be equity enhancing. Are there such goods? I haven’t seen data on this, but at a guess the only candidate goods would be fast food and cigarettes.

2. Exempting healthy foods is desirable/necessary to achieve good nutritional outcomes.

There are two issues here: The first is whether one wants to use Pigouvian taxes and subsidies to bring about behavioural changes in the nation’s eating habits; the second is whether GST exemptions would be the best way to do so. Let’s assume that we do want to use tax interventions. In this case, the optimal policy would be excise taxes on unhealthy foods and excise subsidies on healthy food. The nutritional value of food doesn’t change just because it is used as an intermediate good; apple slices don’t cease to be healthy just because they are served at McDonalds as an alternative to fires in a happy meal. (Note to American readers: the apple slices in New Zealand happy meals are not peeled nor served with caramel dipping sauce!)

3. But we already exempt goods such as existing houses and financial services.

This betrays a misunderstanding of the difference between exemption and zero-rating. Financial services are exempt, not zero rated. This is done to avoid definitional problems, and doesn’t cause the increase in compliance costs that zero rating does.

For second-hand goods, recall the principle that a GST is designed to look like an income tax without the double taxation of those who delay their consumption. Consider a world with a 50% income tax and no taxation of capital income, and then replace it with a 100% GST on newly produced goods and services but not on second-hand goods. It is a trivial exercise in general-equilibrium theory to show that these two worlds are identical. (Exercise for any undergraduate economics students reading this—show that the after-tax prices of both newly produced and second-hand goods will double in this example, even though second-hand good trades are not subject to the GST.) John’s statement that “a new house costs 15 per cent more than the identical house across the road that’s a year old” is simply wrong.

The bottom line is that none of these examples of goods being exempt in any way implies that we have already stepped on to the slippery slope of a dirty GST. Zero-rating fresh fruit and veg would be such a step.

4. “The best thing about the policy is that everyone gets the same break”.

You have to be kidding me. People like me who spend a lot on fresh fruit and vegetables would get a big break; those who meet their nutritional needs from canned and frozen fruit and veg would not. If you want to advocate for a tax break for the middle class at the expense of the poor and the rich, there are more honest ways of doing so than supporting exclusions from the GST that would cater to the consumption patterns of the middle class.