The application of escape clauses to indirect tax changes
In applying its strategy of flexible inflation targeting, the CNB regards its inflation target as a medium-term one from which actual inflation may deviate temporarily. If the economy is affected by a strong exogenous shock which causes the inflation forecast to deviate from the target, the CNB need not react to the first-round effects of the shock. It may apply an exemption ("escape clause") from its obligation to hit the inflation target and accept the deviation of the inflation forecast and subsequently actual inflation from the target caused in this way.
The main reason for applying escape clauses is the fact that the CNB also takes into account the effect of monetary policy on economic stability when meeting the inflation target. Strict elimination of a deviation of actual inflation from the inflation target by means of changes to monetary policy interest rates could lead to undesirable destabilisation of the economy, especially in the case of short-term shocks and supply-side shocks.
Significant changes in the level and structure of indirect tax rates are a specific type of exogenous shock. Since the switch to headline inflation targeting, step changes in indirect taxes have therefore been included in the range of situations that may lead to the application of escape clauses. The Czech Republic's membership of the European Union entailed harmonisation changes to indirect taxes before accession. Gradual harmonisation of excise duties on tobacco products is currently under way.54The individual harmonisation steps are announced in advance and are included in the CNB forecast. The inflation forecasts are thus subject to the effect of indirect tax changes to a relatively large degree. The CNB applies escape clauses ("the mechanism of caveats" is used in the main text of the Inflation Report) to rule out any reaction to the first-round effects of such changes.55In practice, the first-round effects have been subtracted from headline inflation since July 2003, when the effect of taxes was significant for the first time. The CNB has reacted to the deviation of inflation adjusted for the first-round effects of indirect tax changes from the target and has focused on hitting the target for inflation adjusted in this way.
According to the April forecast, the contribution to headline inflation of the first-round effects of the changes to excise duty on cigarettes will be 0.7 percentage point at the monetary policy horizon. The application of the escape clause to these first-round effects means that the CNB will allow headline inflation to rise into the upper half of the tolerance band of the inflation target at the monetary policy horizon. If the CNB did not apply the escape clause, implied monetary policy rates for the next quarter would be higher by roughly 0.3 percentage point.
Similarly, the CNB would apply an escape clause in the case of implementation of the proposed fiscal reform, which includes an increase in the lower VAT rate from 5% to 9%, and the introduction of environmental taxes (see the alternative scenario of the April forecast). In that case, inflation would be above the target at the monetary policy horizon.