The Gross Earnings Deflator

Abstract

In many Western countries, it is felt that it is desirable to switch the tax burden somewhat from direct to indirect taxation. Proposals to introduce a Value Added Tax (VAT) in substitution for income-based taxes have been widely canvassed in, for example, the United States, Australia and New Zealand. A major obstacle to the implementation of these schemes is concern for the effect of such a switch on price indices. In the United States, 'the treatment of the value added tax in official index numbers, especially the consumer price index, might be an important issue were the tax to be adopted here' (Aaron, I98I, p. I 3). In New Zealand, 'the Task Force is aware that a shift from direct to indirect taxation is bound to have effects on prices and incomes. These effects could be inflationary, in immediate impact, and perhaps induce continuing effects' (McCaw, I982, para. 3.8). Since an index should not in itself be an objective of economic policy, such concern may seem absurd. However both casual empiricism and the specification of most empirical models of wage determination suggest that past movements in price indices influence the level of wage settlements. It follows that a change in the tax structure may have inflationary implications beyond its direct effect on price levels. The reason for this is that price indices are used in wage negotiations in an inappropriate way. A consumer price index measures the change in net money expenditure required to maintain the purchasing power of that expenditure. Wage negotiations, however, are concerned with gross incomes. The relevant benchmark against which movements in real wages are to be measured is not the purchasing power of net expenditure but the purchasing power of gross income. In Britain in I 979 a Conservative government was elected with a policy of implementing a major shiftfrom direct to indirect taxation. They raised the standard rate of VAT from 8 to I5 %, and made compensating changes to income tax whose net effect was to leave the tax burden on the majority of the population virtually unchanged (Kay and Morris, Ig79 a). The shift was estimated to raise the Retail Price Index (RPI) by approximately 4 %. This led to political criticism of the use of the RPI in wage negotiations, and to the publication of a new official index, the Tax and Prices Index (TPI). The basic principle behind such an index is simple enough. While a measure such as the RPI asks the question 'what increase in money expenditure is required to enable a household to continue buying a representative bundle of goods?', the TPI asks 'what increase in gross income is required to enable a household to continue buying a representative bundle of goods?' However, the realisation of an index of this type raises a number of difficulties. In particular, [ 357 ]