The slashing of taxes on over 200 items under the goods and services tax (GST) regime has not led to a commensurate decrease in their prices. That’s the complaint against businesses that have refused to cut their prices to pass on the benefit of lower taxes to consumers. In fact, many customers have taken to social media to point out that food outlets like McDonald’s and Starbucks, which now pay 5% instead of 18% in taxes, have raised their menu prices to make up for lower taxes. The government, for its part, has created the National Anti-profiteering Authority (NAA) that will supposedly ensure that the tax cuts are passed on to consumers.
Busting a myth
What businesses are doing today after the cut in taxes, however, is hardly surprising from an economic point of view. Ordinary citizens think that prices are determined by the costs that a business incurs to bring a product to the market. So any decrease in taxes imposed on a business, according to this view, should lower its costs and lead to a fall in prices. Consequently, when a business refuses to drop its prices when its costs drop, it is accused of profiteering at the expense of consumers.
Interestingly, many economists reasoned the same way until the marginal revolution of the late 19th century changed the way they thought about prices. After the marginal revolution, economists recognised the fact that businesses simply try to charge what the market will bear. Stated in simple words, they try to charge the highest price that consumers will be ready to pay for the product. Sometimes this price is well above the costs incurred by the business in bringing the product to the consumers, which leads to good profits. But at other times, the price is far below the costs incurred by the business, which, in turn, leads to losses. So the accusation that businesses can simply exploit consumers by charging prices at will is a myth. It is consumer demand that eventually determines prices, so it is no surprise that businesses don’t care to lower prices when their costs fall — just the way consumers don’t care to pay more when business costs rise.
Killing incentive to invest
Does this mean that lower taxes can offer no price benefits to consumers? That is not the case. When a government slashes the relative tax on a product, it encourages businesses to invest more in the product as they get to earn more profits from it than elsewhere. This leads to an increase in the supply of the product in the market, which naturally leads to lower prices for consumers. The process, which eventually destroys any excess profits, however, takes time to complete and does not happen overnight. Creating bodies like the NAA, which wants to punish businesses that make abnormal profits and thus kills any incentive to invest in the manufacturing of goods that are now taxed less, will only have counterproductive results.
