Tax cuts and interest rates
Posted May 23, 2008on:
Given my belief that these tax cuts, without corresponding cuts in (unproductive types of) government spending, will lead to greater inflationary outcomes I’ve decided it is important to argue the complete opposite case – namely that tax cuts will not impact on inflationary pressures and interest rates.
The common view I work off when stating that tax cuts increase inflationary pressure is that tax cuts increase “aggregate demand“, which in turn will lead upward pressure on prices, and therefore an upward shift in interest rates.
However, there is another popular view that has been raised by Stephen Kirchner of Institutional Economics. Specifically this view states that tax cuts have supply side effects on the economy (which increases the supply of goods in the economy and so reduce inflationary pressures) and some degree of Ricardian equivalence holds – such that any increase in budget surpluses will lead to borrowing from the private sector, as they expect tax cuts later. He makes these arguments here and here (I made a similar argument here).
Furthermore, tax cuts may reduce wage pressures – thereby leading to lower inflation. How? Say that the nominal wage is fixed and there are tax cuts – it this case the whole tax cut immediately goes to the employee. However, unless the employee has significant market power, the employer will be able to extract some of the surplus gained from tax cuts over time, by offering smaller wage increases.
Given these supply side arguments why am I still concerned about inflation?
My concern with inflation lies squarely with “inflation expectations”. The supply side impact of lower taxes takes time to eventuate – but the additional demand associated with this extra income appears immediately. We have been pushing at or over the top of our inflation band for many years now – adding additional government stimulus in a situation where inflation expectations are elevated and the price of necessities are rising appears like bad policy. Why? Because the policy will help to reinforce inflation expectations at the top, or even just above, our target band – once we are their it will require a painful transition period to get inflation back down!
Note that when I say government stimulus I am talking about spending + tax cuts. If society really wants lower taxes we could cut spending and not stoke inflationary pressures. As a nation we have to be willing to face trade-offs – we can’t have heaps of government spending and low taxes!