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The GST cannot stop inflation

The ABC recently ran a series asking what, if anything, governments can do about high inflation beyond simply relying on the Reserve Bank to raise interest rates (a policy tool that every knows is cruel and unusual).

One idea that gets floated is using the GST as an active stabilisation tool, automatically increasing the GST when inflation rises, and cutting it when inflation falls.

At first glance, this sounds sensible. If inflation is too high, why not temporarily raise consumption taxes to dampen spending?

But when you actually model the idea formally, the results are surprisingly bad. Terrible in fact!

The charts below show the welfare loss and inflation volatility in an economy as a function of a single parameter: how aggressively the GST responds to inflation. At zero the GST rate never changes (the economy today). As the parameter becomes positive the GST rises automatically whenever inflation rises with greater degrees of responsiveness.

Perhaps surprisingly, welfare falls sharply (ie welfare losses increase) the more aggressively the GST responds to inflation. Inflation itself also becomes substantially more volatile. What explains this counter intuitive result!?

Downward dog inflation

Imagine we lived in a world where the GST automatically increased whenever inflation rose. If inflation jumped by 3 percentage points the GST would mechanically rise from 10% to 15%.

Now consider the sort of shock Australia has recently experienced: turmoil in the Middle East pushing up global oil prices.

To keep things simple imagine you run a yoga studio. Your business barely uses petrol directly, so the oil shock itself is not especially important for your costs.

But the GST is.

In Australia, firms typically advertise and set prices inclusive of GST. And because many firms only adjust prices infrequently — perhaps once or twice a year — they have to think carefully about where taxes and costs are likely to be over the coming year when they decide on prices today.

So what happens when news breaks of a major geopolitical conflict likely to push inflation higher?

In a world with a varying GST policy, the answer is obvious: businesses immediately expect the GST rate to rise in the near future. War today, means high oil prices in the coming weeks, which means higher inflation prints in the coming months and thus a higher rate of GST for the next year or so.

As a yoga studio owner, this matters enormously. If the GST rises from 10% to 15% while your advertised prices stay fixed, your after-tax revenue falls and your profit margins get squeezed.

So what is the rational response?

You raise prices today.

Even though the oil shock barely affects your own business directly, the expectation of higher future GST causes you to increase prices immediately in anticipation.

And once every firm in the economy starts thinking this way, the policy becomes self-reinforcing.

The initial inflation shock causes firms to expect higher GST rates in future. Firms then raise prices more aggressively today to pay for those future taxes. That additional price-setting behaviour pushes inflation even higher, which in turn triggers even larger GST increases.

Rather than stabilising inflation, the policy amplifies it increasing volatility. In fact if the GST-responsiveness-to-inflation parameter gets too high (about 1.5 in the plots above) the economy becomes “indeterminate” which is economist speak for double plus bad.

Under a constant GST regime, many firms — like the yoga studio — might barely respond to an oil shock at all. But once GST becomes an active “counter-cyclical” tool, even firms with little direct exposure to the original shock have an incentive to raise prices preemptively.

The result is higher inflation volatility, more distorted price-setting behaviour, and ultimately lower welfare across the economy.

The irony is that while counter-cyclical GST policy sounds stabilising in theory, once you account for forward-looking firms and sticky prices, it can end up making inflation dynamics substantially worse.

 

Dr Isaac (Zac) Gross is a lecturer in economics at Monash University. This article was first published via Zac’s blog, Gross National Product, and is reproduced with permission.

 

  •   24 June 2026
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8 Comments
Francis H
June 25, 2026

Zac, my understanding is that taxes like the GST are counted when the ABS calculates inflation. Excises impact inflation as seen with the monthly inflation print this week. The monthly fall in the headline CPI was clearly impacted by the reduction in the fuel excise. If I am correct, then an adjustment higher for inflation will result in a higher inflation result when the CPI is calculated subsequently. With the increases in prices referred to in your article there is a double whammy effect.

On another matter, as a former Federal employee my pension is indexed to the CPI. Every time Governments give rebates ( electricity ) and reduce fuel excises the CPI falls resulting in a fall in the value of the pension. This also has the effect that the so called benefit to me and many others is an illusion. The reduction in the value of my pension caused by electricity rebates alone completely wiped out the benefit of the rebates. It might be argued that the CPI will be higher when the excise is reimposed but that could be 2 years down the track. Also will the subsequent increase equal the decrease now ? I have not seen any articles in the media about this. It needs to be written about. With State Governments desperate to cling to power we are seeing all sorts of freebies which impact the CPI. It also impacts all pensions and wages if the CPI is artificially low because Governments want to buy popularity . This is all without going into the practice of using the CPI as a cost of living index. Which it is not , for example the discounting of technology improvements in upwards CPI calculations, the practice of substitution, the failure to properly reflect housing costs etc etc. Some articles on these matters would be good to see.

OldbutSane
June 25, 2026

Please prove your assertion that electricity and fuel rebates have been worth less than the small reductions in the increase to your indexed Government pension due to electricity rebates or fuel tax reductions. It doesn't make sense as fuel and electricity are very small components of CPI, less than 5% each (according to the information I can find).

Francis H
June 25, 2026

OldbutSane, the ABS stated in one of its releases that the effect of the electricity rebates was 0.7 % lower CPI in one quarter alone. What might seem like small components can have a significant effect on the CPI in one quarter. Everyone remembers the impact of bananas on the CPI some years ago when a cyclone wrecked the banana crop in North Queensland.

Francis H
June 25, 2026

OldbutSane, futher to my earlier reply which might not have gone through, I suggest a google search of Electricity rebate effects on CPI Australia. It is very illuminating and supports my point.

OlsbutSane
June 28, 2026

Actually it doesn't. Yes the rebates have reduced CPI marginally, but your assertion that the effect on your indexed pension is greater than the actual rebates has not been shown at all. You have not shown any calculations proving your statement, just generalised assertions, which prove nothing.

BTW when banana prices increase and affect the CPI I consider that a bonus as I won't buy bananas when they are that expensive!

1
Francis H
June 29, 2026

OldbutSane, the evidence is there if you read the Quarterly releases starting with the September 2024 Quarter until the rebates were wound back a year later. The cumulative effect is evident. As for the bananas example , it is not the choice of the consumer which is the issue but the application of the CPI to all pensions and wages

OldbutSane
July 01, 2026

Francis H

That was not your point and the CPI is not used to index the age and DSP pensions and carer payment and it is not generally applied to wages (but may be a guide).

If you are not happy with the CPI indexing of your Comsuper pension, maybe you should have cashed it out before retiring and tried to get a better return elsewhere (but bet you wouldn't have because it is such a good deal).

 

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