Raising corporate taxes would make inflation worse
What is President Biden’s plan to beat inflation? He tweeted out last week:
This was the first time I have encountered the idea that high rates of inflation can be reduced by raising the corporate income tax. How does it do that? Fortunately, Peter Doocy of Fox News put that question to new White House Press Secretary Karine Jean-Pierre yesterday:
After watching that, I confess that I am none the wiser. In fact, raising corporate taxes will probably make inflation worse.
To see why, ask yourself where our current high levels of inflation have come from. It comes, as the economist Milton Friedman noted, from “a more rapid increase in the quantity of money than in output.” As I noted recently, while
…real GDP — [output] — grew by just 1.9 percent between Q4:2019 and Q4:2021, the amount of M2 — [the quantity of money] — increased by 40.3 percent.
Put simply, the amount of money available to spend on stuff has been growing much faster than the amount of stuff there is to spend it on, bidding up the prices of the stuff that there is.
Figure 1, which will be familiar to anyone who has taken an Econ 101 class, illustrates this. The infusion of new money pushes Aggregate Demand from AD1 to AD2. Real GDP increases from Y1 to Y2, but the price level also increases, from P1 to P2; inflation.*
To solve this we need the Federal Reserve to stop increasing the amount of money so quickly, but we also need to see more stuff being produced to ‘soak up’ that new purchasing power. Increasing corporate income taxes will have the opposite effect. The supply curve shows you how much of a good or service is produced at a given price. Raising corporate taxes will increase the price of producing each unit of the good or service, and thus reduce the amount supplied at any given price.
So an increase in corporate taxes would shift the Aggregate Supply curve to the left. As Figure 2 illustrates, this would lower real GDP (from Y1 to Y2) and increase the price level (from P1 to P2), exactly the opposite of what we are trying to achieve.
A year ago I wrote that “The problems facing the American economy at present are supply side problems.” This remains true. We need to push the Aggregate Supply curve to the right if we want to lower inflation and economist Brian Riedl has some good ideas on how to do that:
*The shape of the supply curve determines to what extent this boost to demand shows up in increases in real GDP or in increases in the price level. The more horizontal it is, the greater will be the effect on output and the more vertical the greater the effect on prices.