Why Raising Taxes Is A Misguided Approach To Inflation Control

Recently, Simon Bazelon and Milan Singh proposed that raising taxes can be an effective way to reduce inflation in their Slow Boring blog post. While their criticisms of using interest rate policy to lower inflation have merit, their proposal to raise taxes is unlikely to work in the manner they describe. It may have the opposite of its intended effect.

Monetary Policy Is More Effective Than Fiscal Policy

Economists generally consider a monetary policy more effective at fighting inflation than a fiscal policy, which includes a tax policy. This is because fiscal policy tends to be slow and inefficient. Too often, it redistributes money from one sector of the economy to another without significantly affecting aggregate demand.

Government spending multipliers tend to be less than one regularly, meaning that one dollar of government spending increases GDP by less than one dollar. In contrast, monetary policy affects aggregate demand by influencing the economy’s money quantity.

Interest Rates Are Not a Good Reflection of the Stance of Monetary Policy

The authors are correct when they argue that interest rate policy, which is one aspect of monetary policy, is an inefficient way to reduce inflation. While higher interest rates can curb borrowers’ spending, they also increase income and spending for savers. Changes in interest rates in and of themselves do little to affect aggregate demand. Instead, they redistribute wealth and income from one group to another.

The Federal Reserve is essentially a follower of interest rates rather than a setter. Instead, 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.

Tax Policy Is Unlikely to Be Effective in Controlling Inflation

While Bazelon and Singh propose tax policy as an alternative to interest rate policy, tax policy is unlikely to be very effective in this role. This is because 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 increase–the opposite of Bazelon and Singh’s desired outcome.

Related Facts

• Monetary policy is controlled by central banks such as the Federal Reserve.
• Governments control fiscal policy through taxation and spending.
• The primary tools of monetary policy are interest rates and money supply.
• The primary tools of fiscal policy are taxation and government spending.

Key Takeaway

Raising taxes as a means to control inflation is not an effective strategy. While increasing taxes will reduce the supply of goods and services, it will not address the root cause of inflation. Instead, monetary policy, which influences the quantity of money in the economy, is a more effective tool for controlling inflation.

Conclusion

In conclusion, while raising taxes may seem like an appealing solution to inflation, it is a misguided approach. Instead, central banks should use monetary policy to influence the quantity of money in the economy, which is a more effective tool for controlling inflation.