VAT and Inflation, Effects of Inflation

 

A global voice in concerned countries introducing value-added tax is that the introduction of the tax would set in motion a spiral in which tax, prices and wages would feed on each other — that is, VAT would be inflationary was heard.

The introduction of VAT, or any tax for that matter, can never, by itself, lead to a sustained increase in the rate of change in the price level.

Such a change in the inflation rate can be produced by an expansionary monetary policy under circumstances. If, however, the term is interpreted as an increase in the price level (or a one-period increase in the inflation rate), then whether VAT is inflationary in this sense would depend on a number of factors. Presently inflation among nations is seen mainly rising oil prices in international market.

After VAT was first introduced, a survey was conducted by Alan S Tait on its impact in several countries on the basis of International Monetary Fund data, which shows that VAT is never introduced in isolation.

There are a number of variables influencing price change, and therefore, it is difficult to empirically assess the effect of VAT on prices. The impact of VAT on prices, therefore, cannot be strictly segregated from the general trend in inflation.
First, the taxes that have been replaced are also relevant. They could be a wholesale sales tax of the cascading type, a simpler VAT, a multistage ring system, a cascade production tax and so on.

Second, the design to yield equal or higher revenue also makes a difference.

Third, other concurrent changes such as rise in oil or steel prices in international and internal markets, increase in utility rates, changes in wage levels, administrative changes such as tighter monetary policy, price control, monitoring of prices and so on, make due impact on the price rise.

It is seen that the net price effect of VAT would be nil if the VAT is an equal-yield tax. There would not be any effect on the overall price change although there may be changes in relative prices.

The tax being revenue neutral, the aggregate demand is unchanged and so there would be no impact on the aggregate price level. The economists all over the world have viewed that VAT is not inflationary.

Thus, this brings us to conclude that the potentially inflationary effect can be constrained by government policies to inform the public and traders about the expected effect of VAT on prices, the use of price controls, monitoring of prices, offsetting adjustment in other taxes and generous provisions to ensure full credit for previously paid taxes on inputs. Moreover a mechanized form of Government can give it a better shape through administration.