I’m taking Jeff Hummel’s Masters’ course in Monetary Theory and Policy. Two lectures ago, he discussed the costs of inflation and highlighted Greg Mankiw’s discussion of it in Greg’s Intermediate Macro text. Greg covered many of the bases but the tone of his treatment suggests that he doesn’t think high inflation, even when it exists, is much of a problem. He compares the views of the public and the views of economists on the issue and finds the views of the public deficient.
Jeff disagreed and highlighted two areas that Greg left out. One is that inflation presents a “signal extraction” problem, making it difficult for people to know whether and by how much relative prices have changed. The second is that inflation is a tax. Greg dealt with that issue but focused on the deadweight loss from the tax rather than the DWL plus government revenue from the tax. When you look at how non-economists think about other taxes, you see that they care about the fact that the government is getting revenue from them. That seems like a reasonable concern, whether the revenue generator is a sales tax or an inflation tax.
Greg did note that inflation creates apparent capital gains (I call them “phantom gains”) that are not gains at all. You buy a stock for $100, inflation is 10%, you’re in a 20% capital gains tax bracket, the stock holds its real value at $110 a year from now, you sell the stock for $110, and you pay $2 in capital gains tax. You’re left with $108, which, inflation-adjusted, is worth $98.18, which is less than what you paid for it a year ago.
I assume that Greg focused on the capital gains tax rather than income taxes because Reagan and Congress, in the Economic Recovery Tax Act of 1981, implemented indexing of tax brackets for inflation, effective in 1985. But there are a few things to note. First, other things besides the capital gains tax are not adjusted for inflation. The thresholds after which you pay taxes on your Social Security income have not been adjusted for inflation in 3 decades. Second, the income cutoff beyond which you can’t contribute to a Roth IRA is not adjusted for inflation. Third, many state governments have not adjusted their tax brackets for inflation.
The discussion in class reminded me of two people. The first is Princeton University economist Alan Blinder.
Blinder, even more than Greg Mankiw, missed people’s upset about inflation in his 1987 book, Hard Heads, Soft Hearts. I reviewed it in Fortune, November 9, 1987. Here’s part of what I wrote on the issue.
In discussing employment and inflation, Blinder says we worry too much about inflation. He estimates that for every percentage-point reduction in the inflation rate, we must accept a two point or so increase in the unemployment rate for one year. Blinder says that is too high a price to pay, and launches into an argument about the true cost of inflation, which, he says, noneconomists tend to exaggerate. If inflation is running at an 8% rate while real wages are rising by 2%, people’s money wages will increase by 10%. The noneconomists among them will attribute the whole 10% gain to their own increased productivity [DRH note: I’m not sure he’s right; I never met this mythical non-economist] and will feel that inflation robbed them of the other 8%. They weren’t robbed at all, Blinder argues: 2% is all they were entitled to, and 2% is what they got.
That argument is incomplete, however. Before 1985 people were being robbed because individual income taxes were not indexed: Inflation kept bumping people into higher margin tax brackets, thus enabling the Treasury to steal some of the income they were entitled to. Blinder acknowledges this difficulty and says at one point that a failure to index the tax system can impose “sizable costs.” But then he turns around and says that unless you are an economist or accountant, this cost “will leave you yawning.”
Where was Blinder during the late 1970s? I knew people with only a high school education who noticed instantly that an 8% increase in their hourly rate translated into only a 6% or so increase in their take-home pay, not enough to stay abreast of inflation. They didn’t yawn when that happened–they got mad, which is one reason taxes ended up being indexed.
By the way, in writing this, I had in mind a discussion I had with a high school graduate named Chrissy Morganello, who was a secretary to three other faculty members and me from 1975 to 1979, when I was an assistant professor of economics at the University of Rochester’s Graduate School of Management.
Here, by the way, is Blinder’s first rate article on “Free Trade” in David R. Henderson, ed., The Concise Encyclopedia of Economics.
Next up: Alice Rivlin’s blasé attitude about high inflation in the 1970s.
READER COMMENTS
Frank
Mar 14 2021 at 9:48pm
Ah, they were prisoners of the short-run Phillips curve.
There may well be another self inflicted imprisonment in the offing.
Vivian Darkbloom
Mar 15 2021 at 6:40am
This is a very good time to remind everyone of the indexing issue. My prediction is that when the current House considers and passes an inevitable tax bill raising taxes on “the rich”, most of those tax increases will not be indexed for inflation. This will (quietly) be considered by the House majority as a political feature, not a tax policy bug. It will be noticed by very few voters, but it won’t escape the folks at CBO where it will be imbedded in the revenue scoring.
Robert Coffey
Mar 15 2021 at 8:51am
I had two criticisms of the Trump tax bill. First, that the SALT limit was indexed to inflation and 2nd that the SALT limit was the same for married or single, so there was a marriage penalty. Two known problems that have been fixed in many places in the tax code and there was no reason to make again.
Robert Coffey
Mar 15 2021 at 8:52am
was NOT indexed to inflation.
Vivian Darkbloom
Mar 15 2021 at 10:13am
I agree that both parties use lack of indexing to achieve both phase-ins and phase-outs by stealth. The result of the SALT limit was to increase federal revenue and the lack of indexing to gradually phase out real SALT deductions further. This was on purpose, but not much discussed in the MSM. Would you have had the same problem if the SALT limit were to have been expressly phased-out, say by reducing it (from the initial $10,000) by $1,000 for each of the ten years after enactment? I’m trying to think how lack of indexing (or even indexing, if the inflation index is accurate) could result in a real tax decrease and have yet to come up with an example.
robc
Mar 15 2021 at 11:58am
If I thought it was being done to phase out SALT altogether (we aren’t indexing and in 10 years it goes away entirely), I would be okay with it. I would have been fine with just flat out getting rid of the deduction. But without an expressed intent, I know that won’t happen. Instead it will be gamed for years to come and fights back and forth over it.
Either index it and get rid of the marriage penalty or eliminate the deduction entirely. I am fine with either, but don’t split the baby.
Vivian Darkbloom
Mar 15 2021 at 1:56pm
Regarding “splitting the baby”, I don’t view these two issues as one baby, but two.
Apropos “the marriage penalty”. As with most things regarding tax policy, “it’s complicated”. There is no such thing, per se, as *the* marriage penalty. In some instances, married couples bear a higher burden than they would as two single persons and sometimes they benefit. It all depends on the specific circumstances. I’ve never heard married couples complain, for example, about the “unlimited marital deduction” for estate and gift tax purposes.
In this specific case, I suspect that you and Robert are looking at this rather too simplistically. It’s hard to make anything but rough generalizations about this because here the “equity” of it (which is subjective in any event) may depend not only on federal policy but the underlying state and local rules. Suffice it to say that I believe there is at least a rational basis for having the same *deduction limit* for these *tax expenses* for married couples and singles. This is because most state and local jurisdictions follow the same general rule as the federal government—married couples are subject to (again, roughly) half the tax on the same income as a single person would be. Imagine, for example, couple A&B who each earn $100K per year and a single person, C, who earns $50K. It’s not unreasonble to generalize for purposes of this example that A&B will pay $10K in taxes, and C will also pay $10K. Should the tax code allow A&B a per capita break that is twice that of C, as measured by income? Is this an example of “we married couples want to have our cake and eat it, too”?
Thomas Hutcheson
Mar 15 2021 at 8:01am
I agree about the signal extraction problem; I thought that was THE main cost to inflation. (Lack of indexing of policy parameters is an additional,but non-essential cost.) These in turn are traded off against the cost of relative prices not being able to adjust if there are constraints to absolute declines in some prices with 2% having been judged as the optimum. It would be interesting to see the calculations that went into the choice of 2% and of PCE vs other indexes. Presumably the rate depends on the size of the expected shocks that drive relative price changes and off hand it appears (based on 2008 and 2020) that the size of those shocks has increased meaning that 2% may no longer be optimum.
Andrew_FL
Mar 15 2021 at 9:37am
Indexing the tax brackets to inflation didn’t totally fix bracket creep, because as everyone’s real income increases, they still climb gradually into higher tax brackets. The tax brackets should’ve been indexed to per capita nominal income, if we’re going to have brackets.
Alan Goldhammer
Mar 15 2021 at 10:36am
Anyone with a reasonable return on their retirement investments will quickly find that they are paying the full income tax on Social Security earnings as the threshold is woefully low.
My only wish for Congress is to enact meaningful tax reform by eliminating all preferences, putting in two reasonable rate levels along with a VAT and then leaving town for the rest of their term.
robc
Mar 15 2021 at 12:01pm
Why do we need an income tax AND a vat?
If the VAT is a better tax, then pass an amendment to get rid of the income tax and switch to a VAT.
I like the last part, but my preference would be pass a Single Land Tax amendment and then leave town.
Thomas Hutcheson
Mar 15 2021 at 4:56pm
How could you make a VAT progressive? It would be even less progressive than the current personal income tax.
Christophe Biocca
Mar 16 2021 at 10:55am
Standard solution is a fixed refund amount combined with a flat rate. That means everyone pays the same marginal rate but people pay very different average rates (some even have a net negative VAT if their consumption expenses are low enough).
robc
Mar 16 2021 at 12:30pm
What Christophe said.
Why is that a requirement?
The other way, which I have to credit David Henderson for, is a progressive income tax with an unlimited tax deduction for savings. That is a pure consumption tax without having to change the system dramatically. You can put as much as you want into a 401k/ira/etc tax free. It isn’t taxed until you take it out. If we went with that, I think you also have to get rid of the early withdrawal penalty, can’t require the wait until 59 1/2 for it to truly work. Let young people save tax-deferred for a house down payment, for example.
Student of Liberty
Mar 16 2021 at 6:07am
You may not need it but your government is very keen in collecting both. The beauty of VAT (for government) is that people do not feel it each time they are paying while paying income tax is painful to most (even for relatively small amounts).
robc
Mar 16 2021 at 12:25pm
Quote from actual interview, about a decade ago, “I don’t pay taxes, I got a refund.”
Now, if I want to quibble, they could be right, maybe they had a refundable credit and didn’t pay any income tax. But more than likely, they just don’t count withholding.
It is weird to everyone else in the world, but it is the good thing about the US sales tax system. We see the tax because when the $10 item costs $11, you realize you have paid tax. VAT is too well hidden.
Robert Schadler
Mar 15 2021 at 3:36pm
This piece and discussion reminded me how few economists are able to avoid taking on the guise of moral philosopher as well. Claims and assertions about a “just society”, “robbed,” all they were “entitled to” are such.
Well, yes: economics is complicated. “Inflation” is part of the complication. Inflation is a “tax” if the government profits from it; if it simply lease those with certain assets poorer, it seems more like Jacques Rueff’s “theft”.
An indexing effort indicates some see inflation as a “wrong” to those with certain assets and try to “make it up to them” but can’t really do so “justly”. The poor (those with less financial flexibility and probably less adept at changing assets) are hurt more by this theft. And more often than not, the government benefits the most.
It takes a lot of moral courage for politicians not to like the results so much as not to do everything they can to foster it.
David Seltzer
Mar 15 2021 at 3:58pm
Per Hummel, “Inflation is a tax.” It seems inflation is a compounding tax. Assuming a constant rate of annual inflation of 2% for five years, 1*(1-.02)^5 means your current dollar is worth $.90 five years hence. A loss of buying power of 9.6 % over that time period.
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