Tax Hikes Drive Inflation in Spain

This is a bit disturbing. As a direct result of EU-enforced austerity policies there are now signs of inflation in the troubled Spanish economy. From the Spanish issue of The Local:

You might have heard of the Big Mac Index which compares product prices around the world using the average cost of a McDonalds hamburger as its chief indicator. Now La Nueva España newspaper in Asturias has given this a Spanish twist: the Tortilla Index. The paper reported on Thursday that inflation is biting into the humble Spanish tortilla. Consumer price index figures show costs for the three main ingredients in the tortilla have gone up in the last 12 months. Potatoes are up a third on February last year, oil is 19 percent more expensive, and customers are having to fork out an extra 12 percent for eggs. The cost of living has gone up 2.8 percent in the last year, Spain’s national stats office the INE reported on Wednesday in its latest consumer price index report. Food prices have climbed 2.7 percent in the same period. Other items which have risen in price include electricity and gas — up over 7 percent in the last year — and medicines, up 12.9 percent in real terms according to the INE.

In September last year the Spanish parliament raised the tax rate in two of the nation’s three value-added tax brackets:

Super-reduced rate: will remain unchanged at 4%. This rate includes basic foodstuffs such as bread, eggs and milk; books and newspapers; medicines. Reduced rate: currently 8% will be raised to 10%. This is charged on transport, tourism, restaurants, water and foodstuffs (except alcoholic beverages). General rate: currently 18% will be increased to 21%. This group includes items not included in the previous two groups such as clothing, footwear, electronics and furniture.

Although there was no increase in the rate charged on food, the increase in the middle tier has direct implications for the cost of, e.g., groceries. Furthermore, since this is a value-added tax and not a straightforward sales tax there is always the risk that tax hikes further back in the product chain affect the price of a product even if the rate on that product has not been raised. This is not supposed to happen, but the value-added tax model is notorious for causing inflation as a result of tax hikes on inputs. In this case, the increase in the tax on transportation would cause an increase in prices of groceries, even though transporters pay their own value-added tax.

Back to the story:

One of the biggest surprises [in the value-added tax hike] has been that various products and services have been moved from the current 8% rate to the new 21% rate – a 13% increase. This is the case of the following: dentists, hairdressers, beauty treatments, funeral services, gyms, cinema & theatre tickets, theme parks & zoos. It is doubtful that companies will be able to absorb such a large increase and therefore there are some areas where consumers can save before these increases come into force.

This is a sneaky, back door way of raising taxes. It is devious because it can fly under the radar as no rates are increased. Our American sales tax is not immune to this kind of manipulation, though a value-added system is less transparent.

Here is another reason why the targeted value-added tax hikes are igniting inflation:

Utilities companies will apply the new 21% rate on bills from 1 September even though consumption was during the previous 18% period – all the more reason for you to ensure you’re on the cheapest tariff given the rises already implemented this year. Also phone & internet use in August and billed in September will have the new rate applied. Water is billed either monthly, or every 2 or 3 months depending on where you live, hence some consumers will see the new tax rate applied on a 3-month bill!

All of these products are inputs in retail business. In an economy as bad as the Spanish, nobody, from the supermarkets down to the local grocery stores, can afford to absorb tax increases on power, water, telecommunications or transportation services. Therefore, we can safely expect that this price trend will sustain. This is not good, because it is conspiring with a disturbingly high rate of unemployment and practically zero GDP growth.

Theoretically, the anemic levels of demand in the economy should not allow the retail industry to raise prices the way they do. In practice, though, taxes such as the value-added tax work as a mark-up on costs and are therefore passed on more or less in their entirety to the consumer. This means that the mark-up on prices will prevail so long as the higher tax rates remain in place.

Higher inflation and high unemployment is a particularly bad recipe for a sustained recession. We know it as stagflation, and it can do a lot of harm to an economy once it sets roots there. The United States seems to have dodged a stagflation bullet in 2012, though the alert remains in place for 2013. Right now, though, it is time to pray that Europe does not get caught in this rather nasty macroeconomic quagmire.