Saturday, May 28, 2011

Tax Increases As Negative Supply Shocks

What may surprise some is the fact that despite having growth significantly above the euro area average, Germany actually had an inflation rate that was slightly below average (2.7% versus 2.8%). And of all debt crisis struck countries, only Ireland (1.5%) had a lower inflation rate, while Portugal (4%), Greece (3.7%), Spain (3.5%) and Italy (2.9%) had higher inflation rates than Germany and the euro area average.

For several reasons, including the Penn effect, you would expect faster growing regions within a currency area to have higher inflation, yet right now the opposite seems to be the case. Why is that?

The main reason is the fact that as part of their fiscal austerity, the crisis countries have raised consumption taxes, mainly the VAT, but in some cases also excise taxes on for example gasoline, tobacco and alcohol. Such tax increases have an effect similar to a negative supply schock. By increasing the tax wedge between what consumers pay and what producers receive, growth will be hurt which reduces the supply of goods while at the same time prices are increased.

The positive correlation between growth and inflation within currency areas presuppose that there aren't any supply shocks of the positive kind in fast growing countries and that there aren't any supply shocks of the negative kind in weak countries. But in this case there has been negative supply shocks for the weak countries in the form of tax increases.