Why Raising Taxes Is A Misguided Approach To Inflation Control

In a recent post for the Slow Boring blog, Simon Bazelon and Milan Singh argue that raising taxes can be an effective way to reduce inflation. Unlike their criticisms of using interest rate policy to lower inflation (which are broadly correct), their proposal to raise taxes is unlikely to work in the manner they describe. In fact, it may even have the opposite of its intended effect.

To begin with, economists generally consider monetary policy to be more effective at fighting inflation than fiscal policy, which includes tax policy. Fiscal policy tends to be slow and inefficient, and too often it just redistributes money from one sector of the economy to another without greatly affecting aggregate demand. This explains why economists such as Valerie Ramie have found that government spending multipliers tend to be less than one in normal times (which means that one dollar of government spending increases GDP by less than one dollar).

Monetary policy works much better for fighting inflation, but the mechanism by which it works is often misunderstood. Bazelon and Singh are correct when they argue that interest rate policy, which is one aspect of monetary policy, is an inefficient way to reduce inflation. They point to a chart that claims to explain how interest rate hikes lead to tighter credit conditions, to lower spending for borrowers, and—ultimately—to lower prices.

The authors claim that the mechanisms outlined in the chart are too complicated to work cleanly. The problems with using interest rates to curb inflation are more serious than this, however. While it is true that higher interest rates are bad for borrowers and that they often curb borrowers’ spending, higher rates also increase income and spending for savers. As with taxes, changes in interest rates in and of themselves do little to affect aggregate demand. Instead, they redistribute wealth and income from one group of people to another—in this case, between borrowers and savers.

As the economist Scott Sumner has pointed out, interest rates are not a good reflection of the stance of monetary policy. In fact, the Federal Reserve is largely a follower—rather than a setter—of interest rates. It responds to market signals by helping guide interest rates closer to where the market determines they should be based on the supply and demand for credit.

This does not mean that monetary policy is ineffective at fighting inflation. Instead, monetary policy affects aggregate demand by influencing the quantity of money in the economy. Total spending falls temporarily in response to a drop in the money supply. Output decreases as well, since prices adjust only after a lag. (Ideally, this process is carefully managed so that output growth merely slows and there is no full-blown recession.)

Bazelon and Singh propose tax policy as an alternative to interest rate policy, but tax policy is unlikely to be very effective in this role. Tax policy primarily affects the supply side of the economy. A substantial tax increase reduces firms’ incentive to produce, thereby reducing the supply of goods and services in the economy relative to the quantity of money. In such a situation, prices would naturally go up—exactly the opposite of Bazelon and Singh’s desired outcome.

Strangely, the authors recognize the productivity-enhancing benefits of other supply-side measures, such as zoning and permitting reforms. But they don’t recognize the productivity benefits of tax cuts. If policymakers want prices to fall, cutting taxes is the natural policy response, not raising them.

However, even if the government implemented large tax cuts, we shouldn’t expect a very long-lasting effect on inflation. Inflation is the rate of change in prices. Changes in taxes, meanwhile, affect the level of taxation. It follows that tax changes are more likely to have level effects on prices than rate of change effects. By contrast, changes in the money growth rate in the economy are much more likely to affect the growth rate of prices (i.e., the inflation rate).

The variable to target to bring down inflation is the rate of change in money growth. Interestingly, money growth has been falling in recent months and has even turned negative. Don’t be surprised if inflation starts to fall with it.

Bazelon and Singh seem to be attracted to the Modern Monetary Theory idea that revenue from higher taxes can be “sucked” out of the economy, thereby reducing the money supply and lowering inflation. While such a situation is conceivable, it is most likely to occur if new revenue is used to reduce the federal debt. Since Treasurys are close substitutes for money, reducing the supply of Treasury bills is similar to (though not exactly the same as) reducing the money supply.

It is unclear whether earmarking new revenues toward paying down the debt is what the authors have in mind. They do mention a possible grand bargain that involves reducing the deficit, which could be a good idea. If this is not the goal, however, and if the new revenue is instead intended to be spent by Congress with no change to borrowing, there is no reason to believe that raising taxes would reduce inflation.

All told, hiking tax rates to fight inflation doesn’t make much sense from an economic point of view. It would be far better for policymakers to rein in excess aggregate demand through sensible monetary policy. That’s a much more direct and simple approach. Such macroeconomic management is not without its challenges, to be sure, but at least it’s based on sound economic thinking.