Monday, October 1, 2007

Does Cutting Taxes cause Inflation?

Does cutting taxes lead to inflation?

Cutting Income Tax

  • Reducing income tax will increase disposable income of consumers. Therefore consumer spending and AD will increase. This could cause inflation, if the economy is already quite close to full capacity.
  • If economic growth is already low, a cut in income tax is unlikely to cause inflation.
  • It also depends on consumer confidence. For example, if consumer confidence is very low, a cut in income tax may not lead to extra spending. People may prefer to save the increase in disposable income. Therefore, inflation will not increase in this case.
  • It is possible cutting income tax will increase incentives to work and therefore, in the long run AS may increase. However, I feel this effect is very minor.

Cutting Indirect Taxes like VAT

  • If the govt cut VAT, from 17.5% to 15% it would effectively increase the spending power of consumers, therefore, there may be an increase in AD and possibly inflation.
  • However, a cut in indirect taxes will also directly reduce the RPI measure of inflation. This is simply because many goods will be cheaper because of the reduction in Tax. However, this will be just a one off reduction in the inflation rate.
  • Some measures of inflation therefore ignore the temporary effects of taxes.
The effect of lower taxes depends on Government Spending / Borrowing
  • The effect of a reduction in taxes also depends on Government spending.
  • If the government cut taxes but also reduce government spending, then the net effect on AD will be neutral and there will be no inflationary affect.
  • If the Government cut taxes and increase borrowing it should lead to an increase in AD.
  • However, some economists will argue a cut in taxes, financed by borrowing will lead to "crowding out" - Private sector buy more bonds so reduce their income.
  • Generally, lower taxes may have an inflationary impact, but the actual effect depends on many variables, such as the ones mentioned here.

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