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I know only a little bit about economics, but I have been puzzled why interest rates should be used to combat inflation where direct solutions exist.

I have some trouble understanding why interest rates are used to battle inflation instead of consumption taxes. As per my understanding, high interest rates should promote saving and combat inflation by causing households to save more and spend less. However, doing so harms the growth of the economy as households are inclined to save more and invest less (such that many investors simply move their money to deposits), which only hurts the economy as new businesses and workers will struggle to keep their income as unemployment at the end will rise. Moreover, high interest rates seem to only help the wealthier as they profit from interest rates while the low income households, which normally hold also a lot of debt will just pay more in interest rates.

Instead, I was thinking that the most direct way to battle inflation is rising consumption taxes brackets (similar to income taxes), which surprisingly do not even exist in many countries (I'm actually unsure if they exist at all). Consumption tax brackets are simply taxes on any consumption (money transferred to another entity for goods/services) similar to income tax brackets. Therefore, if someone is consuming 10,000 per month, he will pay much more consumption taxes than those consuming 2000 per month. This is a direct solution to combat high CPI as the excess consumption in the economy will go down with higher taxes. Investments will suffer if the market expected excess consumption, but not to the same extent of the rising interest rate as saving in deposits (that go to the FED and do not promote growth) will not be favorable (of course the free market adjusts the loan rates and such, but the FED interest rate will stay unchanged).

My question is Why interest rates are used when consumption tax brackets seem to be more direct and effective tool to combat CPI inflation? Why there are no consumption tax brackets at all in most countries?

I want to also add that income tax is not the same as consumption tax as people may earn their money from deposits, investments, inheritance, gifts and so on where each usually have different tax percentage.

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There are several problems with your proposal, and there are several claims that you make that are actually not correct.

First, consumption taxes do not directly combat inflation they actually typically directly result in at least temporary inflation. Inflation is increase in price level. When consumption taxes increase, empirically (e.g. see Carare, A., & Danninger, S. 2008 or Benedek et al. 2015), price level increases since at least some of that tax increase is passed onto a consumer. The evidence comes from regular consumption taxes, such as GST or VAT but there is no economic reason why some sort of individualized progressive consumption tax would not have the same effect, in standard micro supply-demand models the consumption tax will increase prices if it is binding, excluding some people might lead to smaller effect overall but then you will also get smaller effect on demand. Consumption taxes affect demand precisely because they increase prices consumers face, whether explicitly or implicitly.

Now this is just a temporary 'short-run' effect because they result in shift in level of prices (inflation is ongoing process), but it is still effect that makes inflation worse in short run. The consumption tax can have also simultaneous downward effect on inflation, but this effect would come from the negative effect of consumption tax on aggregate demand, which hurts the economy and increases unemployment rate, so this is the same harmful effect you tried to avoid.

In addition, if government spends the money collected by the tax then it will offset large portion of the negative shock to aggregate demand. Most governments spend more money then they collect in taxes so it is very unrealistic to imagine that the same governments will exercise restraint in spending extra tax revenue from such tax.

Moreover, the consumption 'brackets' you propose are not new proposal but are generally unworkable. Government does not have information on your personal consumption. In order to collect this information government would have to collect your personal information every time you enter a store and purchase something. That might be trivial when using credit card, but it becomes extremely cumbersome with cash. In some countries people do not even have ID. Even if you would institute some bureaucracy that would collect information on people who make cash transactions, such tax could be trivially avoided by asking friends or other third parties to make purchases for you. Hence such tax would be easily avoidable, only solution to this problem is either complete abolition of cash and removal of any privacy when it comes to purchases, or having uniform consumption tax rates (hence why countries have GST or VAT).

Furthermore, this is bit beyond this question but from long-run perspective income is equal to consumption, as saving is just postponed consumption, so any sort of redistributive measure (otherwise I see no point in consumption brackets) can be simply always implemented by taxes and transfers on income side where data collection is infinitely more easier compared to consumption and hence such differentiated consumption tax is pointless.

Second, inflation is actually caused, among other reasons, by low interest rates (e.g. see Alvarez et al 2001). Hence, if you keep interest rates low you are fueling higher inflation. You are not really addressing (one of the) root cause(s) here if you want to keep interest rates down.

Third there is very little evidence that low interest rates promote sustainable economic growth. In fact in most economic models of growth there is no nominal interest rate.

Moreover, you claim that higher savings have negative effect on economic growth but that is not true. Growth is actually positively related to savings rate in poor countries, although less so in richer countries that are already on technological frontier, but it does not have negative effect on economic growth Aghion et al 2016). Furthermore, both saving and investment decisions are determined by real interest rate not nominal interest rate.

Nominal interest rate allows people borrow more new money but it does not change the real amount of resources or stuff that is out there. Lower nominal interest rate can stimulate economy when it works below its potential, because that implies there are some underutilized resources people are not tapping to just because of some nominal constraints. However, inflation is clear sign that economy is operating above its potential. At such point low nominal interest rate cannot affect economic output it can only generate more and more inflation. This is why lowering interest rate is used to combat recession, but country can't just grow by lowering its interest rate, if that would be possible there would be no poor countries.

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  • $\begingroup$ Thank you very much for your answer! I agree with some of your points, but would like to further ask some questions. As you noted correctly, income translates to consumption and saving, thus, we can solve the data gathering consumption problem by tracking income, which is already tracked, and saving (which I guess is easier). Actually, the consumption tax is then equivalent to some sort of income tax plus some sort of saving tax rebate. I also would argue that VAT is different than my proposed tax as it should have similar effects to income tax assuming the saving rate is constant. $\endgroup$
    – D. A.
    Sep 26, 2023 at 16:39
  • $\begingroup$ Regarding government spending, i do agree that the government can use the money, but this is always true if the government acts with no economical common sense. In general the government can just loan money by issuing bonds no matter what is the interest rate and then go bankrupt or that the central bank can do questionable policies like in Turkey. Economic decisions are still not automated. $\endgroup$
    – D. A.
    Sep 26, 2023 at 16:40
  • $\begingroup$ Regarding your point about saving rates, I indeed agree if the money is invested in growth companies, which is actually incentivized with consumption tax, and doesn't just stay in the FED account (deposits) producing money with no economic activity. If the interest rate is 1000% then the FED will incentivize people to just put their money in deposits and there will be no investments in risky companies/R&D and so on as per the paper you sent, especially if their cashflows assumed to be more in the future as investors will have much higher discount rate. The paper explicitly consider investing. $\endgroup$
    – D. A.
    Sep 26, 2023 at 16:41
  • $\begingroup$ Regarding your last point about interest rates, I do agree that low interest rates are stimulating the economy, but it doesn't have to be inflation at the end if it is just not the correct time to consume (so the stimulating effects are mitigated by large taxes). $\endgroup$
    – D. A.
    Sep 26, 2023 at 16:41
  • $\begingroup$ Let's assume that the consumption tax brackets were 0% for <1000\$ and 50% > 1000\$ per month, and now because of surging prices we change it to 10% <1000$ and 100% >1000\$ (so people pay double for the same goods) so people will wait for the lower taxes and we will redistribute the consumption more evenly in time. In the extreme case one can just do infinite percent tax which will cause any consumption above 1000\$ to be no profitable and so I don't see how inflation will persist in such case. $\endgroup$
    – D. A.
    Sep 26, 2023 at 16:41

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