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Should Congress Raise Taxes To Fight Inflation?

In a Monday Wall Street Journal column (paywall), President Biden urged Congress to help fight inflation by raising tax rates on the very wealthy and using the money to reduce the deficit. Does that strategy make sense in today’s economic environment?

At least in theory, raising taxes could ease inflation. But not necessarily for the reason Biden suggested. Tax hikes enacted this year would not have much immediate impact on government borrowing. But they could slow inflation by reducing consumer demand for goods and services.

Big caveats

There are two big caveats, however. While Biden is focused on tax hikes on the wealthy and corporations to reduce the deficit, the most direct way to use taxes to slow inflation would be to raise levies on low- and moderate-income households, whose spending habits are most sensitive to changes in incomes. Trouble is, that would put the burden of inflation-fighting on the most vulnerable. Besides, the idea is not going anywhere just months before a congressional election.

Then there is the matter of timing. A tax increase might be good policy today, while the economy still is running hot and inflation remains the primary concern. But circumstances could change very rapidly. An inflation-busting tax increase could be exactly the wrong medicine later this year or in 2023—once a succession of Federal Reserve Board interest rate hikes slows growth or even throws the economy into recession.

If Congress wants to use tax policy to slow consumer demand, it would have to do so right now. And it needs to target the changes properly. Since it likely will do neither and since raising taxes today only to lower them again in a matter of months makes little sense, perhaps it ought to leave the inflation-fighting to the Fed.

Who would respond to tax hikes?

In fairness, Biden’s Journal op-ed acknowledged that the “Federal Reserve has a primary responsibility to control inflation.” But when it comes to tax policy, he repeated past requests for more IRS funding to collect unpaid taxes and for international tax reform. And then he said this: “We should end the outrageous unfairness in the tax code that allows a billionaire to pay lower rates than a teacher or firefighter.”

Leaving inflation-fighting to politicians always is…awkward. While Democrats would strongly resist any efforts to raise taxes on low- and moderate- income households, those are the people most likely to reduce spending for every dollar of extra taxes they pay. This may be especially true since many of these households spent the savings they amassed after receiving government payments during the pandemic.

Higher-income households are less responsive to tax increases and may not reduce their spending quite so much, though declines in after-tax income still would change their behavior somewhat. The effects may be especially muted today since these consumers still are sitting on massive piles of cash, the recent stock market decline notwithstanding.

What about raising taxes on businesses? Remember, today’s inflation is caused by a mix of high demand and an unusually low supply of goods. It is hard to see how raising taxes on goods producers would increase the supply of those products.

Bigger problems ahead

Biden is right that tax increases could slow the growth of the federal debt, assuming government doesn’t spend the new revenue. In its latest projections, the Congressional Budget Office estimates the federal government will pay $8 trillion in interest over the next 10 years, a result of both rising interest rates and growing debt. But the short-term fiscal impact of any tax increases is likely to be modest at best.

The US may be facing more urgent problems than long-term debt. Treasury Secretary Janet Yellen, among others, is warning that the world economy could slip into recession, due to a to a mix of factors including steep and rising energy prices, tightening monetary policy, ongoing worldwide supply chain problems, COVID-19 related lockdowns in China, and Russia’s invasion of Ukraine. These global circumstances are well-beyond the reach of US tax policy.

That brings us back to the political challenges. Biden and the Hill Democratic leadership are anxious to cobble together a congressional majority to raise taxes on the wealthy and corporations. But the going remains slow.

And few lawmakers of either party are willing to raise taxes on low- and middle-income households. Just ask Sen. Rick Scott (R-FL) who did suggest raising taxes on households who currently pay no federal income tax. Gleeful Democrats want to turn his words into campaign ads. And his idea got the iciest of cold shoulders from his Senate Republican colleagues.

We are left, then, with this: Individual income tax increases on working families could moderate inflation but add to the hardship of those already struggling. And Biden has flatly opposed any tax hikes on households making $400,000 or less. Even if Congress could pull it off, the timing likely would be all wrong.

Maybe the right answer is the usual one: Given enormous geopolitical and economic uncertainties and a slow-to-react Congress, the hard work of responding to high inflation should be left to the Fed, not tax policy.