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

AEI Election Watch 2014: What will happen and why it matters
image A nation divided by marriage
image Teaching reform
image Socialist party pushing $20 minimum wage defends $13-an-hour job listing
AEI on Facebook
Events Calendar
  • 20
    MON
  • 21
    TUE
  • 22
    WED
  • 23
    THU
  • 24
    FRI
Monday, October 20, 2014 | 2:00 p.m. – 3:30 p.m.
Warfare beneath the waves: The undersea domain in Asia

We welcome you to join us for a panel discussion of the undersea military competition occurring in Asia and what it means for the United States and its allies.

Tuesday, October 21, 2014 | 8:30 a.m. – 10:00 a.m.
AEI Election Watch 2014: What will happen and why it matters

AEI’s Election Watch is back! Please join us for two sessions of the longest-running election program in Washington, DC. 

Wednesday, October 22, 2014 | 1:00 p.m. – 2:30 p.m.
What now for the Common Core?

We welcome you to join us at AEI for a discussion of what’s next for the Common Core.

Event Registration is Closed
Thursday, October 23, 2014 | 10:00 a.m. – 11:00 a.m.
Brazil’s presidential election: Real challenges, real choices

Please join AEI for a discussion examining each candidate’s platform and prospects for victory and the impact that a possible shift toward free-market policies in Brazil might have on South America as a whole.

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