Macroeconomic Effects of a Switch to Indirect Taxes: Some Evidence from the UK and the EC

Abstract

This paper considers the evidence from simulations with major econometric models of the UK and EC relating to the effects on the main macroeconomic variables of a switch towards indirect taxation. The conclusion from this evidence is that a switch from income tax towards indirect taxation tends to increase the price level, the rate of inflation, the current account deficit, and the public sector borrowing requirement, and to reduce the country’s net wealth, at any given level of real GDP. One especially important conclusion is that the increase in inflation is significantly due to the cut in income tax, and not only to the effects of the rise in indirect taxation; and that the effects on inflation of the cut in income tax tend to last longer than those of the rise in indirect taxation. If the government of the country making the switch in taxation tries to hold down the consequently higher inflation and the rise in the current account deficit by reducing economic growth, the adverse economic effects will be correspondingly greater — and this appears to be what happened in both Britain and New Zealand, the two OECD countries that have made a marked shift in tax structure in this direction over the past decade.