More Inflation & VAT Fun

My post of late yesterday, which was on the incidence of VAT rather than inflation, ended up far too lengthy, so to edit that down to the bare minimum...

1. The Consumer Price Index figures (Excel, Table 1) are given for separate classes of spending, some VAT-able (e.g. 'Alcoholic beverages and tobacco') and some not (e.g. 'Food and non-alcoholic beverages'). The main rate of VAT has changed quite significantly three times in the past four years, so if we compare the relative price changes of VAT-able and non-VAT-able items, this gives us a good indication of how much VAT is passed on to the consumer (in higher prices) and how much is borne by the producer (in lower margins).

2. Between November 2009 and November 2011, the average CPI for non-VAT-able supplies went up from 129.9 to 141.9, which means there was 9.3% 'monetary' inflation (as per Lola's definition below). That's our baseline.

3. In November 2009, the main VAT rate was 15% and by November 2010 it had been increased to 20%, so if it were true that producers can pass on all VAT to the consumer by increasing prices, then VAT-able supplies would be subject to additional 4.3% 'government-made' inflation (i.e. old price £1.15, new price £1.20, £1.20/£1.15 = 1.043) on top of 'monetary' price inflation of 9.3%.

4. So predicted CPI inflation for VAT-able supplies over the period would be 14% (1.093 * 1.20/1.15 = 1.14).

5. As it happens, the average CPI for VAT-able supplies went up from 103.1 to 113.2 over the same period, which is total inflation of 9.8%. So by subtracting our baseline 'monetary' inflation of 9.3%, we see that the consumer lost 0.5 (higher prices) and the producer lost 3.2 (old net selling price = 100.0/1.15 = 87.0, and the new net selling price = 100.5/1.20 = 83.8).

6. Thus the consumer only suffered one-seventh (=0.5/0.5+3.2) of the extra 5% VAT in terms of higher prices, and the producer suffered six-sevenths of the VAT (=3.2/0.5+3.2).

7. So the next time people try to tell you that VAT is a 'good tax' because it is borne by the consumer not the producer, or that this year's CPI inflation figures will be lower because the last VAT increase drops out of the equation, feel free to laugh in their faces.
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As background, Lola tried to put John Redwood straight on the topic of inflation, this seems like a good way of looking at it, so I'll repost the whole comment here:

There is a big problem with Mr R’s analysis and that is a confusion between ‘inflation’ and the ‘rise in the cost of living’. The problem is that the Bank of England shares this confusion which is explains why their predictions (impossible anyway) have been/will continue to be, dire.

Firstly, inflation is a function of money. Money is a commodity with, for all intents and purposes, a zero cost of production. If too much is produced its price falls, and hence the goods and services priced in that commodity we exchange for it will rise.

Secondly, the cost of living can be affected by a range of factors that prevent the prices of the goods and services we buy achieving equilibrium, or trending lower, as capitalism does more for less every day. Mostly these are government inspired taxes, subsidies (the reverse of taxes), sclerotic regulation and similar interventions in the spontaneous order of the free market. These price rises are not inflation. They are simply price rises caused by government. This is what confused Brown (easily done with such a numpty). He thought that the lack of price rises meant that his loose money/high debt policies weren’t inflationary. What he failed to factor in were the price reductions coming on stream from the economic liberation of China and similar. His legacy is real inflation.

The situation now is that the government in trying to put right both Brown’s inflation – an unwarranted expansion in money and credit, and his price rises – excessive taxation/subsidies and regulation, by increasing prices by increasing taxes, rather than by properly cutting goverment spending. Which Mr R has already said many times that they are not doing at all.

What now has to happen and will happen, despite whatever the Coalition or the Bank of England do, is deflation and de-gearing. The deflation is already under way as the money supply (i.e. the [fraudulent?] creation of credit) contracts. At the same time assets purchased at inflated prices and bad investment made under the false price signals under Brown’s lunacy will have be liquidated, and they are being. In fact most of these were in real estate, and house prices will fall a lot more.

But because the Government and the Bank of England mis-define inflation, they will make this process unnecessarily painful, and so prevent us from benefiting from this process. Government-made price rises from taxes and the like will make us even poorer and worst of all utterly constrain real wealth creation and the maximising of production, which in its turn would create real jobs.

All pretty sensible, you might think. And John Redwood's reply?

Reply: The Bank’s task is to control measured inflation, which is measured by a basket of goods where relative prices may shift, and where there are arguments about how you adjust the index for changing quality and styles of product purchased. Measured inflation may be your monetary inflation or movements in prices caused by other factors.