If the government increases the VAT rate then, obviously, inflation is going to rise. Prices of things will go up by the amount that VAT has gone up so inflation must rise by the VAT increase. This is obvious.
It is indeed obvious and it's also not true. Which is one of those little contradictions that people like me just live for. Hey, everyone's got to have some fun in this life and my enjoyments seem less harmful than those of many others.
The Finance Advisor Salehuddin Ahmed has told us that yes, the VAT rate has gone up but also that this really won't affect the inflation rate very much if at all. The secret is in this: “The main indicators of our inflation basket are items like rice and lentils.”
Now, one thing about tax rises is that they are one time changes in the inflation rate. If prices -- just to use a number, a made up one -- rise by 10% this month because of a new tax then inflation over the next 12 months will start from that basic 10%. But in month 13 that 10% price increase has dropped out of our inflation measure -- because we measure inflation over the previous 12 months. So, in one sense a tax rise is not so much an increase in inflation as a change in the price level. We usually -- usually and not exactly -- think of inflation as something that continues, not a one time step change.
But it's that rice and lentils thing which is the real point here. Our economy contains perhaps one billion items. That's not one billion lentils, but one billion different things. This type of lentil, that, left hand thread screws, half inch, brass, right hand thread screws, half inch, brass, and has anyone ever managed to count how many different rices or chilis are available? And sofas, t-shirts, and all the rest.
The government does not, in fact, track the prices of 1 billion different things. No one does -- quite literally, no one at all. What is done instead is to make a decision about what are the important things where prices should be tracked.
The assumption is made that things which people spend a lot of their income upon are important. If 20% of incomes are spent upon rice and chilis (just an example) then those are important prices to be tracked. Left hand thread brass screws not so much -- it's only Ahmed and Faisal over in Chittagong who ever buy any anyway (a joke, but, brass, seawater, left thread for vibration from engines, could be). So, our measure of inflation should -- because it's a big and important cost for lots of people -- include the food basics but not every fastening device in the country.
What we actually do is look at what people in general spend. What's the average “shopping basket?” There are even different flavours of this, including or not including housing costs, for example. We then call that the inflation basket and monitor the prices of those 300 or 500 things. Then we weight price changes. So, if rice is 10% of spending and the price moves 10% then that's a 1% change in the overall inflation rate. If chilis 5% of spending, 10% price change, 0.5% of inflation and so on.
This basket changes over time and in different places too. In my lifetime, in my native Britain, MP3 players didn't exist, were some new weirdness, an essential in the inflation basket and now are old hats and not counted any more. All based upon how many people were paying how much of their income for them.
And thus the trick being done here about VAT. Yes, the rate -- rates, perhaps, on different things -- have gone up. But the things that VAT has gone up upon are the things that don’t really appear in our inflation basket. Because they're just not the things that all of us spend a large, or even significant, part of our incomes upon. So, they don't count for the purpose of calculating inflation.
Seems like a trick but really, it isn't.
There is a trick here though. As not many of us spend very much of our income on these things where VAT has risen the changes won't raise very much money. But then, yes, we've new politicians now but how far do we trust even them with more of our money anyway?
Tim Worstall is a senior fellow at the Adam Smith Institute in London.
