The Grocery Commissioner does not have a magic wand that will pass all GST savings onto food consumers

Regular readers of this blog, who also pay attention to the news, will have anticipated that I wasn't going to let this one slide. The Labour Party has announced that, if re-elected, it will remove GST from fresh and frozen food. As the New Zealand Herald reported earlier this week:

Hipkins and several ministers took to Lower Hutt yesterday to confirm Labour’s predicted election promise that it would remove GST from fresh and frozen fruit and vegetables from April next year if elected, putting $4-5 per week back into people’s pockets at an overall cost of $2 billion over four years.

When it comes to economic illiteracy in government, I don't think anything will every beat the stupidity around "it's not a tax, it's an excise". However, removing GST from food is close. Just read some of the expert comments in this New Zealand Herald article. Even the wildly pro-Labour CTU economist Craig Renney could only manage the lukewarm:

“It wouldn’t be my first choice if we were going to do this, but it’s definitely something that’s worth exploring”...

Worth exploring, then quietly forgetting all about the exploration, and disposing of the map you took to get there in a place where no one will ever find it. As I said a couple of weeks ago "this is a policy failure in waiting, if the government ever chose to implement it". I've covered similar points a few times (see here and here), so I'm not going to flog that dead horse again. Instead, I want to pick up on a comment from this New Zealand Herald article:

The 15 per cent tax would remain on items that had been processed, such as canned goods and juices. An expert group within Inland Revenue would be established to decide what products were exempt, and the Grocery Commissioner would be responsible for ensuring savings were passed on to consumers.

The Labour Party website says that (emphasis is theirs):

The Grocery Commissioner will monitor supermarkets, and report publicly to make sure that the actual cost benefits are passed on by supermarkets to New Zealanders. We will be tasking the newly established Grocery Commissioner with ensuring that supermarkets and other grocery outlets are not profiting from this policy change.

What the hell are "actual cost benefits"? Are they costs, or benefits? Let's be charitable and put that additional economic illiteracy aside, and assume that the Labour Party is trying to say that they want all of the cost savings from removing GST to be passed onto consumers. On the face of it, that seems like a reasonable expectation. Except that it will be impossible for the Grocery Commissioner to enforce.

To see why, consider the market for fresh food, as shown in the diagram below. If there is no GST, then the market would operate in equilibrium, with a price of P0 and a quantity of fresh food traded of Q0. However, GST, which is paid by the seller, effectively increases the sellers' costs. We represent this with a new curve, S+tax. GST is an ad valorem tax, which means that the amount of the tax is a proportion of the price of the good. So, the S+tax curve starts off close to the supply curve, and gets progressively further away as the price of the good increases. With GST in place, the price that consumers pay for food increases to PC. The producer receives that price from the consumer, and then passes the GST onto the government, leaving the producer with an effective price of PP (the difference between PC and PP is the amount of GST per unit sold). With the higher price including GST, the consumer demand less food (QT), and with the lower effective price after paying GST, the sellers supply less food (also QT). There is no excess supply or excess demand. Now, removing GST moves the market from a price of PC for consumers to the equilibrium price of P0 - consumers end up paying a lower price and buying more (Q0 instead of QT). However, the effective price for sellers increases from PP to P0 as well - producers end up receiving a higher price and selling more (Q0 instead of QT). Both consumers and producers benefit (in terms of price) from removing GST from food.

We can also look at this in terms of economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, with GST in place, consumer surplus is the area ABPC. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, with GST in place, producer surplus is the area PPCF. The GST that is collected by the government, which is the per-unit amount of GST, multiplied by the quantity of food sold) is equal to the area PCBCPP. Total welfare is the sum of the three areas (consumer surplus, producer surplus, and government revenue), and is equal to the area ABCF.

When GST is removed, consumer surplus increases to the area AEP0, producer surplus increases to the area P0EF, and total welfare increases to the area AEF. Overall society gains total welfare equal to the area BEC, which was the deadweight loss of GST. [*] However, notice that both consumers and producers benefit (in terms of economic welfare) from removing GST from food. In an economists' view, eliminating the deadweight loss may be the only redeeming feature of this policy. [*]

But wait, you say! This is where the Grocery Commissioner steps in and says to the sellers: "You have to pass on the 'actual cost benefits' to the consumers". The Grocery Commissioner then waves their magic wand and the sellers lower the price for consumers all the way to PP, thereby ensuring that the whole difference between PC and PP is passed onto the consumer. That situation is also shown in the diagram above. At the price PP, the seller is willing to sell the quantity QT (just like before). However, consumers are wanting to buy QD food at this lower price. There is excess demand for food at the low price (there is a shortage). There isn't enough food available (QT) at the low price PP to satisfy all of the consumer demand for it (QD).

What happens to economic welfare? Producer surplus remains the area PPCF, just as before GST was removed. Consumer surplus increases to the area ABCPP, which is presumably higher than it would be at equilibrium, However, total welfare remains equal to the area ABCF, and the deadweight loss remains equal to the area BEC. In other words, in economic welfare terms, removing GST and forcing producers to continue to sell at the same effective (excluding GST) price would have the effect of transferring economic welfare from the government to consumers. Hooray for consumers.

However, then you have to think about which consumers will get that extra economic welfare. It's not all consumers. It's only consumers that buy fresh or frozen food. To be fair, that is probably most (if not all) consumers, but the bigger spenders (that is, higher income households) will benefit the most. If you really cared about low-income households, you could do a better job of helping low-income households by ringfencing the existing GST collected from fresh and frozen food, and using that money to increase social security benefits, family tax credits, or simply giving a transfer directly to all low-income households.

Now, let's go back to the Grocery Commissioner. It turns out that they don't have a magic wand that can keep the price at PP after GST is removed. The market will move back to equilibrium, and the benefits of removing GST from fresh and frozen food will be shared between consumers and sellers. It's not going to be possible to dictate that all of the tax savings are passed onto consumers, in the same way that it's not possible to dictate that a tax is only paid by one side of the market (for more on that point, see here).

So, unless the government is planning to replace Pierre van Heerden with Harry Potter, they're not going to ensure that all of the GST savings are passed onto consumers.

*****

[*] Although even removing the deadweight loss is not enough to fully redeem the policy, as noted in my other posts on this topic (see below), and in the criticisms of the experts.

Read more:

• Judge rules that snuggies are blankets, not clothes
• Stephen Hickson on why we shouldn't remove GST from food
• We also shouldn't be debating removing GST from food