Sunday, 23 January 2011

A major inflation driver ?

UK and Greece were among the countries with the highest inflation rates in Europe throughout 2010. What is their secret? Hikes in VAT…

VAT is an acronym for Value Added Tax.
While all European (and especially Euro – Area) countries have VAT taxes in place, not all have increased VAT rates during the past 2-3 years. Two of those that did are Greece and the UK. Among those that didn’t are France and Germany.

In the UK VAT was hiked in 17,5% from 15% on January 2010 and it will be hiked in 20% on January 2011.

source: ECB

In Greece there were a number of hikes in 2010 and some reductions for certain goods but overall there was a substantial increase in 2010.

France has not put through any changes in the VAT rates since 2000, while Germany has not altered said rates since January 2007.

It is obvious that the two aforementioned countries that raised the VAT rates currently have the highest inflation rates. So, there is clearly positive correlation between indirect tax rates and inflation (at least in cases where retailers and producers cannot or are not willing to shave their margins further or trade in products that are relatively price inelastic).

One could say that part of the rise in consumer prices could be attributed to rising commodities prices, but during the second half of 2010 that commodities’ prices staged a substantial rebound, consumer price indices in Greece and the UK are mostly flat. So the inflation differential, in my view, should be attributed to the hike in VAT.

The problem, with VAT and all indirect taxes (apart from stoking inflation) is that they are unfair from a social perspective. Generally, the higher a person’s income is the less of it he/she actually needs to spend in order to fulfill its basic needs. This means that people with lower incomes spend a significantly bigger chunk of their income, hence with indirect taxes they are more heavily taxed than people with higher incomes. 

But if that is so, why in times like this do governments hike VAT taxes? Surely their popularity (at least in some cases) is at all-time lows so they surely don’t need the criticism and unrest that such moves generate. Maybe a look at the next graph can throw some light at this.

source: OECD

In other words it is easier to collect indirect taxes than income taxes. This is especially true in countries with a large informal sector. These incomes cannot be taxed through income taxes but at least a part of them will find their way into buying goods and services, thus with indirect taxes governments can indirectly and partially tax these incomes too. 

Of course, this doesn’t make indirect taxes socially fair…



  1. It is not just VAT but overall tax increases. Excluding tax increases inflation in Greece is below 2% (rough estimate). it should be given that since the adoption of the euro a huge competitiveness gap was created and most competitive countries (read Germany) have low inflation.

  2. I totally agree...and the competitiveness gap already existed but the Euro made it a whole lot worse....that's the definition of a real currency appreciation (for Greece) and a real currency depreciation (for Germany or Holland etc.)...

  3. A very good article Nickos. Several questions arise.
    It is a fact that inflation is largely predictable in the short- term horizon and thus the asset allocation policy of a short - term investor is based on this fact.
    But is it really predictable in the short -term??
    If the answer is no, from an investment perspective, the inflation risk can be considered a major factor for a short - term investor.This has as a result a different asset allocation policy for the short - term investor who "has to" hedge her/his inflation risk.

    Up to date the inflation is considered predictable in a short -term horizon and thus the inflation uncertainty is extremely low..but is it now the time that maybe this fact must be reconsidered??

    The hike of the VAT taxes of the aforementioned countries have an indirect impact of the asset allocation policy of a short - term investor...


  4. Thank you Thanos...I'm glad that you liked the post and I'm glad that you made this comment so we can have something to discuss...

    Well, I think that there is always the possibility of an unpredictable event that drives prices upwards out of the in Greece, we have a vast experience of such strikes, sending vegetable prices unexpectable policy decision that hikes tax rates, hence affecting prices...or with a more global scope...a worldwide oil-carriers strike that can send oil prices flying.....or i times like ours, where there is social unrest in certain countries, a sabotage of crops or oil production facilities that can induce a short-term inflationary shock...

    But these are really black swan events...they don't happen that often...I guess one has to look at the possibility of such events occuring when deciding his asset allocation, but I don't know what are his chances of predicting one...I obviously am no expert on asset allocation....

  5. p.s. what do you think..??