Raising taxes does not slow inflation

Will a rise in taxes slow inflation?

A useful starting point is a defi nition of inflation. Infl ation is a long-lasting rise in the general level of prices. It is a rise which goes on until something changes to stop it. This is in contrast to a change in the price level, which is a move from one price level to another, at which the price level then stays.

The fact that infl ation is a continuous process should immediately make one pause before claiming that a rise in taxes will stop it. Unless the price level is like an imaginary frictionless ball on an imaginary frictionless (and infinitely large) billiard table – in which case one tap would set it moving forever – for inflation one should look for a cause that is present so long as the infl ation is present. One should look for a continuous cause for a continuous

It might be claimed that a tax increase would remove a continuous cause, for the cause is ‘excess demand’ – demand greater than can be supplied without upward price pressure. Can a tax increase do that? What is to be done with the tax revenue? If it is not to be spent by its recipient, the government, then it will reduce government borrowing, lead to debt repayment, or, in the extraordinary case where a government not only is not borrowing but has no debts to repay, to the government acquiring assets.

Consider the expenditure consequences of each of these in turn. If less is borrowed, then the money which was to be lent will be lent or spent elsewhere. It will not just vanish. If the taxes are used to repay existing debts, then the recipient of the repayment will in turn do something with it – lend (to someone who will spend) – or spend directly. (Of course no-one would claim that the pattern of spending will not be affected, but that is a different matter.)
And exactly the same applies to the acquisition of assets. If these are acquired from the domestic private sector, the recipients have money to spend.

It might be objected at this point that the above arguments seem to deny the existence, even in principle, of the Keynesian ‘multiplier’. That, it may be recollected, claimed to show that (for example) a rise in government spending financed by a rise in taxes would lead to an increase in total spending, as private expenditure would fall by less than the rise in taxes.

How can that be?

People must somehow cut their expenditure by less than the rise in taxes – which they can only do by saving less. What happens to the people who were borrowing those savings? They will be unable to spend. This does not end up reducing private spending by as much as the rise in government spending goes up only if that private saving was somehow sitting there unused – a possibility perhaps in a depression, with the price level actually falling so that
people defer spending in the expectation that ‘prices will be lower tomorrow’. But we are not dealing with that, but with the problem of infl ation; so that special case need not be considered further.

So far, then, it has been argued that there are two problems with the claim that a rise in taxes will slow infl ation. First, infl ation is a continuous process but a rise in taxes is a one-off cause, so it is hard to argue that the latter will stop the former. Second, the effects of a rise in taxes on private sector spending have been considered, and it has been shown that certainly in an environment of strong demand and rising prices, a rise in taxes cannot be expected to reduce total spending, by the government and the private sector combined, in
the economy (although it may well change its composition).

So much for analysis. What about evidence? The evidence goes the same way. The effects of tax increases on spending are uncertain – uncertain both in size and in timing. Evidence can be drawn both from the UK and overseas. First, the UK. In 1967 fiscal policy was tightened after a devaluation. There was no balance- of- payments effect. That only came when domestic demand was squeezed by a monetary tightening. Looking further back in
history, we find infl ation rising and falling with no associated changes in taxes: for example, prices fell on average from 1870 to the early 1890s, and then rose steadily to 1914. But there was no matching change (or even series of changes) in taxes. And in the USA, in the late 1960s, a tax increase was imposed but inflation continued until monetary policy was tightened.

In short, the evidence does not suggest that in general a fiscal tightening is necessary or suffi cient to slow inflation. What of the special case mentioned earlier? This is when governments are financing their expenditure by money creation rather than by taxing or borrowing. Almost every hyperinfl ation – an inflation greater than 50 per cent per month – has resulted from such behaviour. Tax increases to stop money creation would then be necessary
to stop the hyperinfl ation. But governments have generally got into that situation because they had lost the political support to let them raise taxes – so the recommendation is desirable but not possible.

In normal times a tax increase (or a spending cut) might, via reducing government borrowing, reduce interest rates, and this might induce people to hold more money, thus reducing the excess of money supply over money demand. But this would be a once only effect on the excess stock of money; to slow infl ation a fall in the rate of growth of excess money is necessary.

To conclude, the claim that a rise in taxes will slow infl ation is without analytical foundation (except in the case of hyperinfl ation) and is inconsistent with the facts. There is therefore absolutely no reason why taxes in Britain should go up to slow inflation.

1 comment:

  1. The first comment about a single tax increase decreasing inflation to zero is absurd. No one is arguing that raising taxes is supposed to stop the ongoing process of inflation. It is designed to slow it down. It seems that as long as there is economic growth, inflation will always rise. In terms of the second part of the comment then indeed it seems that the theory behind government taking excess money as taxation does not explain how the money is taken out of the system. There are ways in which government might do that; buy foreign reserves, repay foreign debt?