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?