Tax increases and the price level

Shutterstock.com

Article Highlights

  • I explain in this article that the impact of a taxincrease on the price level depends on how theFederal Reserve reacts to the tax.

    Tweet This

The policy debate features considerable confusion about what kinds of tax increases may cause the overall price level to rise and the consequences of any such price increases. One view mistakenly holds that any business tax increase results in higher prices because businesses must pass on their costs. A related misconception holds that the rise in prices shifts the burden of the tax increase to consumers as a group. Although these views may seem plausible, they are invalid because they fail to recognize that the overall price level is determined by monetary policy.

I explain in this article that the impact of a tax increase on the price level depends on how the Federal Reserve reacts to the tax. The Federal Reserve's response is likely to be determined by how the tax increase affects the labor market. The Fed has no reason to raise the price level in response to increases in employee payroll taxes, personal income taxes, and business income taxes. The Fed may increase the price level in response to increases in employer payroll taxes, VATs, and retail sales taxes, but only if the tax increases are large. Any price increase leaves the distribution of the tax increase's underlying burden largely unchanged, but it has some impact on particular groups.

The only current tax proposals for which a potential increase in the price level is a serious issue are those that would introduce large VATs or retail sales taxes. I offer some thoughts on whether and how the price increases could be avoided if they were undesired, and the implications of any price increases that might occur.

I begin the analysis by considering the potential effects of employee and employer payroll taxes on the overall price level, which offer a simple illustration of the basic principles. 

Viard: Tax increases and the price level

Download PDF

 

For a complete listing of all On the Margin articles, please visit:www.aei.org/onthemargin/.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Alan D.
Viard

What's new on AEI

Defeating ISIS: AEI experts weigh-in before the president’s address on Wednesday
image Degrading, defeating, and destroying the Islamic State
image Wealth Building Home Loan: Building wealth through homeownership and retirement savings
image The $3 iPhone
AEI on Facebook
Events Calendar
  • 15
    MON
  • 16
    TUE
  • 17
    WED
  • 18
    THU
  • 19
    FRI
Tuesday, September 16, 2014 | 5:00 p.m. – 6:00 p.m.
The Constitution as political theory

Please join us for the third-annual Walter Berns Constitution Day Lecture as James Ceasar, Harry F. Byrd Professor of Politics at the University of Virginia, explores some of the Constitution’s most significant contributions to political theory, focusing on themes that have been largely unexamined in current scholarship.

Event Registration is Closed
Wednesday, September 17, 2014 | 8:10 a.m. – Thursday, September 18, 2014 | 1:30 p.m.
Third international conference on housing risk: New risk measures and their applications

We invite you to join us for this year’s international conference on housing risk — cosponsored by the Collateral Risk Network and AEI International Center on Housing Risk — which will focus on new mortgage and collateral risk measures and their applications.

Event Registration is Closed
Thursday, September 18, 2014 | 2:15 p.m. – 3:00 p.m.
Speaker of the House John Boehner on resetting America’s economic foundation

Please join us as Speaker John Boehner (R-OH) delivers his five-point policy vision to reset America’s economy.

Friday, September 19, 2014 | 9:15 a.m. – 11:00 a.m.
Reforming Medicare: What does the public think?

Please join us as a panel of distinguished experts explore the implications of the report and the consumer role in shaping the future of Medicare.

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.