22 Nov 2014

Krugman Shows How Consumption Taxes Raise and Lower Price Inflation

Krugman 11 Comments

Back in 2012, some people were worried that rising price inflation in the UK meant that the Bank of England should tighten. But Krugman explained why that was wrong:

But, say the small-[output]-gap people, if Britain is deeply depressed relative to potential, we should be seeing deflation, whereas there’s actually inflation. Is this a decisive argument?

Well, the great bulk of UK inflation these past few years reflects one-off factors: VAT increases, commodity prices, and import prices. Domestically generated inflation is low, and headline inflation is declining too. [Bold added.]

Everyone got that? Krugman was saying that Britain’s increase in the Value Added Tax (VAT) contributed to a spike on headline price inflation, so it could safely be ignored and there was no need to tighten.

Now regarding Japan, Krugman gave his advice right to the Prime Minister:

With a handful of aides and secretaries present at the reception room on the fifth floor of Abe’s residence in the Nagatacho district southwest of the Imperial Palace, Krugman began by praising Abenomics, describing how much he respected the program to revive Japan after 15 years of deflation, Honda said.

The only problem was the sales tax, Krugman said, according to Honda. Honda, Hamada and another aide, Eiichi Hasegawa, kept quiet. Honda says that by the end of the meeting, he was convinced Abe would decide on postponement.

Hamada, who had advised Abe on his pick for Bank of Japan governor, said that “Abe listened to Krugman’s view very carefully.” Hamada said in an interview Nov. 18 that “he probably helped the prime minister make up his mind.”

Abe himself highlighted his discussion with Krugman when speaking on the national public television broadcaster NHK three days ago.

Escaping Deflation

“He said we should be cautious this time in raising the sales tax and if we weren’t it would break the back of the economy,” Abe said. “He said if that happened, we wouldn’t escape deflation, it would be uncertain whether we could revive the economy and repair the nation’s finances. I think that’s the case.” [Bold added.]

So Krugman was urging for the continuation of stimulative fiscal policies, because increasing the sales tax would lead to (price) deflation.

It looks like a general consumption tax either raises consumer prices or reduces them, based on what the answer needs to be to justify the extension of Krugman’s policies.

11 Responses to “Krugman Shows How Consumption Taxes Raise and Lower Price Inflation”

  1. LK says:

    I don’t see any contradiction.

    “He said we should be cautious this time in raising the sales tax and if we weren’t it would break the back of the economy,” Abe said. “He said if that happened, we wouldn’t escape deflation”

    The “that” seems to me to refer to “break the back of the economy”. If the Japanese economy falls into recession, it will very probably experience deflation .

    (1) if you raise the sales tax that will be contractionary fiscal policy, though it might have a mild short term inflationary effect

    (2) but as the contractionary effect of the tax increase works its way though the economy, economic activity will fall, and if this is severe enough it will might lead to deflationary effects (though not in the way people ordinarily think*).

    In short, there is no contradiction here. I am going to be generous and assume that you’ve (honestly) misunderstood the relevant passage.
    * in modern economy deflation happens as:
    (1) flexprice sectors (such as commodities and other factors) experience deflation during demand shocks

    (2) **some** mark-up prices might be adjusted as total average unit costs fall and the firm decides to reduce prices, or more probably many firms will not raise prices in recessions.

  2. Daniel Kuehn says:

    Never reason from a price change, Bob.

    LK thinks the important word here is “that”. I think the important word here is “one-off”. Regardless which of these do you disagree with?:

    1. Taxes cause firms to raise prices.
    2. Broad taxes cause firms to broadly raise prices.
    3. Taxes reduce output.
    4. Depressed output depresses prices.

    If you disagree with any of these now is the time to tell us, because they all seem sensible to me and in a dynamic roll-out of a policy they all come into play. As far as I can tell Krugman is making a claim about both the short and medium run here. The concern with the UK is not that inflation will gallop away forever after all – he is concerned that depressed conditions will return, precisely as in Japan.

  3. Daniel Kuehn says:

    I think this new project with Tom Woods is going to be… interesting.

  4. Brent says:

    I will volunteer that itbis not obvious why depressed output is going to lower prices. Lower output can be, and is in fact in the case of an indirect tax, due to reduction in supply.

    • Daniel Kuehn says:

      Sure, although this is a consumption tax.

      The point is there’s no obvious funny business here. Falling output need not be associated with falling prices (that would be reasoning from a quantity change!), but nobody is being obviously contradictory by suggesting that in a particular case it would.

  5. Andrew_FL says:

    Perhaps Krugman meant that VAT inflation is not “real” inflation and that raising the VAT would not help escape from “real” deflation, it might only create the illusion that you’ve created some inflation.

    Of course, the distinction between “real” and “fake” inflation seems to have more to do with what happens to the level of spending than anything else. Both kinds of price increases are, of course, as real to the people having to pay them as any other.

    Krugman places a great deal of importance between some alleged difference between taxing money holdings versus taxing money expenditures.

    • Tel says:


      Aug 2013:

      Abe has made ending 15 years of deflation and revitalizing the economy among his top priorities. Some advisers and members of his ruling Liberal Democratic Party want to delay or water down the tax increases, worried they could hurt a budding economic recovery.

      At Monday’s debate, Kazumasa Iwata, head of a private think-tank and former Bank of Japan (BOJ) deputy governor, said the government should increase the tax rate by 1 percent each year for five years, instead of raising it in two stages.

      If that was impossible and the government were to go ahead with the increases as scheduled, it should offset some of the pain by compiling an extra budget of up to 5 trillion yen, he said.

      The Finance Ministry, on the other hand, wants Abe to proceed given the nation’s dire finances, with public debt having ballooned to twice the size of its $5 trillion economy.

      From a consumer’s point of view a 1 percent each year sales tax rise should “feel” very similar to price inflation.

      In hindsight, this option probably would have been smarter. It would have avoided the obvious pull-forward of consumption, and reduced the shock. Also, less risk in doing that because at any stage the government can delay further rate rises.

      • Andrew_FL says:

        On the other hand, the 1% a year increase in the sales tax accrues the money directly to the Government, which may make all manner of mischief with it.

        • Tel says:

          The mischief was already done when they got themselves so deeply into debt.

          • Andrew_FL says:

            More mischief. Assuming they wouldn’t use it to pay down their debt. Which they probably wouldn’t

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