Explain how the welfare impact of the GST increase on a household may depend on its relative preferences between the two types of goods.

Suppose that the Australian government is considering giving households some tax relief in the near future through income tax cuts, and at the same time also contemplating an increase in the Goods and Services Tax (GST).1

Using the geometric techniques and concepts learnt in Topic 1, write a report that examines how the above stated policies may affect the consumption choices and welfare of a household that purchases two types of goods: GST exempt “Food”, and GST taxed “Other goods”.

In writing the report, consider the following pointers:

(i) Consider the GST to be an ad valorem tax levied on all goods and services (that is “Other goods”) except for food. Assume that a household considers GST exempt “Food” to be inferior and GST taxed “Other goods” to be normal.

(ii) You should begin by explaining how a standalone or “pure” GST increase would affect a household’s consumption choice and welfare. In this context, you should also briefly mention (i.e. explain in words) how the welfare impact of the GST increase on a household may depend on its relative preferences between the two types of goods. (9 points)

(iii) Next, you should explain how a standalone or “pure” income tax cut would affect a household’s consumption choice and welfare for a given set of preferences between the two goods. (6 points)

(iv) Subsequently you should consider the combined impact of the two policy changes where a household simultaneously experiences both a GST increase and receives an income tax cut. For a given set of preferences between the two goods, explain and geometrically illustrate the circumstances that determine whether the household is better off, indifferent or worse-off under such a combined policy. (11 points)

(v) Based on your analysis, briefly comment on the welfare impact of such a combined policy on households that are purely reliant on Centrelink transfer payments such as Newstart allowances. (4 points)

1 Indeed some recent media reports hint at such a possibility. For example, consider the article “Soothing tax cuts to follow budget pain” as published in The Age on the 31st of May, 2014.