Tax increases and the price level

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

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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

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About the Author

 

Alan D.
Viard
  • Alan D. Viard is a resident scholar at the American Enterprise Institute (AEI), where he studies federal tax and budget policy.

    Prior to joining AEI, Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also been a visiting scholar at the US Department of the Treasury's Office of Tax Analysis, a senior economist at the White House's Council of Economic Advisers, and a staff economist at the Joint Committee on Taxation of the US Congress. While at AEI, Viard has also taught public finance at Georgetown University’s Public Policy Institute. Earlier in his career, Viard spent time in Japan as a visiting scholar at Osaka University’s Institute of Social and Economic Research.

    A prolific writer, Viard is a frequent contributor to AEI’s “On the Margin” column in Tax Notes and was nominated for Tax Notes’s 2009 Tax Person of the Year. He has also testified before Congress, and his work has been featured in a wide range of publications, including Room for Debate in The New York Times, TheAtlantic.com, Bloomberg, NPR’s Planet Money, and The Hill. Viard is the coauthor of “Progressive Consumption Taxation: The X Tax Revisited” (2012) and “The Real Tax Burden: Beyond Dollars and Cents” (2011), and the editor of “Tax Policy Lessons from the 2000s” (2009).

    Viard received his Ph.D. in economics from Harvard University and a B.A. in economics from Yale University. He also completed the first year of the J.D. program at the University of Chicago Law School, where he qualified for law review and was awarded the Joseph Henry Beale prize for legal research and writing.
  • Phone: 202-419-5202
    Email: aviard@aei.org
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    Name: Regan Kuchan
    Phone: 202-862-5903
    Email: regan.kuchan@aei.org

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