A child’s guide to price determination in the market: Tax cuts won’t always reduce prices

Asani has been an alert student reading for her Advanced Level exam. She is an inquisitive student and makes it her business to probe into matters that are economics about which she has no clear understanding. Fortunately, her Grandfather – Sarath Mahatthaya – an ex senior officer of the Ministry of Finance, is available for her to raise questions that she cannot understand and seek clarifications. 

Previously, she had a very fruitful discussion with him on the Millennium Challenge Corporation’s aid package to Sri Lanka, known as MCC Compact (access it here: http://www.ft.lk/columns/A-child-s-guide-to-MCC-Compact-Sri-Lanka/4-689753). Now she has a new problem. 

The Government has cut the Value Added Tax or VAT rate from 15% to 8% and removed a large number of businesses from VAT by increasing the minimum sales level from Rs. 3 million a quarter to Rs. 75 million a quarter. To reinforce this measure, two other taxes have also been abolished, namely, the Nation Building Tax or NBT and Economic Services Charge or ESC. The objective has been to push the market prices of most consumer goods down and provide relief to consumers. But it hasn’t happened in the market and both the Presidential Secretariat and the Inland Revenue Department have been worried (http://www.ft.lk/front-page/IRD-puts-VAT-relief-at-Rs-143-b-urges-trade-to-pass-it-on-to-consumers/44-693835).  

The total relief package involving all tax cuts and changes is given at http://www.treasury.gov.lk/documents/10181/744209/Amendment +pdf+IRD21012020/21465e08-d13d-4834-b787-8c5ecdceed56?version=1.0. She asks her Grandfather about this seeming paradox:

Q:Asani: Grandpa, there were reductions in VAT by the Government and the traders were expected to reduce the prices and make available the relief to consumers. But this has not happened and the Government is worried. What is the reason for this?

A:Sarath Mahatthaya: The worry is mainly due to a misunderstanding of how prices are determined in the market. Prices are determined by the interaction of both the demand and the supply forces. Either one alone cannot determine the prices. It is like cutting a cloth with a pair of scissors. Can you say which blade, the upper one or the lower one, that cuts the cloth? If we say that it is the upper one, it is wrong. If we say it is the lower one, then it is also wrong. The cloth is cut by both the upper one and the lower one jointly. The VAT cut may reduce the supply prices of goods if and only if traders had already passed the VAT to consumers. But whether the market prices have also declined after the VAT cut will depend on what has actually happened to the demand. 

The worry is mainly due to a misunderstanding of how prices are determined in the market. Prices are determined by the interaction of both the demand and the supply forces. Either one alone cannot determine the prices. It is like cutting a cloth with a pair of scissors. Can you say which blade, the upper one or the lower one, that cuts the cloth? If we say that it is the upper one, it is wrong. If we say it is the lower one, then it is also wrong. The cloth is cut by both the upper one and the lower one jointly. The VAT cut may reduce the supply prices of goods if and only if traders had already passed the VAT to consumers. But whether the market prices have also declined after the VAT cut will depend on what has actually happened to the demand

A: But our teacher said that when a tax that has been imposed on a good is reduced, the price of the good should fall. What you say is that she is wrong?

S: She has ignored the demand factor that influences the market prices. When the tax on a good is reduced, the supplier is able to supply the same at a lower price minus of the tax. For example, suppose a tax of Rs. 10 has been imposed on a kilogram of rice. If the cost of production is Rs. 100, the supplier will add the tax of Rs. 10 on the cost and supplies it to the market at Rs. 110 per kilo. If the tax of Rs. 10 is taken out, then, the supplier is able to supply it to the market at Rs. 100. It is only supplier’s price tag. But what happens to the market price of rice is determined what has actually happened to the demand. If the demand has increased when the tax is removed by an equal amount, then, the market price remains same. If the demand does not change but remain at the same level, then, the market price should fall. But whether it falls exactly by Rs. 10 will depend on the elasticity of the demand. 

A: What is this elasticity of demand that you talk about?

S: Elasticity is the relative response of the buyer to a relative change in the price. I can explain it by using a parable. Suppose that I ask you to stand up. If you stand up faster than I ask you, your behaviour is highly elastic. It is a situation like when the prices fall by one percent, the consumer increases his buying by more than one percent. If we further go forward without example, if you stand up at the same speed as I ask you, your response is exactly in line with my command. Neither more nor less. In the same way, if the consumer increases his demand exactly by one percent when the prices have fallen by one percent, the elasticity is said to be one. Finally, if you stand up slower than my command, your response is inflexible. If you don’t stand up at all, your response is totally inflexible. 

If prices fall by one percent and if the consumer increases his demand by less than one percent, then it is inelastic demand. If the consumer doesn’t change his buying at all, then it is a situation where the demand is totally inelastic. No matter what happens to the price, the consumer buys the same

In the market, it is a situation like this. If prices fall by one percent and if the consumer increases his demand by less than one percent, then it is inelastic demand. If the consumer doesn’t change his buying at all, then it is a situation where the demand is totally inelastic. No matter what happens to the price, the consumer buys the same.

A: I now understand. But Grandpa, how does this elasticity affect the market price when a tax is reduced? Can you explain it? 

S: It happens this way. If the consumer buys everything in the market irrespective of the price, his demand is perfectly elastic. If you graph the demand curve, it is a horizontal line. In this case, no matter by what amount the supply price is reduced, the market price remains the same. Since the supplier increases the quantity available at that market price, the consumer buys the entire amount at the prevailing market price. Hence, the tax cut has no impact on the prices there. 

Markets are very complex organisations and they can change at every moment. When we cut the taxes and expect market prices to fall, we expect markets to remain unchanged. That does not happen in reality because we know that everything under the sun is subject to continuous change. When we have the newly changed situation, the rules of the game also change and can’t expect to have the previously anticipated results in the market

If we take the example from the other extreme, that is, the consumer’s demand is perfectly inelastic, then the demand curve is a vertical line. In this case the prices would fall by the full amount of the tax cut since the consumer buys the same amount at a lower price now. What the Government had expected from the reduction of VAT had been this situation. But for it to happen, the consumer demand should be totally inflexible or unresponsive to price changes. But there are only a few commodities that possess this characteristic. A good example is salt. People buy more or less the same quantity of salt irrespective of what has happened to the price. 

All other demand conditions are in-between these two extremes. The demand is either more elastic or less elastic. If it is more elastic, the price reduction is relatively small. If on the other hand the demand is less elastic, the price reduction is relatively large. Hence, one should look at the elasticity of the demand for a good before blaming the producers for not reducing the prices. Producers may have reduced the prices. But the market price is determined not only by the supply, but by both the demand and the supply forces. Here again, the amount of market price reduction depends on the size of the elasticity of demand for a particular product.

A: But when taxes are imposed on goods, market prices go up. Don’t they?

S: Yes, but it depends on the elasticity of supply. That is, by what percentage a supplier would change the supply relative to a percentage change in the price. If he doesn’t increase supply at all, then, his supply is perfectly inelastic. In this case, his supply curve is a vertical line like an upright coconut tree. Since he supplies only a given quantity no matter what the price is, any tax imposed on that good has no impact on the price.  

If the consumer buys everything in the market irrespective of the price, his demand is perfectly elastic. If you graph the demand curve, it is a horizontal line. In this case, no matter by what amount the supply price is reduced, the market price remains the same. Since the supplier increases the quantity available at that market price, the consumer buys the entire amount at the prevailing market price. Hence, the tax cut has no impact on the prices there

Similarly, if he is ready to supply an unlimited quantity at a given price, his supply is perfectly elastic. When you plot it in a graph, it is a horizontal line, like a coconut tree that has fallen to the ground. In this case, his supply curve moves upward by the amount of the tax imposed, because he is ready to supply an unlimited quantity at the new higher price now. 

All other price increases are in-between these two extremes. But what actually happens to market prices will depend on how the consumers respond to price changes. Therefore, the rule for cutting a cloth by both blades of a pair of scissors is still valid.

A: What it means is that tax cuts are not a very good move to reduce market prices, are they?

S: Yes, that is because markets are very complex organisations and they can change at every moment. When we cut the taxes and expect market prices to fall, we expect markets to remain unchanged. That does not happen in reality because we know that everything under the sun is subject to continuous change. When we have the newly changed situation, the rules of the game also change and can’t expect to have the previously anticipated results in the market. What it means is that we must look for what is to be foreseen. The 19th century French economist Frederic Bastiat used this analogy to distinguish a good economist from a bad economist. He said that a bad economist will see only what is being seen, but a good economist will see what is to be foreseen!

A: Grandpa, what are those other factors that cause a change in the market? What have we ignored?

S: When taxes were cut, there was belief that market demand would remain unchanged. But if the demand changes, either an increase or a decrease, it affects the market prices and prevent the expected result from happening. 

The demand depends on the money income which the consumers are having. That income can change in the immediate future due to two reasons. One is new money printed by the Central Bank and made available to people through Government expenditure programs. For instance, suppose the Government has a cash problem to pay salaries. It then has to borrow from the market by issuing, most probably Treasury bills. If people do not buy those Treasury bills, the Government does not have an option, but to get the Central Bank to buy those Treasury bills and make available the required cash to the Government. The Central Bank does so by printing new money. When the Government uses that money to pay salaries, people will get new money into their hands and start spending on goods and services. That increases the demand. 

We’ve already been warned by international rating agencies about it. They’ve changed our rating outlook from stable to negative. Instead of finding fault with them, we must find ways to tackle the problem in the immediate future. The proposed tax reforms will help us in the long run. But in the immediate future, managing the economy without causing a major damage to it is challenging

The other is a sudden increase in the take-home pay of people which economists call the disposable income. That is the income minus taxes paid. If there is a reduction in the tax rates, the take-home pay of people will go up allowing them to buy more goods and services. That too increases the demand and upset the plans of the Government to reduce market price through VAT cuts.

A: OMG! That means we cannot look at the VAT cut in isolation and have to analyse it by looking at other factors that are relevant.

S: Precisely. Both these factors in the coming months will cause an increase in the demand. The VAT cut and other tax reforms which the Government has introduced will reduce the revenue of the Government drastically immediately. The VAT cut alone, according to Inland Revenue people will reduce Government revenue by about Rs. 148 billion. The income tax reduction on companies engaged in the production of alcohol and tobacco from 40% to 28% as from 1 April will cause the Government to lose a tax revenue of about Rs. 8 billion. 

Similarly, the increase in the tax eligibility limit from the current Rs. 1.2 million to Rs. 3 million and abolition of the withholding taxes on income from employment and interest earnings will deny a regular monthly cash flow to the Treasury. It will take time for Inland Revenue people to catch all the people who are not paying taxes now and get them to pay taxes. Hence, in the next few months, the Government will have to use Central Bank’s money printing power generously. 

But it will increase money income of people leading to an increase in the demand. Even if the Government borrows abroad to finance local expenditure the result is the same. That is because the government will sell its foreign exchange to the Central Bank for rupees and spend the rupee income. The Central Bank will have to print rupees to give to the Government. 

Similarly, the abolition of withholding taxes on employment income and interest earnings will leave more cash in the hands of people increasing their take-home pay. That too will increase the demand. What this means is that the goal of reducing market prices through VAT cut will be negated by increases in the demand for goods. This year is a critical year for the Government as well as for the Central Bank. Already, inflation has moved a little above 6%, the upper limit of the inflation targeting corridor of the Central Bank. With the increase in the new demand, it is extremely difficult for the Bank to keep inflation within its targeted limits.

A: Coming colours are not good, as ordinary people say, isn’t it, Grandpa?

S: Yes, and we’ve already been warned by international rating agencies about it. They’ve changed our rating outlook from stable to negative. Instead of finding fault with them, we must find ways to tackle the problem in the immediate future. The proposed tax reforms will help us in the long run. But in the immediate future, managing the economy without causing a major damage to it is challenging.

A: Thanks, Grandpa. I now understand the implications.

S: Good that you’ve understood it. Let’s keep this dialogue continuing.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)