How sales taxes could boost economic growth

Research suggests higher taxes could help end stagnation in developed economies

Credit: Eiko Ojala

Dee Gill | Feb 15, 2017

Sections Economics Public Policy

Collections Tax Policy

The fight against sluggish global economic growth has been expensive, protracted, and unexpectedly vexing, leaving central bankers in developed economies with a laundry list of shared frustrations. Meager economic growth, flagging wages, and low inflation persist, in spite of bankers’ monetary stimuli, and threaten to quash upward mobility for young job seekers and midcareer employees in even the richest countries.

There’s a poster child for what countries do not want to become: Japan. The former economic powerhouse has been stuck in low-growth purgatory since 1991. And yet, as much as they’d like to avoid it, some countries have been sliding in that direction. 

Many big economies are stagnating, and economists are running out of options to fix them. The conventional monetary policy for encouraging spending has been to drop short-term interest rates. But with rates already near, at, or below zero, that method is all but exhausted. Some economists have also started to empirically and theoretically question the power of forward guidance, in which central banks publicize plans for future interest-rate policies, at the zero lower bound.

To create the rising prices that fuel higher wages and economic growth, central banks must convince consumers and companies to spend more money. But controversial asset-buying programs that brought down long-term interest rates have not also produced sustained price increases as hoped, and they have inflated central-bank balance sheets. In the United States and Europe, those figures recently stood between 24 and 36 percent of GDP, according to WSJ Pro Central Banking. Japan’s central-bank balance sheet was a whopping 90 percent of GDP, and prices are still going down. 

The situation has confounded many economists, who predicted rampant inflation by now.  

Central banks and governments badly need a new stimulus tool, preferably one that doesn’t cost a lot of money. Some researchers are proposing a fix that might sound unappetizing: raising sales taxes as a means of jump-starting economic growth. 

Francesco D’Acunto of the University of Maryland, Daniel Hoang of Germany’s Karlsruhe Institute of Technology, and Chicago Booth’s Michael Weber find evidence that a preannounced tax hike—a 3-percentage-point increase in Germany’s Value Added Tax enacted in 2007—provided just the kind of growth stimulus central banks desperately need today. 

In the 14 months between the government announcing the tax hike and its effective date, German consumers’ willingness to purchase large-ticket items rose by 34 percent, according to the research. Moreover, that excess willingness on display ahead of the VAT hike reverted to its preannouncement levels.

The researchers’ conclusions suggest that consumption taxes could be a cheap alternative to monetary policy for goosing sluggish economies. The strategy is termed “unconventional fiscal policy.” 

Why we need inflation

Anyone who has lived through high inflation, such as the double-digit inflation of the late 1970s in the US, may be skeptical of any plan to raise prices. Few consumers would welcome a return to 13 percent mortgages, or to paychecks that buy progressively fewer goods.

But low inflation presents equally worrisome problems. Companies do not spend money to expand, because they do not see rising demand for their products. There is little job growth and meager wage growth, which makes consumers reluctant to spend on the products that the companies sell. Also, consumers might put off buying appliances and other large purchases in hopes of buying them cheaper later. In the US, this vicious cycle stifles upward mobility, as hard work doesn’t produce the same opportunities to make more money and improve quality of life as one would see in a growing economy. For most countries, an ideal annual inflation rate is between 2 and 3 percent.

Tax becomes an incentive to spend
After a German sales tax was enacted, people’s willingness to spend remained comparable to the time before the tax was announced.

Japan’s economy illustrates the ravages of low inflation. In the nearly 25 years since the country’s stock and real-estate prices collapsed, Japan’s economy has barely grown. Corporate Japan is hoarding cash estimated at 50 percent of the country’s GDP. Pay hikes are running at about 2 percent a year, even though low unemployment has created a tight job market. Japanese stock prices today are roughly where they were in the year 2000. Despite record-low borrowing rates (some mortgage rates are below 1 percent), Japanese consumers aren’t buying. Deflation, or falling prices, has given them good reason to hold off on purchases. The near-zero interest rate paid to savers also makes accumulating funds for retirement difficult.

Although Japan has been fighting it the longest, this cycle of low inflation and low growth repeats itself throughout the developed world today. Even the stronger economies such as the US and the UK have seen prices hold fairly steady in recent years. 

The situation has confounded many economists, who predicted in recent years that the US would be experiencing rampant inflation by now. In hopes of promoting investment, many central banks, including in the US and Europe, bought massive amounts of financial assets in the years following the Great Recession. Because the programs required central banks to create new assets for the purchases—the banks essentially made money out of nothing—mainstream economists warned that high inflation would follow. But the critics were wrong. Not only did the money-printing schemes fail to inflate prices appreciably, parts of the eurozone are now flirting with deflation. 

Meanwhile, GDP growth across Europe was well below 2 percent last year. In the US, the Fed forecasts GDP growth of about 2 percent in 2016, with lower growth in the following two years. 

Buy now, or pay later 

The idea that the threat of a sales-tax hike might stimulate stagnant economies has been around for some 25 years. But before the researchers homed in on the German VAT increase, economists had not documented such an effect in real life. 

University of Michigan’s Matthew D. Shapiro first made the case, in 1991, for using a tax increase to get consumers to spend. Harvard University’s Martin Feldstein proposed in 2002 that recession-plagued Japan announce plans for quarterly VAT increases, along with simultaneous income-tax reductions, to entice households to spend money ahead of the cost increases. (Both sales taxes and VATs are consumption taxes: a sales tax applies to goods, while a VAT generally applies to both goods and services.)

A decade later, another group of economists—Isabel Correia and Pedro Teles, both of Banco de Portugal and Universidade Católica Portuguesa, Harvard’s Emmanuel Farhi, and Federal Reserve Bank of Minneapolis’s Juan Pablo Nicolini—demonstrated theoretically that the tax policy Feldstein described could stimulate economic activity when interest rates were at or near zero, which is the zero lower bound that limits central bankers’ options for providing growth through conventional monetary policy.

Still, economists struggled to prove that consumers changed their spending plans when faced with impending inflation. Two separate studies from 2015 report conflicting conclusions. A study led by University of Notre Dame’s Rüdiger Bachmann finds no statistically significant association between households’ inflation expectations and their readiness to spend on durable goods such as appliances, lawn equipment, and other household investments expected to last for a few years, such as cars and houses. A study led by the New York Fed’s Richard K. Crump, using data from the Federal Reserve Bank of New York’s Survey of Consumer Expectations, finds a significant positive association between inflation expectations and spending growth expectations. 

Evidence in Germany 

D’Acunto and his team exploit a natural experiment that closely resembles the theoretical situation explored by Correia and her colleagues, who had supposed that a government, at a time of flat nominal interest rates, would announce in advance increases in consumption taxes. And something like that did happen in 2005, when Germany unexpectedly announced a 3-percentage-point increase in VAT in 2007. Germany acted for political rather than economic reasons; the move was required to bring the German deficit in line with EU rules governing debt-to-GDP ratios. To comply with the requirements of the 1992 Maastricht Treaty, which ultimately created the European Union, the increase became effective in January 2007. The European Central Bank explicitly stated it would not adjust interest rates to counter the inflationary effects of the tax. 

The VAT-increase announcement immediately increased German expectations of inflation, but it did not change inflation expectations in similar households in the UK, France, and Sweden, according to analysis of monthly household surveys conducted by the European Commission. By November 2006, German households, compared to the control group, were 34 percent more willing to buy durable goods. By 2007, the announcement had increased consumer price inflation in Germany. 

While sales or VAT taxes generally apply equally, they have a greater effect on the poor, who spend a larger percentage of their disposable income on consumer goods.

Moreover, the researchers find no negative effects from the tax increase after January 2007. German households’ spending expectations matched those of their foreign counterparts before the VAT increase was announced—and after the hike went into effect.

Weber and his colleagues conclude that this unconventional fiscal policy is a viable option for stimulating stagnant economies. They suggest raising the tax incrementally, by perhaps 1–2 percent a year over several years. Germany reduced income and other direct taxes by 2 percent to soften the added costs for consumers, and Weber says that he would expect to see such pairings in practice, as well as other moves such as tax rebates, to make a tax increase more politically palatable. However, he stresses that such an offset is not necessary for the plan to produce spending. 

A practical stimulus? 

The stimulus Weber describes is hard to swallow in a recession-weary world. In the US, where wages are depressed and many middle-aged people are unemployed or underemployed, politicians rarely win votes by promising tax hikes. 

In the US, moreover, raising sales taxes would be tricky in practice, as the central government does not currently assess this type of tax. Rather, 45 of 50 states collect sales taxes at varying rates, while five states do not charge any sales taxes. Implementing higher taxes as stimulus would require either a new, VAT-like tax or a coordinated effort by all 50 states, which have independent tax laws.

Another uncommon idea: Overshoot inflation targets

Since the Great Recession, much of the developed world has suffered from chronically low inflation. In Japan, the central bank is using an uncommon strategy to try to grow the economy: it’s manipulating inflation expectations by overshooting inflation targets.

See more

On top of that, consumption taxes are regressive. While sales or VAT taxes generally apply equally, they have a greater effect on the poor, who spend a larger percentage of their disposable income on consumer goods. Adding to the controversy, taxing authorities decide what is or is not considered a necessary item exempt from taxation. Advocates in the US and the UK have protested taxation of feminine sanitary products, for example. “That’s a totally valid point,” says Weber about the taxes’ regressive nature, but he says a tax could be implemented in a budget-neutral way, for example, by pairing a sales tax with income-tax cuts and monetary transfers to the unemployed. 

And he already has an endgame in mind: ultimately, if the policy were to work as intended, consumers would start buying more goods. The central bank would escape the zero lower bound. Then unconventional fiscal policy would pass the baton back to conventional monetary policy.

The global economic backdrop is making it possible for such a suggestion to enter the discussion. Some central banks are toying with stimulus plans that would have been considered wildly unorthodox for developed economies a decade ago. The European Central Bank, as well as its counterparts in Switzerland and Japan, has experimented with negative interest rates. In Denmark, homeowners are getting paid interest on their mortgages, according to Gemma Tetlow writing in the Financial Times, which also reports that some banks in Ireland, Denmark, and Switzerland have been charging companies to hold cash. 

So far, the Fed governors have seemed averse to straying too far from the stimulus tools already in use. At an annual summit of leading central bankers in Jackson Hole, Wyoming, in 2016, Fed Chair Janet Yellen indicated that rate changes and, when needed, asset purchases remain the tools of choice for managing US economic growth. She did not mention negative interest rates or taxes.

But if the US won’t experiment with an unorthodox tool, perhaps another country will. Japan is a special case, says Weber, but the researchers have been presenting their findings at central banks including the Deutsche Bundesbank, the European Central Bank, Banca d’Italia, Banque de France, and the Reserve Bank of Australia. Weber thinks that the most-likely candidates for trying out sales-tax hikes for stimulus purposes are long-suffering countries, especially those whose high debt levels make debt-financed fiscal stimulus difficult. 

“A country where you might see it implemented is Italy,” Weber says. “Italy’s GDP has been barely growing in real terms for the past three decades,” and its debt-to-GDP ratio is high, he says. “They need a budget-neutral (stimulus) policy.” Weber presented the evidence for unconventional fiscal policy in 2015 at the Banca d’Italia, to good reception.