Is Consumption a Giffen Good?

That lower-income Americans don’t save is a widely-accepted problem. In general, liberals believe wealth inequality (a function of savings rate) can be mitigated with strong social insurance programs and cash transfers. Both liberals and conservatives believe in the value of “nudging” people into saving more via opt-out retirement programs. Only conservatives, however, seem to believe a simple sales tax* would help the poor save more. Liberals retort by (rightly) noting that a non-progressive consumption tax is, by definition, highly regressive. The burden of a sales tax falls on the poorest. (Note I’m talking about the famous FairTax not better systems like an X Tax, or a graduated levy on wages/business cash flow, which hardly get the political traction of simple sales taxes).

With a number of Republican-heavy states planning on taxing sales instead of income and Congress debating a national Internet sales tax, I find myself in the awkward position of agreeing with Grover Norquist. By citing that sales taxes are regressive, liberals fail to advance debate in a meaningful manner. The sad truth is that the GOP is largely interested in anti-progressive modes of taxation. Sales fits the bill.

But, based on a simplistic understanding of economic models, conservatives believe that a simple sales tax would somehow increase savings rate. Take this fairly well-argued article for a national VAT from 1996:

Perhaps the feature of consumption taxes that its proponents cite most often is that they are not imposed on income derived from savings and investment, making higher rates of saving and economic growth more likely

Now, keep this in mind, while I explain a very interesting phenomenon from developmental economics, the Giffen Good. (Feel free to skip the next section if you understand the dynamics thereof) Perhaps the most fundamental rule of economics is that, ceteris paribus, the quantity demanded of a certain good at a given point in time is inversely proportional to its price (did I get everything?) A handful of items defy this “law”. Veblen goods, are usually luxury items for which the price is itself part of the value, signaling class and exclusivity. For these goods, there are certain price levels at which the demand curve slopes upward.

A far more elusive such item is the “Giffen Good”. Think about what happens when the price of Coke increases: the relative (opportunity) cost of Pepsi falls increasing its demand. Simple, right? This is called the “substitution effect”. But there’s another force at play. In economics, the purchasing power of your unit of account is inversely proportional to the price level. As the price level increases, your relative income falls. Now, economists define “inferior goods” to be those goods for which increased income results in decreased demand. Think fast-food and Goodwill. Conversely, when income falls demand increases.

Putting this all together, there might (there actually are, a very interesting series of articles here, here, and here) be a good:

  • That is economically “inferior”
  • For which the income effect is greater than the substitution effect
  • For which the good represents a large portion of overall income

The classical example is rice in several Chinese provinces. Here, farmers substitute between rice and meat, where rice is inferior, but staple. An increase in the price of rice results in a greater outlay in meeting the necessary amount, without enough leftover to purchase meat, which is then redirected into increased consumption of rice.

I think there’s strong reason to believe consumption itself is a Giffen good, in other words increasing the cost of consumption (through a sales tax) will only further increase consumption. Let’s look at the evidence.

  • As far as allocating income there are two, and only two, options: consumption or saving/investment – let’s assume that a citizen rationally substitutes between the two.
  • Consumption is clearly an inferior good. As income increases the marginal propensity to consume falls, and the relative share of savings and investment are far more prominent at high income levels. (Note, I understand that total consumption increases with income, but as the object of concern is savings rate, it is the relative share that matters)
  • There are no alternatives to substitution between income and savings.
  • A certain level of consumption is necessary (to buy food, gas, clothing, shelter, etc.)

So think about the target family earning $30,000 about whose savings rate the conservatives are oh-so-concerned. Said family saves $1,000 a year, has a “staple” spending of $27,000 and a discretionary spending of $2,000 (note that this isn’t discretionary as in a vacation to the Alps Florida, but buying a few extra books or a movie).

If sales tax is increased by 10%, even if the family cuts all discretionary spending, there is still a shortage of $700 from taxes on the necessary consumption. This can only come from savings rate.

So, on this family, a 10% increase in consumption tax, counterintuitively, directs 2.3% of total income back to consumption from savings. Oh, and, remember – income tax cuts won’t help this mooching member of the “47%”.

So next time your friendly neighbor GOP governor tells you that a sales tax will somehow help the poor, ask him if he’s ever sold rice in rural China.

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