Friday, 23 May 2008

Inflation and tax cuts

At the visible hand in economics blog they write
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.
But why does aggregate demand increase? Why does demand change if I spend a dollar rather than the government spending that dollar?

I guess that the argument is that with a tax cut I get to spend an extra dollar but the government doesn't reduce its spending by a dollar. So the real issue isn't aggregate demand but rather how does the government fund its dollar of spending now that it has given me my dollar back. It can either increase debt by a dollar, but in so far as the world is Ricardian I would see the dollar of extra debt as future tax and thus save my tax cut to pay for the extra tax in the future, or it can expand the money supply but we have an independent central bank so the government shouldn't be able to do this. So why does a tax cut generate inflation?

12 comments:

Matt Nolan said...

"It can either increase debt by a dollar, but in so far as the world is Ricardian I would see the dollar of extra debt as future tax and thus save my tax cut to pay for the extra tax in the future"

Agreed, however there are some issues.

1) Binding liquidity constraints for households would lead to additional spending from tax cuts even if they had perfect foresight on the governments spending path. Assuming inflation expectations are partially adaptive (or the existence of an inflation feedback mechanism in the shape of a wage-price spiral) then this would lead to higher levels of inflation.

2) Bounded rationality - consumption levels are "irrationally" sticky, as a result tax cuts now will help to hold up demand artificially increasing pressure on the price level when resources are limited - increasing inflation expectations.

3) The impact on peoples expectation of the equilibrium level of government spending. This budget may have committed the government to a lower level of spending (growth) in the medium term than people expected, which reduces peoples expected future tax liability. This makes the cut in taxes more akin to a permanent cut than a temporary cut.

Now the third reason sounds silly, as the reduction in lifelong government consumption will be at least as dis-inflationary as the increase in private consumption.

However, if we buy that inflation feeds on itself (so are partially adaptive, or there is a feedback mechanism) - then inflation expectations are incredibly important. The increase in private spending happens now, while the decrease in government spending happens in the future. As a result, they will help to reinforce higher levels of inflation expectations and thereby higher levels of future inflation.

4) People expect tax cuts will lead to high inflation - lifting inflation expectations.

Fundamentally, all these arguments rely on inflation expectations being especially persistent - either through a lack of Reserve Bank credibility or the failure of strict rationality. I think we're always going to have a little bit of both.

Heterosexual middle class white male said...

Why is Keynesianism so well and alive in NZ???

Tax cuts raise incentives for firms to invest and for people to work, which will increase productivity and output in the longer run.

Matt Nolan said...

"Why is Keynesianism so well and alive in NZ???"

Its not just New Zealand - the practice of using monetary policy as a stabilisation instrument is implicitly Keynesian, and this is done all around the world.

Keynesian ideas provide a good description of the short run - as long as we believe persistent price pressures in the short run impact on inflation expectations which in turn drives inflation, then there will always be scope for Keynesian ideas.

The question then is, why do Keynesian explanations hold up so well in the short-run? This is practically the research project of New Keynesians - who try to increase the realism associated with New Classical models.

Paul Walker said...

Matt: I agree the world is not fully Ricardian, for lots of reasons. But even if it isn't, it still looks like the reason for any increase in AD is the fact that government spending has not been reduced. So the real issue isn't the tax cut, its the level of government spending. If spending is not under control then AD will keep on increasing.

As to "Its not just New Zealand - the practice of using monetary policy as a stabilisation instrument is implicitly Keynesian, and this is done all around the world." Didn't a non-Keynesian, Milton Friedman, have something to do with us using monetary policy as anti-inflation weapon?

Heterosexual middle class white male said...

So for you tax cuts are not different from printing money!!

Matt Nolan said...

Hi HMCWM,

"So for you tax cuts are not different from printing money!!"

Yes, they are different. My statement was that these tax cuts will increase short-term price pressures and lift inflation expectations - which will in turn increase inflationary pressures. I didn't say there would be no output adjustment, infact if you read my post I state that I believe such a switch will increase the supply of goods in the economy.

However, we don't choose a "quantity" of money, we choose a price for money (the interest rate). If we price money in the same way we would in the case without tax cuts we would end up with higher inflation expectations and thereby stronger growth in money demand - and thereby we could say that there would be stronger growth in the quantity of money and inflation. I'm not saying that the inflationary pressure is the same as funding the tax cuts through money supply growth - I'm just saying there will be some pressure on medium term inflation.

Hi Paul,

"So the real issue isn't the tax cut, its the level of government spending"

I completely agree that if spending had been cut in-line with tax cuts inflationary pressures would not increase - as demand for our limited set of resource wouldn't be pushed up leading to no increase in inflation expectations.

"Didn't a non-Keynesian, Milton Friedman, have something to do with us using monetary policy as anti-inflation weapon?"

Lets not forget that Milton was originally a Keynesian - he's main departure came when he noted that growth in the money supply (above productivity) was the primary driver of true inflation. However, is the central bank interested in controlling money supply growth, limiting inflation, or in "stabilising" economic activity.

In truth - central banks are uncertain about the truth (or at least causation associated with) of the money supply growth = inflation argument (especially given the endogeneity that seems prevelant in the "velocity of money"). As a result stabilisation and the impact on inflation expectations are the main factors any Reserve Bank will be interested in.

There is often a trade-off between stabilisation and inflation expectations - something that Neo/New Keynesians believe. This was the foundation of the Taylor rule, which closely describes the actual actions of central banks.

Most economists would agree that interest rates can be used to fight inflation (central banks attempted to do such things before Friedman) - the question truly is, what causes inflation.

I'm sticking with inflation expectations as a significant determinant - luckily the RBNZ can influence these expectations by lifting interest rates and slowing domestic economic activity. However, expansionary fiscal policy does counteract this even in the face of consumers that behave in accordance with Ricardian equivalence - thanks to the reasons I stated earlier.

Heterosexual middle class white male said...

When did NZ become a closed economy?

Matt Nolan said...

"When did NZ become a closed economy?"

I agree that the fact we are a small open economy impacts on the degree with which the RBNZ can influence interest rates - but it doesn't change the direction of the impact. Fundamentally this is because capital isn't perfectly mobile and because we have a floating exchange rate.

Is that the point you were trying to raise?

Heterosexual middle class white male said...

Will the increase in AD be for non-tradeable goods only?

It's tax increases that should cause inflationary pressures. Tax cuts have the opposite effects.

Matt Nolan said...

"Will the increase in AD be for non-tradeable goods only?"

No, but it will increase demand for non-tradables, so even if nothing happened to tradables there would be an increase in prices.

Furthermore, on the tradable side increased demand from consumers increases New Zealand's demand for other currencies (so that we can buy these goods overseas) - this increases the supply of New Zealand dollars on the currency market and decreases our dollar (all other things equal). As a result, even with an open economy tax cuts are inflationary from both channels.

Paul Walker said...

I note that a similar debate is going on at the Not PC blog. One comment there is particularly interesting, see the Crampton comment here.

Heterosexual middle class white male said...

On your "furthermore" argument: If an increase in demand for tradables does not lead to increases in prices of tradables, then how does that cause inflation? Could you please remind me the definition of inflation?