23 February, 2020

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A Child’s Guide To Price Determination In The Market: Tax Cuts Won’t Always Reduce Prices

By W A Wijewardena

Dr. W.A Wijewardena

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. 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.

The total relief package involving all tax cuts and changes is given here. 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.

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.

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.

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.

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.

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 waw1949@gmail.com

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Latest comments

  • 2
    0

    But politicians that returned to power were well aware of this or not ?

    I mean that varioius factors not just tax reductions should work if cost of living to go down right ?

    People were misled, but Premier Rajakashe is today speechless and even more ignorant to the questions of the people.

    I think our people should NOT trust the politicians and their election pledges any more.

    This Child would raise the question, if at least one of the pledges they made in election campaign has been fullfilled sofar ?
    :
    What would be the answer the Grandpa would leave to that ? Not a single pledge is fullfilled my dear grand son, it was all misleading.
    :
    But the Grandpa should also let the child know – THANK LANKEN PEOPLE AT LARGE ARE BORN IDIOTS, they just let them abused and misled again and again.

    • 0
      2

      Mr. Buramphisincho,
      /
      Yes…..
      They are well aware.
      \
      Having said that……. I will tell you another side of this story which we are well aware.
      /
      Yes……..
      When a tax that has been imposed on a good is reduced…. price drops and demand increase.
      And three things happen simultaneously.
      1. Manufacturer can keep a higher profit margin.
      2. Manufacturer can increase production.
      3. New manufacturers emerge.
      \
      What is the result…….
      /
      1 a. Manufacturer can by a new car….. or build a new house….. or spend money in a night club.
      And….
      A driver…. Garage man….. Mason…. A night club dancer….. will have fresh employment.
      2 a / 3 a. Increase of fresh new employment and more important……… HIGH DEMAND for employment.
      \
      When you say USA is a developed country (In literal terms) what is the real meaning of that phase….?
      It means that “the entrepreneur” in USA is having money (In simple terms).
      So…..
      Owner of Microsoft is rich…
      Owner of the Spacex is rich…
      Owner of the Facebook is rich…
      Owner of the etc….. etc….. etc…
      AND
      USofF…….A is a rich country.

      • 0
        0

        Get your facts right Pascal the DIMWIT.

        Your arguemtns would serve me as ANDARE STORIES that my grannies narrated to me while i was going to sleep in my childhood.

        Just come with facts, what have the BALLIGE PUTHAS mastered properly since they have been in power since 18 Nov 2019

        1) People are made silent today, with bhiishanaya, psychosis ear is back to their doorsteps.
        .even if cost of living is above any thinkable levels for the commners, but they are the ones who voted him to power, but stay as if they are caught by dragons today
        .
        Are they dreaming of buying a car you asskisser ?
        .
        2) With over 6 billions of US dollars need to be collected sum to pay off the HEAVY DEBTs that they deliberately made prior to 2015- how can they pay this off, if MCC or any other funds would not flow into the country ?

        3)They have promised conssions to the people, that voted them into power, but not even a single pledge be fullfilled to this date, .. make them very nevours, people wth no having proper medicine across the country, the state run by Ballige puthas, be uanble to manage anything but lip services….

        4) In the near future, people will have to come to street and protest, … then ballige puthas will start shooting on human targets so that bring their human flesh into cosumer bins….. as IDIAMIN and Lybian mendid… else, what can we expect from THESE BARBARIANS:

        5) Ballige puthas are not able men that they prove once and this time it will become worst. They are born killers, and they should be punished by all mighty gods.. that youwill see in the days to come.

      • 0
        0

        Get your facts right Pasqual puthe…. I have no idea if your staple food is the Rajaakshe asuchi…

        Why you the like men fall in to that level, telling that you love srilanka ?

        Do you let your wife be raped by Rajapakshe criminals ?

  • 0
    0

    Tax cuts are supposed to add a few rupees to the consumer pockets, business people do better as their products or services become cheaper. That would essentially reduce the consumer price index is stupid politics by bankrupt politicians. Many do tax cuts to accelerate the economy and that is not via lowering the consumer price index. If Sri Lankans asking that, country can not be a middle income country as they say.

  • 4
    0

    A good analysis of basic economic facts in relation to elasticity and inflexibility. One thing economists do not seem to consider is ethics. While producers receive tax relief, they may not pass the relief to consumers knowing that demand will increase for goods. In a perfect marketplace, these economic facts will work well. However, in SL business people are dishonest, duplicitous and altogether uncaring. So, if the producers don’t scam the system, the intermediaries will. Therefore, the govt will need to force production of goods that add value at the same time as maintaining a healthy consumer market supply. These value-added goods can be exported in return for hard currencies which can help pay for imports like medicines and equipment but not luxury cars and gadgets for the rascals who rape the country.

    • 2
      0

      Pethiagoda@

      BELEIVE or not like or not, there should be taxes that could improve the state income.
      :
      That is how WESTERN countries maintain their services. In Germany, where I am, we pay high taxes and we work also over time. Our overtime are not always paid but we have to. That is the system. But not many would go on strikes, since everyone in this country has to pay their taxes regardless of their status or power.

      If people woul dnot pay taxes as is the case in SRLANKA; but expect further govt to finance their education, hospital and all others free, the things would not work for the betterment of the people on long term. One Japanese expert recently quetsioned me, why the govt has to bear the loads of free offers to the people if the nation is marching to be UPPER INCOME nation?
      We should be grateful to the state, that free schooling and university is still in srilnaka, that is not the case in Pakistan or th elike countries that struggle to achieve our levels.
      Free education has improved our higher literaicy rates, but political literacy remain as that of tribal nations. People are esily manipulative by the tricks being applied by predatory politicians.
      Just imagine the MCC issue, Rajakshes abused their mouth at the time, previous govt wanted to discuss it in Parliament, but today, the buggers themselves work on that… why ?
      People are made silent for their abusive politics.

    • 1
      0

      Lasnatha,
      You must go back to Adam Smith. Where does market principles which are driven by the “invisible hand” aka profit mentions about ethics?

      By the way, I have warned many times starting election times about this possible outcome. Tax cuts certainly can boost economies by added investments but the even the added investments results in prices increased due to increased demands. Prices will not go down until increased production turns into increased supply. If my memory is correct, I think that WAW himself wrote a column soon after GoRa came to power highlighting the positive aspects of the tax cut scheme. The funny thing about tax cut hope is Vasu, the sworn Marxist also now turning into a supporter of the so-called neo-liberal economics.

      When the SLPP+SLFP were in the opposition, they were always screaming against UNP economic policies branding them as neo-liberal. Now, it is them trying to eat the cake as well but from the wrong end! If anybody believes even for a moment that Cabraal & PBJ can take Ra..kse bros to economic enlightenment, then they are utterly mistaken!

  • 0
    0

    I am not an economist, therefore, I do not pay much attention to economics of the state unless it has a direct impact on my finances. However, I can understand the simple logic of elasticity of demand as described by Mr Wijewardena but what I can’t understand is, aren’t there others like him at the Finance Ministry / Central Bank who advises the politicians on the pros & cons of taxation changes? Obviously, there are but its a case of not daring to oppose the authoritarian wishes of the President & it all boils down to political hype to convince the masses of the glorious regime. In the past, we had uneducated Presidents like Premadasa who did not like advise from professionals & squandered public funds by doing it ‘his way’ & now we seem to be having yet another.

    Whether the loss of revenue to the Govt, through reduction of taxation is recovered by other forms of stealth taxation is another matter. At the end of the day, does the average man on the street has more disposable income due to tax breaks is the question. Direct sales tax in the form of VAT in UK is 20%. Food, books & children’s’ clothing are exempt & consumer goods are priced inclusive VAT but other goods & services will have the VAT added separately in the invoice, therefore, any benefit from reduction of VAT is seen immediately by the consumer. In SL particularly, probably due to unique market condition’s (of supply & demand), traders are quick to add price increases but slow to pass on reductions. For the average man on the street, what matters is how much money is left over at the end of the month after spending for essentials & I will raise my hat to GR if I have a little bit extra cash at the end of the day, irrespective how he does it (& not having to queue up for hours for essentials as in the ‘ration book’ era of Mrs B either).

  • 2
    2

    The tax cuts are not based on economic principles, it is based on Political needs. President and Prime Minister wants to get the support of people to get two third in the parliament. Unless they can’t get two third in the parliament they can’t bring back white van, they can’t get money from China as they did before and they can’t large scale investments for which they can get billions of commissions. Our Agriculture sector suffered a lot due to weather conditions, poor productivity in the export sector. President promised free fertilisers, salary increases to workers and directors without knowing how much wealth Srilanka has and How much debt we have to pay. You can win the votes of Sinhala Buddhists with lies but you can’t win the economy with the lies.

  • 0
    0

    I am not an economist,but value-added tax (VAT) is a consumption tax levied on products at every point of sale where value has been added, starting from raw materials and going all the way to the final retail purchase. But finally the entire VAT is passed to the consumer. This means that the entire Tax is paid by the consumer.If VAT is reduced the tax component of the price is automatically reduced and hence the price should fall.
    For your comments Dr W.A.W

  • 0
    0

    Taxes are how the government collects revenue. This revenue is then used to fund public services (schools, hospitals, roads, etc.). With more revenue, the government can provide better quality services. The caveat is inflation. If the cost of living is high, more taxes will be very unpopular. Luckily we are moving into an era of automation making low inflation and high taxes possible. At some point, it will be possible to produce most essentials cheaply, due to the low labor cost. The labor cost is low because humans have been replaced by robots, meaning the producer is able to “break even” faster on the balance sheet. At this stage, the government will have a new dilemma: how to keep all the unemployed people occupied. It will have to offer them some kind of subsidy. We will see this trend first in the developed world, and then in the developing world.

    • 0
      0

      Yes, that should be common to lankens too. People dont like to pay tax in our country.

      Few years ago, one of my friends was on a training in UK. He is a surgeon. He said to me, what is the purpose of working for a salary that is 40% or more taxed. I dont think he continued to stay in the UK. Not just that only but for some other reasons, he returned to the country.
      And our people as some japanese experts repeat today, wait until GOVT do lot more to them. Almost many things are given free by lanken govt. Today it has become like a school going pupil over backpacked with overloads so that he could end up being a damage at him spine. A state cant offer almost everything free for a nation whose income levels are comparable to that of a mid income earning people. I have no clue, if the statistics are doctored in favour of Rajaakshe goons, but if it is a right, then we should not allow PEOPLE in this country to abuse the state.
      :
      I wonder those MBBS holders, becoming and getting their degrees free but the manner, they treat the own people in a bad manner. They are kept above the law. Not much need to be studied, but looking at the manner GMOA maswaddas behaves as if they are appointed to work for RAJAKASHEs and the like vicious politicians is beyond all ethics and morals.
      I thought, doctors would have hearts. Just because they are doctors they should not go above their limits. They should not be part of active politics.
      I now beleieve, it lies on the SRILANKANE genetics. They should be made aware, the manner they in general behave is WRONG.

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