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Senator Joe Manchin

Financial Planning > Tax Planning > Tax Reform

No, Mr. Manchin, Taxes Don’t Cause Inflation

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What You Need to Know

  • On the contrary, higher taxes can help get prices under control, a tax professor and former Treasury official argues.

Senator Joe Manchin, in rejecting the package of tax increases and climate measures central to President Joe Biden’s economic agenda, has cited an issue of legitimate concern for Americans: the unacceptably high level of inflation.

Lest anyone be misled, I must set the record straight: Higher taxes do not stoke inflation. On the contrary, they can help get prices under control.

The economics profession, contentious as it is, has achieved near consensus on some core principles. For example: price ceilings generate shortages, tariffs distort trade, carbon taxes are efficient — and tax increases reduce inflation. Even economists who oppose higher taxes recognize this simple fact. Inflation results from a mismatch: When demand for goods and services exceeds supply, prices increase. Raising taxes has the opposite effect, reducing disposable income and hence demand.

What, then, is Senator Manchin thinking? The Biden plan would increase taxes on wealthy individuals and corporations — including by implementing a historic agreement on minimum taxes for multinational companies — and direct the revenue toward priorities such as clean-energy tax credits to mitigate climate change. I can imagine four concerns, none of which stands up to scrutiny.

1. What if the spending outweighs the tax revenue, increasing aggregate demand? This is possible, but it can be prevented by sticking to the principle of net deficit reduction — something that Manchin could insist upon, and that negotiators have already accepted.

2. What if the type of tax increases proves inflationary? Wealthy people are less reliant on marginal income, so higher taxes might have less effect on their demand. But the effect is still negative: Higher taxes won’t encourage them to spend more.

3. What if higher taxes impair supply? No doubt, the pandemic and the war in Ukraine have contributed to inflation, by preventing supply from meeting demand. But aggregate supply is much less directly sensitive to tax: It depends more on economic fundamentals such as labor, capital stock and technology. To the extent there’s a mismatch, the immediate solution is to address demand — all the more reason to raise taxes to bring it into line.

The proposed tax increases will reduce after-tax profits for corporations and for certain wealthy individuals with pass-through businesses, but they won’t change the incentive to produce goods and services. The international provisions, which curb the tax advantages of foreign income, might even encourage more domestic production. Same for the stock-buybacks tax, which will nudge executives toward reinvesting profits into expansion.

4. What if the timing is off, and the tax increases take effect when inflation has subsided and the economy is shrinking? The proposed taxes are particularly unlikely to exacerbate a recession. Companies don’t pay profits tax when they don’t have profits, and they can carry forward losses to offset tax in future years, when growth is still fragile. Closing loopholes for the rich also won’t impose any hardship. Nobody below a very high income threshold will be affected.

Actually, the tax increases will help the Federal Reserve manage inflation. The Fed can influence demand only indirectly: By increasing interest rates, it boosts the cost of borrowing (which affects investment in things such as houses and factories) and the exchange rate of the dollar (which reduces net exports). By reducing demand more directly, higher taxes will generate a more balanced outcome, allowing the Fed to achieve its inflation goals with less negative impact on investment and exports.

All told, Senator Manchin, now is an excellent time to raise taxes.

Pictured: Sen. Joe Manchin, D-W. Va. (Photo: Bloomberg)

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Kimberly Clausing is a professor of tax law and policy at UCLA School of Law. She has served as deputy assistant secretary for tax analysis at the Treasury Department, and is the author of “Open: The Progressive Case for Free Trade, Immigration and Global Capital.”

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