Consumption taxes and inflation
In a recent post, Matt Yglesias argues for using fiscal policy – tax increases or benefits cuts – to control inflation, rather than relying on interest rate hikes. There is certainly an argument to be made here, but his suggestions for reducing consumption seem less than ideal.
Yglesias floats the idea of limiting Social Security inflation adjustments for retirees with higher incomes. He also mentions capping deductions, and cutting Medicare reimbursement rates to drain dollars out of the pockets of medical providers.
A similar but perhaps more promising idea is to implement a temporary, progressive consumption tax. To fix ideas, we might put a temporary 5% tax on all consumption expenditures over $5,000 per month. In practice, that would probably mean an across-the-board 5% sales tax, but with a monthly rebate of $250 per household (5% of $5,000). The flat rebate makes the proposal progressive. The temporary tax would give people an incentive to delay purchases for a few months, until the tax ends. Reduced spending would help bring supply and demand back into balance and bring down inflation. Then as supply constraints abate or demand settles down the consumption tax rate can be reduced, and we can all go out and spend again.
This has a few possible advantages over raising interest rates to reduce demand. First, it would discourage consumption across a wide variety of economic sectors. You can cut your consumption today by postponing a vacation, by buying less lavish Christmas gifts, or by postponing purchase of a new car. Raising interest rates mostly hits home construction, and the purchase of durable goods on credit (a new car if you finance), and the effect on the broader economy is indirect.
A consumption tax might also have a more immediate effect on demand than increases in interest rates. If you are a home builder with a construction project in the works, and the Fed raises interest rates, you may find it worthwhile to finish the home even though you will not be able to sell it for as much money as you thought (buyers will pay less because mortgage rates are higher). This delays the effect of the interest rate increase on demand, leading to a “long and variable lag”.
It may also be possible to adjust a consumption tax more quickly than interest rates in response to changed conditions. The Fed tends to telegraph its rate changes in advance and to change interest rates slowly; this delays the effect of rate changes. But with a consumption tax, it is not clear what would stop the Fed (or whatever agency is in charge of the tax) from adjusting the tax rate quickly, and especially from cutting the tax quickly when conditions improve.
A temporary consumption tax may also be more credible and transparent to consumers than a temporary interest rate increase. With a temporary tax, you are know how much you will save by waiting to purchase a new car, though you may be somewhat uncertain how long you will have to wait. A temporary interest rate hike may be much less transparent to consumers (“how much will the cost of my auto loan decrease if I wait a year to buy a new car?” may be a hard question for many to answer).
Finally, a consumption tax would allow us to avoid the seriously negative spillover effects of rates hikes in the United States on other countries.
One drawback of a temporary consumption tax is that it would cause a one-time bump up in prices, but this would be reversed when the tax is repealed. It’s not clear to me that this would be an economic problem, but I may be missing something.
I am not a macro person, but I took a quick look to see what has been written on this subject and found a few papers on the effect of using announcements of future increases in consumption taxes to stimulate current spending in a recession. These papers suggest this might be effective. What I am suggesting is to do the opposite to cool an overheated economy. Using temporary tax increases to coax people into delaying consumption seems likely to be more effective announcing a future tax increase, since people are myopic and a current increase with a promised future cut may seem more credible than announcing a future tax hike during a recession. I assume there is much more written on this topic, but my quick search didn’t turn it up.
The politics of a consumption tax would be difficult. On the other hand, doing anything through legislation is difficult, and a consumption tax seems fairer than Yglesias’ more targeted proposals, and fairer in a way that would make it easier to pass than the taxes Yglesias mentions. I doubt seniors or medical providers will be happy about having their incomes squeezed to bring down inflation. No one likes being singled out to pay for a public good. But maybe people could be convinced to do their part if others chip in as well. Reciprocity is important to people. And it is much less painful to spread a tax increase around than to concentrate it on a few groups.
Yglesias seems to have in mind a permanent reduction in spending power. He does not argue that Social Security COLAs should be delayed for upper income people, or that Medicare reimbursement rates should be lowered for 6 or 12 months. It is not clear that a permanent reduction in purchasing power is needed to deal with our current inflation problem. In any event, if Yglesias is worried about long term fiscal balance, which may prove to be an issue going forward if “secular stagnation” has ended and real interest rates remain high, his proposals seem inapt (a point I think he would agree with). Broad tax reform – including possibly a consumption tax – seems more promising than the kludgy revenue increases he is proposing.
One final point. This underscores how helpful it would be if everyone had a bank account that the government could use to deposit consumption tax rebates, carbon tax rebates, pandemic support payments, refundable child tax credits and similar payments in a timely way. Postal banking, anyone?
Given the role consumption plays in global warming, and other problems, consumption taxes will be.
https://www.investopedia.com/articles/economics/08/keynesian-economics.asp
…It is important to understand that the role of the government in the economy is not solely to dampen the effects of recessions or pull a country out of depression; it also must keep the economy from heating up too quickly. Keynesian economics suggests that the interaction between the government and the overall economy move in the direction opposite to that of the business cycle: more spending in a downturn, less spending in an upturn. If an economic boom creates high rates of inflation, the government could cut back its spending or increase taxes. This is referred to as fiscal policy…
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[Of course there a two major obstacles that prevent raising taxes in the US to dampen an overheated economy. Most obvious is the toxic politics that emerges from the tensions between our two major political ideologies that dominate the marketing of government policy proposals. That is essentially the high cost of competitive pandering for votes among an under-educated electorate. Second though, is the common interests among our economic and political elites to maintain sufficient government debt to support safe assets for our surplus trading partners’s dollar denominated savings that maintain their favorable FOREX rates allowing persistent trade deficits for the US. ]
Eric:
Good morning, 8 AM here in the Southwest. I am going to be the first to answer this original commentarial post (?). The issues are a combination of several factors. Covid shutdown, supply chain manipulation, and too many dollars chasing too little product or services.
The Fed keeps raising its rates in the hope of impacting the economy when it already has done so. As I posted Mark Weisbrot’s commentary just this morning.
I think we have killed it and the recent 1/2 of one percent increase was not needed. The Fed could have carried the old rate on for another month or two to feel comfortable. It did not. Powell wants to be another Volcker. Maybe Volcker went too far in his quest to rein in the economy by slaughtering the peasants of which I was one.
The programs put in place by Biden were progressive. Dollars flowed to the lower income brackets and also companies and politicians who did not need it.
How did this fix the supply chain issues? Companies such as semiconductor manufacturing shut down its two-stage manufacturing process. Companies did not place orders for them to keep going in the short term. No start up inventory. Same thing happening in 2008. I was a part of it chasing components. It did limit supply and companies increased pricing due to their own negligence in ordering allowed them to increase prices. We paid it because we had to do so. The government stimulus fed the beast in all economic sectors.
We had transportation issues to a lesser extent. I have heard the reasoning for this year’s issues. Not enough chassis, ships waiting in the bays, trains filled to capacity. Companies were told to work shifts and overtime to clear the ports, train companies cut their staffing and over utilized the remaining engineers and conductors. It was a planned reduction of staffing to maximize profits.
If process was normal, the demand would have been handled in a far better manner. It was not and I lay the blame on corporations. Too much manipulation of the supply chain to maximize profits.
Run, to be clear, I’m not saying a temporary consumption tax would be optimal now. I’ve already expressed my doubts about the Fed’s tightening, and now I’m more worried about recession than inflation. But we should have the capacity to do this institutionalized, so that we have an additional tool in our macro tool kit for the next disaster.
Eric:
What are your proposals? To fix the container and ship backup on the West Coast, Biden mandated additional shifts. To fix the issues with railroads, rather than add more engineers and conductors, Biden blocked s potential strike. Having one engineer per train makes no sense. Forty years ago, this all started with the elimination of cabooses and the additional staff. Is the cost of labor the highest cost of transportation?
Sales taxes are not progressive even with a 5% rebate. Monthly expenses over $5000 per month hits at a level that does reach what would be middle class based on inflation adjustments for the past 5 or 6 decades.
The problem with this inflation I do not see as too much spending by the general public. It is supply chain issue as a result of MBA thinking of just in time strategies which left no room for an Oops!. This is true for our infrastructure for moving stuff. Combined with market consolidation allowing price gouging, a justice system that favors corporations (large and larger ones) 85% of the time, decline in labor market power, and an oversized financial sector of our economy (a sector that used to be in service to the production sector which now is a value creator of its own), we have a massive economic structural problem which adding a tax here, raising a rate there can not solve.
Digby has a good post which references Stiglitz and macroeconomist Regmi Ira via the Roosevelt institute. https://digbysblog.net/2022/12/15/get-brain-on-inflation-policy/
Daniel, I’ve seen the Stiglitz piece. I’m personally agnostic about the causes of our current inflation, though I worry more about recession than inflation now and I’ve posted a few times expressing doubts about the harm the current inflation is doing.
Regardless of the underlying causes, it seems to me that fiscal policy can be used to reduce spending and thus to reduce current price pressures, and that might be a better option than using interest rates. It should be on the table for dealing with aggregate supply/demand imbalances in the future.
First,
This article and comments makes me proud to be a Bear. An actual rational discussion. One does not see that in the Media or the newsletters that appear in my email box.
Second, why is cutting Social Security always the low hanging fruit? It has more to do with nibbling SS to death than any rational “cut in consumption” of the so-clled rich.
A patriotic emergency inflation tax on excess profits (price gouging) would by my suggestion, but even more modest tax increases seem to be off the table for reasons mentioned above.
But as one of the slaughtered innocents of the Volker recession, I confess to an emotional (no claim to intellectual) skepticism about interest rate increases. Though I hope such an increase will help preserve my small fortune (very small) from dying of inflation and unaffordable risks of the stock market.
No discussion of a financial transaction tax?
Arne
start one.
now for the irrational part:
the Volker inflation started out as a supply shock inflation. but there was still enough wage-push left in labor to turn it into “inflationary spiral.” so the Economists were justified in their own eyes for figitng it with interest rates induced recession.
I thought at the time that Paul Samuelson was silly in suggesting that inflation was oused by workers demanding higher wages than they were worth.. i couldn’t imagine sitting in an unemployment office holding out for higher wages. If there was any tendency in that direction is was more likely workers trying to get wages that would keep up with inflation. When if was finally over, workers had clearly lost.
At the time I called it the Reagan Recession and thought it was engineered to discipline workers, and the hippies who were able to cause so much trouble because their parents had the money to support them.
Being ignorant, I haven’t entirely let go of that hypothesis. So I suspect the current inflation is caused by supply shock price gouging, and a little bit of workers finding out during the Covid recession that they didn’t “need” a job so much that they had to accept low pay and bad conditions. Hence the need to discipline them again with another recession. Hence the next round of Volkernomics. Unless it’s just that Economists read that interest rates are the cure to inflation in their freshman econ text and that was the end of their thinking about it.
[Coberly,
You are really onto something here “Paul Samuelson was silly in suggesting that inflation was (sic) oused by workers demanding higher wages than they were worth” and here “Economists read that interest rates are the cure to inflation in their freshman econ text and that was the end of their thinking.” Perhaps more than you suspect.]
https://en.wikipedia.org/wiki/Neoclassical_synthesis
The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis,[1] or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937),[2] Franco Modigliani (1944),[3] and Paul Samuelson (1948),[4] who dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 60s, and 70s.[5]
A series of developments occurred that shook the neoclassical synthesis in the 1970s as the advent of stagflation and the work of monetarists like Milton Friedman cast doubt on neo-Keynesian conceptions of monetary theory. The conditions of the period proved the impossibility of maintaining sustainable growth and low level of inflation via the measures suggested by the school.[6] The result would be a series of new ideas to bring tools to macroeconomic analysis that would be capable of explaining the economic events of the 1970s. Subsequent new Keynesian and new classical economists strived to provide macroeconomics with microeconomic foundations, incorporating traditionally Keynesian and neoclassical characteristics respectively. These schools eventually came to form a “new neoclassical synthesis“, analogous to the neoclassical one,[6][7] that currently underpins the mainstream of macroeconomic theory.[8][9][10] …
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This development in economics thinking was not intended to improve upon Keynes, but rather to erode his influence gradually and replace it with thinking more amenable to financialization to reap perpetual trade and fiscal deficits in the pursuit of ever high economic rents take by the wealthy utilizing global price arbitrage to drive down labor wages and evade labor and environmental regulation.