Why sales taxes do not affect prices directly

This is a continuation as to why Feiglin is wrong when he says that zero VAT on newly built homes will benefit the rich more than the poor, thereby widening the gap between rich and poor. (For people new to this blog, I still support Feiglin for Prime Minister enthusiastically. He’s just wrong on this issue.)

This is a very important point that few people understand, precisely because it is so counterintuitive. Consumption taxes like value added taxes, in Hebrew מע״מ for מס ערך מוסף, do not have a direct impact on the prices of goods that are taxed. If you search this blog, you’ll find that earlier posts from several years ago have made the same mistake in assuming that VAT is simply passed on to the consumer. It never is. It is impossible to pass on a consumption tax to a consumer. It is always passed backward onto the retailer, never forward on to the end consumer.

Murray Rothbard wrote about this in Man Economy and State, Chapter 12, section D, paragraph 4. Here it is: (I finished the 1,369 page book two months ago. Yay for me.)

In considering the general sales tax, many people are misled by the fact that the price paid by the consumer necessarily includes the tax. If someone goes to a movie and pays $1.00 admission, and if he sees prominently posted the information that this covers a “price” of 85¢ and a tax of 15¢, he tends to conclude that the tax has simply been added on to the “price.” But $1.00 is the price, not 85¢, the latter sum simply being the revenue accruing to the firm after taxes. The revenue to the firm has, in effect, been reduced to allow for payment of taxes.

The general sales tax Rothbard refers to is the VAT, or the מע״מ. So if we translate that to houses and use Feiglin’s flawed analogy, a house that costs 1.6M NIS, does NOT actually cost 288K less than that on the free market because of the VAT which is supposedly tacked on to the end. The house costs 1.6M, period, regardless of whether there is a VAT or not. Why must this be so?

Because a price is not just a number that a seller sets in order to make a certain profit he feels like making. If that were true nobody would ever sell at a loss. A price is what the seller can get on the market regardless of the profit he makes or doesn’t make. In other words, it’s not like the seller of a house or the builder of a house who is selling it feels like he has to make X profit on the house and therefore sells it for 1.6M assuming a VAT, but would sell it for 288K less if he sells it without a VAT and get the same profit. It doesn’t work that way.

A price is a finely tuned level where buyers and sellers equal out. It is the point where supply and demand meet, not the point at which the seller feels he has made enough money. If by divine intervention the VAT were abolished tomorrow, the price of housing would NOT suddenly shrink by 20% or whatever the VAT is. If it did you’d have a rush of demand that would immediately bid the price back up to the current levels.

A clear illustration of this is what happens at a supermarket sale designed to get you interested in a product. The supermarket often sets something at below a market price and then limits you to a certain amount of it. Say tomatoes are on sale for a shekel a kilo when the real free market price is 3 shekels a kilo. The store will inevitably limit you to, say, 3 kilos. Why the limit? Because by going below the free market price, it has voluntarily introduced a shortage, necessitating the limiting. If it were at the free market price, there would be no limit on any customer, because the free market price IS ITSELF the limit.

The current price of housing is the equilibrium point between supply and demand. If VAT were gone tomorrow on everything, the prices of everything would stay the same because the equilibrium point between buyers and sellers of anything has not changed overnight. If suddenly the price of housing dropped by the VAT amount, then you’d have more buyers willing to buy than sellers willing to sell, and the price would quickly jump back up to the current market price. Perhaps a few sales would be made at current prices minus the VAT, but they would be made so fast that the competitive bidding would very quickly push the price back up within days or hours to reach equilibrium again.

Therefore, there IS no benefit to rich people of 288K on a 1.6M house, because the price WOULD NOT CHANGE. Neither is there any direct benefit on any other buyer of any house no matter how rich or poor he may be.

Where there IS direct benefit is on the SELLER of the house, or the builder of the house who is the seller, in that he gets to keep the amount of money previously stolen from him by the government. The SELLER of a 400K house and a 1.6M house could be the same person. In fact, the seller of a 400K house could be rich while the seller of a 1.6M house could be poor. The benefit to them of getting rid of the VAT is that they no longer have to pay 20% (or whatever the VAT is) to the government, so they can keep that and reinvest it in say building more houses instead of buying more $60K Iron Dome missiles to swat flies out of the air from Gaza.

That eventually ups supply, gradually bringing the price down on everything. So yes, getting rid of VAT does lower prices INDIRECTLY, only by increasing supply through reinvestment of profits that would have otherwise been taken by government and spent on some inner city school prison. But in Israel, since the government owns 93% of the land, there is no way to up supply even if the VAT is obliterated. So housing prices would continue to rise, as Feiglin says in his post. However, even so getting rid of the VAT would lower prices on whatever the bigger profits were reinvested in, so we’d be better off on net anyway even if housing prices are not affected because of the government land monopoly restricting supply.

Conclusion: It’s not that buyers of more expensive houses will get a greater benefit. They won’t. It’s that sellers of more expensive houses will have less stolen from them. Those sellers could be anyone. Stop with the class warfare, I don’t want to hear anything about Rich vs Poor and the supposed battle between them. The battle is between taxpayers and tax receivers. The battle is between rich and poor taxpayers vs rich and poor tax receivers.

We need to fight the tax receivers until they no longer receive anything. (Yes, this includes Feiglin himself as a Knesset Member, and the only reason I give him an exception is that he is leading the fight from within the government, and there is no other way I see of taking them down legally and nonviolently.)

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5 thoughts on “Why sales taxes do not affect prices directly

  1. This is somewhat old, but so what.

    A great analysis (and it so cogently demonstrates just how weak the vast majority of people when it comes to economics), but there is another reason why prices won’t go down until the bubble pops, and that is the increased ability to borrow is what really drives prices up, all else being equal.

    As the Bank of Israel has loosened leverage limits and lowered interest rates, it has enabled prospective buyers to borrow much more money. People shop for a monthly payment, not a house price. Yes, the government controls close to 100% of the land in the country, but even still, prices were only going up very slowly until 2008, pretty much in line with GDP growth, when it started lowering interesting rates and reducing margin requirements on mortgages. It’s a little more complex, because foreign buyers might have additional access to capital/credit that locals don’t, but that is a narrow niche, compared to the vast majority of local buyers. But the bottom line is, prices can’t go up if the money (or credit) is just not there to push them up.

    The zero VAT proposal wouldn’t change the above in any way (as you pointed out). Prices in SOME cases immediately after implementation might go down (my guess is it would be to avoid the stigma of being labeled a price gouger or something similar), but it would literally be blip, like a flash crash in the markets that immediately corrects itself.

    The Israeli economy does have some advantages over the US in its own expansionary phase, but there will be a point where the bubble does indeed pop, when the central bank reins in the credit expansion.

  2. Lower taxes brings more sellers into the market, immediately,and not just after an interval, and makes sellers more eager. So prices would drop, or not rise as fast.,.

  3. >> If VAT were gone tomorrow on everything, the prices of everything would stay the same because the equilibrium point between buyers and sellers of anything has not changed overnight.

    Actually, sales taxes do change the equilibrium point, because sellers can afford to – or are more willing to – sell for less. Sellers always can be assumed to try tp get the maximum they can, but they will never sell below the a minimum. (unless it’s what is called a fire sale, and they have to take whatever they can get)

    • Sammy –

      Removing sales taxes can only change the equilibrium point indirectly by increasing seller profits, which are then reinvested into more supply. It can’t change the equilibrium by making sellers willing to sell for less. Sellers will certainly be willing to sell for less, but that is irrelevant, because buyers will bid the price back up to the previous equilibrium. Only after some time will the extra supply kick in to lower equilibrium, if at all. There is no maximum or minimum a seller is willing to sell at. He will sell at whatever the market price is, regardless of whether it is a “fire sale” or not. Sellers always take what they can get. They can get what the market price is.

      A real fire sale is when a seller purposely pushes his price below the market price, causing a rush and a shortage, meaning not everyone willing to buy at that price will get to. A fire sale is not simply a seller selling at below his buying costs. That’s just a loss.

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