Recession was needed to control inflation, lower taxes are needed for growth

Almost all central banks use the output gap model to explain the inflation process. They also use to the model to forecast inflation. Romanian National Bank is not an exception. The graph below is put together using data from the Inflation reports. It shows end of year annual inflation relative to the NBR’s calculation of the output gap. The grey area represents the recession period and the vertical splits the data into real and estimated.

For those not familiar with the concept the output gap is a statistical estimation of the difference between potential GDP and actual GDP. Positive values mean the economy is growing above potential while negative values show the economy is below potential. Therefore, when the economy is growing above potential in theory it means that resources in the economy are fully utilized and there is a higher probability that prices will rise due to higher costs. The opposite is expected – lower inflation – for an economy below potential.

I do not believe in this model. The output gap hides if the potential GDP is at 6%, 1 % or -3% and in the end is just an estimate without any theory to back it up. Still, I think in extreme cases it can show you something. From the graph below, it is obvious that it took Romania a prolonged period of recession and years of muddling through below potential GDP to bring inflation down to reach the target of 3% for 2011.

However, going forward, things are not so simple. In the absence of oil price shocks or tax shocks I think the biggest risk for Romania is deflation.  It will be interesting to see how the Romanian economy will cope as real rates will  increase due to the surprise drop in prices. The immediate result in my view will be zero growth or even recession.

To counter this I hope NBR will not go crazy and try to push inflation up to keep real rates low. There is a better solution: lower taxes.  A policy of lowering taxes and commitment to cut public expenditures will help private aggregate demand and investment increase. In the end it is a healthier and more sustainable way to navigate through the  muddy and troubled waters of the following period.

P.S.:

For those not familiar with the Romanian economy, the chart below shows the recent progress of this variable relative to three other countries in the region.

Finally, is good to remain humble and focused as it will take some time for inflationary expectations to be modified in Romania. As you can see in the last 12 months average annual inflation in Romania was almost double than inflation in other countries in the region.

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11 responses to “Recession was needed to control inflation, lower taxes are needed for growth

  • ddr

    I’m not sure lower taxes can help in our current situation. Most companies have incurred tax losses in the past years and therefore can recover them 5 to 7 years from here on. Lowering the profit tax would not impact them in any way.

    On the other hand there are a lot of studies conducted by the European Commission which show that decreases in the VAT rate do not reduce prices, and therefore do not stimulate consumption because prices are sticky and are not very likely to go down. Companies will most likely increase their profit margin instead of lowering prices.

    Excise duties are set by the EU which means the Romanian Gov. cannot lower them.

    Individiual taxation is the key if you want lower taxes. In theory this would mean people would have a higher available income to spend and companies would in turn have lower costs thus being stimulated to hire more people. If the Gov. decides to lower payroll taxes but continues to behave like it has so far individuals/companies will put aside the extra income and not increase consumption or their number of employees.

    Bottom line, we need a more credible and predictible Government if we want lower taxes to have a positive effect on economic growth. Otherwise we will only end up with a larger public deficit.

    • Stefan Balica

      “On the other hand there are a lot of studies conducted by the European Commission which show that decreases in the VAT rate do not reduce prices, and therefore do not stimulate consumption because prices are sticky and are not very likely to go down. Companies will most likely increase their profit margin instead of lowering prices.”
      I don’t buy this. Please share with us those studies. Some unbiased ones would be great too. A VAT of 24% is an excessive one. I don’t think a smaller one can do wonders but it can help everyone.

    • florincitu

      @DDR
      In the short term we desperately need income, profit and social contributions lower. Of course VAT is too high for current economic conditions. In order not to shock the economy a credible plan to cut expenditures and VAT should be made public.
      Playing with nominal rate via monetary policy will only give the feeling that things are getting better but the problems will pile up behind.

      • ddr

        I agree VAT is too high, payroll taxes as well. I really don’t like having to pay a large portion of my salary to the state vor very bad services as I don’t like paying 24% extra for everything I buy. However, from a Macro point of view, decreasing your revenue from VAT without finding other sources of income will prove a bad idea.
        The same thing happened with the flat tax. Imposing a 16% flat tax on company profits was supposed to increase budget revenues. It didn’t, not even in boom years. Moreover the lost revenues were covered from external loans and not by fighting fiscal evasion or broadening the fiscal base. Therefore the VAT had to increase in order to balance the budget.

        If taxes are lowered, but the same or an equally incompetent government is in charge, will people&companies buy&hire more, or simply increase their savings&provisions looking at tax cuts as something only temporary?

      • florincitu

        @ddr

        The point about the perception of tax cuts being temporary is key.
        Nevertheless, I look at the issue from a different point. Lower taxes and short term lower revenues should act as a constraint on the government expenditures in a rules based fiscal policy regime. The end result should be higher economic growth and employment. In this environment the government should be smaller and thus require less revenues.

        The “problem” from the government’s point of view with 16% flat tax was indeed lower revenue which is misleading. The flat tax helped consumption and economic growth but in the same time the government grew (increased the number of employees and their remuneration).

        You cannot have lower taxes without a smaller government and it is the only combination left for us. We already tried high taxes-big government and somewhat lower taxes-big government.

  • B

    Titlul contine o mica eroare gramaticala “was need” trebuia cred ca sa fie “was needed”…. Altfel felicitari pentru continut!

  • Daniel

    Let me see if I’m getting this straight.

    Monetary policy is too tight … which could cause a recession.
    The solution … no relaxation of monetary policy, but a drop in taxes …

    Does not compute.

    When you’ve tightened your belt too much … you loosen it.

    A drop in taxes is sorely needed, but there seems to be a terrible confusion between fiscal policy and monetary policy …

    • florincitu

      @daniel. I’ve been speaking about a more relaxed monetary policy for some time, please see my posts dedicated to this subject. However, my point here is that you can lower real rates by increasing future inflation or via higher productivity. My option is the latter which should be the result of lower taxes for capital leading to higher business investment.

      I should have made it easier to understand that I talk about long term term growth, monetary policy could potentially help short term. Although if we look at the US it does not seem to have helped much.

      Sent from my iPhone

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