An Interesting Natural Experiment

Today is Friday, 1 October, which means that the new GST rate increase is now in effect. GST is New Zealand's Goods and Services Tax, which is applied to everything from bus rides to "white goods" like washing machines to food. Pretty much anything you can buy in New Zealand is affected by GST--in fact, if you look at your receipt (or "tax invoice"), you'll often see the amount of GST listed there.

The rate hike (they call taxes here "rates") is a change of 2.5 percentage points from the current 12.5%, which was established in 1989, to a new rate of 15%. This means that everything I buy will now be 2.5% more expensive, further depleting the value of the steadily sinking USD/NZD exchange rate.

A tax increase is not a new experience for me: a year or two ago, Massachusetts increased their state sales tax from 5%, which it had been all my life (at least as long as I can remember), to 6.25%. However, this was a rather seamless transition, and there are a few things about New Zealand that make the GST rate increase more interesting.

First, all prices displayed in New Zealand already have GST "baked in." When something costs $10.00 in a store, that's how much you'll pay at the register--not like the US, where sales tax is calculated on top of the displayed price. This means that increasing a sales tax in New Zealand involves physically going around and changing the price tags on everything in your store, and not simply programming your cash registers to charge a new sales tax rate. Economists refer to these sort of costs associated with changing prices as "menu costs." In fact, the large Countdown supermarket downtown is closing down overnight in order to switch all the price tags on their products--the extra labo(u)r required and lost sales are an example of menu costs in action.

Further adding to the complication is the fact that the smallest unit of New Zealand coinage is the ten-cent coin--there are no five- or one-cent pieces like the US. This makes calculating a 2.5% increase more interesting, especially because retailers seem prefer to display prices like "$5.00" or "$9.50" that are easy to make change from. With the new GST increase, something that originally cost $5.00 should now cost $5.13. Will this price be rounded up to $5.20 or down to $5.10?

So, this is a pretty unique opportunity to see a natural economic experiment in action. I can think of three likely scenarios, all of which will probably occur to some degree. There will be businesses that dutifully change their prices to reflect GST exactly, rounding up or down if there are any conflicts (as a general rule, if you're paying with cash and your total ends in five or lower, you get rounded down, and rounded up if the total ends in six or higher. If you're paying with EFTPOS, you pay the exact amount). As I was walking down Queen Street this evening, I saw a coffee shop owner erasing prices on his menu board and doing just that.

Some firms, of course, may find that the menu costs are too high to justify switching prices, Or perhaps they may determine that the demand for their products is highly elastic, and even a small change in prices would reduce demand. I saw an article about a dairy owner (dairy = convenience store) who said that he wouldn't be adjusting prices on beverages or ice creams because people already think they're too expensive (I agree...NZD$3.50 for a soft drink or a bottle of juice? Really?). These firms find it more efficient to simply take the 2.5% hit to their profits than change prices.

What I expect may happen is that businesses will take advantage of the opportunity and raise prices above the GST rate increase. I can imagine business owners saying "I'm going through all this hassle to change the prices to reflect the new GST anyway, why not raise prices another 50 cents or so? I've been meaning to do that for ages." So I think for some businesses, prices may increase more than just 2.5%.

At any rate, the economics side of me is very interested to see what's going to happen to prices here in the coming weeks. I'll try to keep you updated about how prices change, and if any of my predictions came true.