Taxation is an indispensable anti-inflation policy tool in Modern Monetary Theory

There was an unedifying and fairly undignified war on Twitter recently about whether Modern Monetary Theory (MMT) economics advocate using taxes to deal with inflation. Like all these Twitter ‘debates’, the opening proposition was a ‘gotcha’ attempt that was correct from one angle but then missed the point when it was applied to whether MMT is a valid framework or not. The responses from the MMT ‘activists’ were also overly defensive and reflected the fact that they had fallen for the framing trap presented by the antagonist. In this blog post, I want to clarify the MMT position on the use of taxes and inflation policy. What you will learn is that both positions presented in that Twitter war were largely erroneous, and, conflated concepts, either knowingly (probably not) or unknowingly, to leave a muddy mess. As the cloud became thicker, the ‘debate’ descended, as all these Twitter exchanges seem to, into unhelpful accusations of racial insult, claims of ignorance and stupidity, and worse. Not very helpful.

These Twitter exchanges are incredibly unproductive.

Twitter is not the forum for having debates and using it for that purpose usually ends in grief as it did this week.

I think the MMT activists who get roped into these trifling exchanges, thinking they are defending some verity, usually end up undermining our educational mission.

The fact the exchanges also typically end up in name calling, personal accusations and worse, just reinforces that point and opens the MMT side up to accusations of arrogance and defensiveness.

Anyway, I wish those who were interested in our work avoided these sorts of interchanges.

The Twitter exchange started with an antagonist stating that using taxes to tame inflation would be politically unpopular.

Under most circumstances I would agree but then would implore the person to tease out whether they are referring to tax revenue or changes in tax rates.

That difference matters.

The problem was that the person transitioned from this mostly correct point (depending on how we understand those terms and associations) to accusing MMT economists of not understanding the inflation process and being bereft of credibility.

Enter a prominent MMT economist (not one of the original team) who sought to deny the allegation that MMT relies on “tax increases as a primary weapon against ex post inflation”.

That statement just muddied the waters because the antagonist and the MMT activists that were armed to the teeth with keyboard angst failed to comprehend the nuance.

Various antagonists (who are seemingly on standby to wade into these asinine disputes) then produced textual evidence, they thought, proving that MMT economists (they used writing from Warren Mosler and Randy Wray as exhibits) did advocate using tax increases to tame inflation.

And if they had have consulted my work they would have found several passages where I would have argued the same proposition.

Taxes in MMT, in addition to their redistributive and allocative functions (dissauding people from smoking etc), are an essential tool in allowing governments to pursue a spending program without pushing nominal spending growth ahead of the real productive capacity of the economy.

Which means they serve a anti-inflation function.

The problem was that the antagonists didn’t really appreciate what the textual segments they produced were meaning.

They took the words literally and applied them to their purpose.

The problem is that they didn’t differentiate between tax revenue as a vehicle for setting the non-inflationary size of government and the manipulation of tax rates to modify total spending.

Both functions of the tax system are part of the anti-inflationary ‘weapons’ that government has at its disposal.

But unless you distinguish those functions, we end up in the mess that I saw unfold on Twitter this week, where both sides of the debate were really arguing about a meaningless set of propositions.

One of the other problems that lead to these Twitter misadventures is that there is a tendency for MMT activists to conflate their political agendas with the MMT framework of analysis.

They find that the framework may, at times, deliver conclusions that are incompatible with their political motives, and instead of recognising that openly, they seek to re-frame what they claim is MMT.

That is an additional source of opaqueness and leads to accusations that MMT economists just make it up on the run.

We don’t.

And among the original team there is no disagreement on what MMT is and isn’t.

But if people start getting loose with concepts to suit their own ends, then it can easily be said that MMT is not a consistent body of knowledge.

So let me explain how MMT constructs the issue of taxes as an anti-inflation weapon and leads to the conclusion that taxes are a primary weapon against inflation within the MMT body of knowledge.

Tax revenue sets the non-inflationary size of government

Consider the following graph, which shows government tax revenue and spending for a range of nations as at 2015.

I chose 2015 because it was after the GFC and before the pandemic – so representative of more normal behaviour.

While most nations run small fiscal deficits, the point of the graph is that large spending governments require large volumes of tax revenue.

The revenue is not to fund the spending but to create the real resource space that can absorb government spending in a non-inflationary manner.

Let’s dig into that a bit deeper.

Initially, with a worth fiat currency (digital or physical tokens), there must be a motive created in the non-government sector to ensure they use the government’s currency.

The imposition of the tax liability does the trick because it forces the non-government sector to supply productive resources to the government sector, which in turn allows the government to fulfill its spending program.

That is step one.

Another way of seeing that is to understand that given that the non-government sector requires the government’s fiat currency to pay its taxation liabilities, the imposition of a tax liability (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector.

The tax liability thus frees up real resources that would otherwise have been utilised through non-government spending.

The unemployed or idle non-government resources can then be brought back into productive use via government spending which amounts to a transfer of real goods and services from the non-government to the government sector.

In turn, this transfer facilitates the government’s socio-economic program.

While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities.

Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue.

Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.

And the scale of this relationship – or, in other words, the size of government – then dictates the scale of the (initial) unemployment created by the tax liability.

Relatively large governments require large tax revenues, while smaller footprint governments require smaller tax takes.

But note that scaling relationship is not about ‘funding’.

It is about creating the non-inflationary real resource space to absorb the scale of government spending desired.

The policy design must ensure that the tax revenue is sufficient – and depriving the non-government sector of resource usage – to accommodate the scale of spending desired.

While the orthodox conception is that taxation provides revenue to the government which it requires in order to spend, the MMT conception is that the tax revenue is an indispensable policy requirement in order to ensure the government can operate at its desired scale, without pushing the economy into an inflationary episode.

This insight then has implications for shifts in government policy (scale).

For example, consider a Green Transition, which will almost certainly require an increased scale of government activity in the economy – resource demand – at least in the first stages of the decarbonisation.

It is inconceivable that the increased demand for public resource use will be achievable without increased tax revenue given that an open competition for resources would set off a major inflationary episode (driven by excess nominal demand).

Again, this is about setting scale and that is a crucial role that taxes play.

So when critics produce textual segments from MMT economists that say that taxes are an important anti-inflationary tool, they should understand these starting points as a context, rather than concluding that tax rate changes are always going to be the preferred tool for dealing with cyclical fluctuations in nominal spending.

We turn to this second ‘tax perspective’ now.

Tax rate changes can be used to manipulate spending

The other perspective on taxation is that it is a policy tool that can be varied to deal with cyclical shifts in spending.

It is here that the politics of tax policy are most relevant.

Generally, it is true that a government would become very unpopular if it varied its tax rate structures regularly to deal with cyclical fluctuations.

There are times, when the adjusting tax rates in the short-term or on a once-off basis (say a special hypothecated levy) is political easy to accomplish.

For example, in 1997, the then British Labour government introduced a new ‘windfall’ tax on “the excess profits of the privatised utilities” as a once-off measure to redress the ridiculously low sale price that the Tory government had allowed (Source).

More recently, the current Tory government has proposed a windfall tax on energy companies, who through no good work of their own are experiencing booming profits as a result of the Ukraine war.

The purpose of the tax is to put pressure on the companies to reduce energy prices by reducing their excess profits and redistributing the funds to those in need as a result of the energy price gouging from the companies.

Other governments are being encouraged to use these ‘windfall’ tax initiatives to reduce inflationary pressures arising from profit gouging.

So it is not always true that governments are politically unable to vary tax liabilities on a cyclical basis rather than as a structural means to change the scale of government (as above).

But I accept the point that using tax rate manipulation to deal with temporary demand excesses, for example, is not politically easy, even if it would be a very effective way to alter spending levels.

Further, as is clear in all the MMT literature the government has a range of policy tools that can be implemented in the short-run to modify inflationary pressures and do not attract the same political damage as tax variations might.

And, which tool is suitable depends on the source of the price pressure.

It is a complex process disentangling the primary reason for the price impulses from the derivative impacts.

For example, at present, central bankers are claiming that the inflationary pressures are generalising and that means interest rates have to rise.

But an initial supply shock (example, oil shock) increases unit costs through the vertically-integrates supply chain.

All energy using operations which have price setting power to defend real profit margins then push the cost increase onto the next level in the chain, and ultimately, onto final consumers.

The inflation is then general.

But that state still might not have a further propagating mechanism – like workers seeking to engage in real wage resistance and push up (and gain) nominal wage increases.

In which case, the inflation will dissipate quickly once the initial cause – the oil price rise – is reversed.

The point is that in some cases, tax rate changes might be required – for example, the reduction of excise taxes on petrol might be entertained in the short-run.

In other cases, other policies would be more effective.

I have previously advocated, for example, making public transport free to alleviate the oil problem.

Governments could make child care free (in Australia it is mostly a privatised, fee-for-service sector).

They could scrap indexation agreements with medical funds and cap energy prices.

And more.

So in a cyclical event, there are many policy tools that can be introduced to reduce inflationary pressures – tax rate changes being one of an assortment.

Conclusion

I hope that clarifies the matter.

It is wrong to state that MMT does not advocate the use of taxation as a primary policy tool against inflation.

But agreeing with that proposition does not then lead to the conclusion that tax rate changes will always be the preferred cyclical variable to offset price pressures.

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.