Saturday, October 24, 2020

sales tax as monetary policy

 This falls well in the half-baked (or less) wheelhouse of this blog: to help assist monetary policy, we should have a national sales tax that follows the short-term interest rate.  If short-term rates are 0, the sales tax goes away; if they're around a 5% annual rate, we have a tax of 2.5%, if it's an 8% annual rate the tax is 4%, etc.

I came to this idea, such as it is, from thinking about "Modern Monetary Theory", the advocates of which want to use fiscal policy to control inflation to a much greater extent than we do now; in particular, if inflation got too high, we would raise taxes to take money out of circulation to cool it down.  What I haven't heard noted in my consumption of their material is that what you would need to tax would be consumption, not income.  In particular, if you had a class of subsistence-plus farmers who had income but never spent it, taxing them would do no good whatsoever for reining in inflation; the money they're sitting on is economically inert.  If demand for the quantity of goods and services being produced is high enough to push up prices, the only way to prevent that is to somehow effectively reduce that demand, and the way you would do that in anything like this framework would be a combination of reducing the ability of people who want to spend money to do so and of encouraging those people to delay their spending.  To the extent that you get people to save their money, that addresses the problem.

An important thing to note about encouraging people to save money rather than spend is that it depends on real interest rates, not nominal ones; "real" in this context means "inflation-adjusted", except that what actually matters is not realized inflation, but expected inflation.  For a given interest rate, people will generally be more willing to save if they think inflation will be low (so they can buy more stuff in the future if the save now) than if they think inflation will be high; by the time we know what actual inflation is over a time period, it's well after the decision was made.  Another important thing to note is that, if the sales tax is changing with time, your actual purchasing power at a given time depends on after-tax prices.  In the short-run, a tax response to inflation means that you're responding to an erosion in purchasing power by further eroding people's purchasing power.  If you link it to interest rates (or something else in the economy that's likely to be low in recessions and high in inflationary expansions), though, that higher tax is at least expected to be temporary — the expected after-tax inflation rate is lower than the expected before-tax inflation rate.  (Or, if you prefer, there's a tax incentive for deferring spending to a time when the tax has come down.)

I find this easier to discuss in terms of periods of high inflation, but it should work the other way, too; if people think a sales tax is going to kick in in two years, spending more now becomes comparatively more attractive, and the after-tax real interest rate is lower even before taking account of the result that we're hoping this has on inflation.  If you can make this credible — if you can make people really believe that there will be a sales tax in two years — then this should enhance the ability of low nominal interest rates to get people spending money now, while avoiding some of the mechanical and psychological difficulties associated with negative nominal interest rates.

If we could ignore mechanical difficulties, of course, negative interest rates would be more attractive, but so would a negative sales tax; note that what's important for the substitution effect is not the level of the tax, but its expected change, and to the extent that we're trying to affect the amount of money in the system and expect that to do some work for us, a tax that's actually negative when we're trying to stimulate spending is in fact what we'd want.  (While the primary logic of mailing out checks this past spring was straightforward relief rather than stimulus, it provided some nominal stimulus by enabling spending.)  To some extent you could get the money-balance effect by lowering other taxes instead — even with this sales-tax scheme, funding the government probably requires positive income tax rates, but they could be lower if some of the revenue comes from the sales tax instead — but maybe a negative sales tax would be easier than some other negative taxes.  The idea of a negative income tax has gotten more attention, and to some extent, with the EITC, we have that.  It may also be, though, that "the sales tax" would be better implemented through the income tax, where it might look more like a savings incentive — instead of a 5% sales tax, you would increase income tax rates 5 percentage points above their baseline level, but with a 5% credit for new savings, making clear that part of the point is encouraging people to save the money to spend later instead of now, and instead of a -5% sales tax you could have temporarily lower income tax rates, but with a similarly temporary savings tax to encourage spending now.  One problem with doing it this way is also a problem with using a value-added tax, which is sometimes said to be equivalent to a consumption tax; that problem is one of timing.  I envision the tax changing in the middle of a year, rather than having a constant value for each tax year; maybe that's unnecessary.  A value-added tax takes time to bubble its way up through the supply chain.  In either case, though, a delay in implementation causes the tax to trip over its own feet a bit; remember that a significant part of the effect is to come from the expected mean-reversion, that is that raising the tax should lead to the expectation that it will be lower in the future than it is now, and saying "we're going to raise, you'll feel the rise in six months" encourages exactly the opposite of what we want in the near-term.