The Economics of GST - Robbing Peter to pay Peter?

A blog claims that increasing GST to fund social programmes is like robbing Peter to pay Peter (http://aaron-ng.info/blog/robbing-peter-to-pay-peter.html). Some of my friends also expressed how the stated intent of the GST increase - to help the poor - sounded like oxymoronic spin.

I feel compelled to say something, from the standpoint of my profession. In reference to the above mentioned blog, the robbing Peter example is incorrect. In a nutshell, the economics of the tax is sound.

The policy maker has to raise tax to finance the necessary expenditure. What is the best way to do it? The best tax is one that does not distort the price signals. The classic one is the lump sum tax. Once the tax is levied as a lump sum, there is no impact on the relative prices between goods at all. Margaret Thatcher tried this with the Poll Tax (every one was to pay a fixed sum) back in 1989. Good economics, but bad politics. People were simply aghast with the idea that every one had to pay the same amount. It led to widespread riots and eventually brought down the her government.

So no Poll Tax. What about others? Income taxes have a negative effect on work incentives, which explains why other countries are cutting, not raising, it.

What about consumption taxes? If the consumption tax is levied across all goods, it does not change relative prices. Prices of all goods increase by the same percentage. So if you are clamouring for exemptions for the poor (such as on food, medical items etc etc), you may be well intentioned, but are in fact introducing changes to relative prices as a result of the tax.

An undergraduate economics student will know that this creates what is known as a excess burden - which is a loss to society. Why? Because the relative prices are distorted by the uneven application of the tax, people over consume those goods that are exempted and under consume those that are not. It becomes a resource distortion to the economy - resources are not allocated to the goods most highly valued, but by the favouritism of the tax.

But of course, at this point, many of you would jump up and say - wait a minute, isn't consumption tax levied on all goods regressive, since the poor spends proportionately more on consumption? Yes and no. Indeed, every one (including, but not only, the poor) will be worse off in terms of welfare with the increase in GST. The trick however is to compensate the poor an amount no smaller than the loss they suffer (economic jargon: compensating variation). The key therefore is how much the Government compensates the poor in terms of income packages elsewhere. The whole package has to be taken into account.

But does this make sense financially, taxing and giving back? GST will affect all of us, but the compensating package will only be for those who need it (however defined). Since the policy maker is not giving every one compensation, it therefore makes sense financially for him. He can either choose to compensate the poor more, or spend on other programmes. He is robbing every one, including Prosperous Peter and Poor Paul. He then gives Paul an amount no smaller than what he takes from him. Peter gets nothing. The policy maker might even have some left for himself.

Explaining the economics is easy, it is rational and it is scientific. But I can understand how dealing with the emotions of the tax increase will be much more difficult. Margaret Thatcher will know.