Discover more from Making Economics Matter
Inflation Reduction Act
Is it all in the Name?
In the economics I was brought up with and teach, the idea that Congress could take action to reduce inflation is difficult to understand, at least in the US. Fiscal tools of tax and spending are the levers controlled by Congress while monetary policy is conducted by an independent monetary authority, called the Fed. To the extent Milton Friedman’s dictum of years and years ago that links inflation to excessive monetary growth still holds, it is the Fed not Congress that takes actions to impact inflation, at least in the US.
So, how do we interpret the Inflation Reduction Act recently passed by Congress and signed into law by President Biden?
Thanks for reading Making Economics Matter! Subscribe for free to receive new posts and support my work.
One possibility is that our Congressional leaders and followers are better informed about how the economy works than, say, Milton Friedman and other economists. Better to consider other possibilities.
It seems to me to understand how this act can reduce inflation, we could start from delineating the main determinants of inflation and then see how the act influences those channels. That seems too boring and academic. How about going the other way by considering the main components of the Act to see how they might influence inflation?
This is a good place to start since a large component of the bill includes measures to increase taxes, both directly through raising some taxes and indirectly through additional funding for the IRS.Proponents of the Act stress the deficit reduction dimension.
Imagine that the bill does increase revenues of the government and thus, even with increased spending, reduces the deficit. Almost all of that reduction is forecasted to come in the last few years of the 10 year budget horizon.So whatever the deficit reduction effects might be, they will come later, with the increased spending coming sooner.
Leaving all the timing (and with it the question of commitment), reducing the deficit is not the same as reducing inflation. Period. Something else is needed.
There are two ways to link the deficit to inflation. One is a bit magical, the other brings us back to Friedman.
The magic comes from the so-called Phillips curve. It is often seen as an inverse relationship between the unemployment rate, a measure of the pace of economic activity, and the rate of inflation. The key here is inverse: if unemployment goes up, then inflation will come down, or so the story goes.
From this perspective, the reduced deficit would lead to a reduction in inflation through higher unemployment. You might even call that a path to lower inflation by inducing a recession through contractionary fiscal policy.
But not all deficit spending is the same in terms of its impact. To see why, suppose the government raises both taxes and spending (but by less than the tax revenue increase) so that the net effect is to reduce the deficit by $300 billion. Will this necessarily reduce economic activity?
At one extreme, suppose the $300 billion would have been spent on building the infrastructure of the economy, which is complementary to firm investment. Then with this reduction in spending many firms will be less productive and their owners (including all of us who own stocks directly and indirectly) will lose. These supply side effects of the cut in spending will surely reduce economic activity and increase unemployment.
Alternatively, suppose the revenue increase comes from a tax on high income households. Given the current tax policies, these are the same households who pay a large share of income taxes. So, if the policy taxes these households now rather than in the future, then from the viewpoint of their lifetime income net of taxes nothing changes. If there is not change in lifetime income, then there will be no change in consumption and thus no change in economic activity. So this type of tax increase, though it reduces the deficit, would not lead to a reduction in inflation.
In the end, the link between deficit spending and inflation through the Phillips curve, so that spending reduces unemployment and this is inflationary, is rather tenuous. It is not just that the Phillips curve itself is illusionary but also that the link between deficit spending and unemployment has a number of “ifs”.
The Friedman line is different as it ties monetary creation through the Fed to the deficit. Of the many ways to pay off the debt accumulated through years of deficits, printing money is often very tempting. It is like an invisible tax. For some economies, fiscal and monetary decisions are integrated. In the US, there is a separate monetary authority that may, depending on its operating procedures, be induced to finance deficits through money creation.
So, the logic goes, if a monetary authority prints money to finance deficits, then the reduced deficits under the bill will lead to less money being printed and thus lower inflation.
With the current estimates of the reduction in the budget deficit of $20 billion over the first five years of the act, there is not much money creation that will be reduced! This view is certainly consistent with the forecasts of minimal inflation effects of the Inflation Reduction Act.
Medical Expenditures and Energy Costs
The Act does indeed have policies that impact both the magnitude of medical expenditures and the production and consumption of energy. On the medical cost side, a big piece of this is linked to government negotiation of drug prices with producers. This, along with other provisions, is forecasted to save about $260 billion in US government outlays.
On the energy side, this seems to be the big ticket item in the bill, with spending of around $370 billion. There are incentives here to influence both the demand and supply of energy. Now, for example, inducing households to substitute away from gas to electric cars might have some environmental benefits, but it is hard to see the link between that substitution and the rate of inflation.
But these details are beside the point. Inflation is not about one price moving relative to another, what economists poetically call a change in relative prices. So if the price of gas at the pump rises and the price of beer falls (or does not rise as much), this is not really inflation. It is just a change in relative prices. The same point holds if the government succeeds in negotiating a lower price for some drug.
Normally, we think of inflation as a sustained increase in the overall price level. This is not the same as a one time change in a price relative to others. So these policies aimed at medical costs and forms of clean energy are not really about fighting inflation.
Beliefs! Maybe it does not matter exactly what the policy actually does. Instead, it might be that policies work just by fixing beliefs. So if everyone believes that the Inflation Reduction Act will reduce inflation, then they take actions so that inflation is lower. This is not Milton Friedman’s world, but one in which what people expectations can become self-fulfilling. Maybe our congressional leaders read those papers and constructed policy with that in mind.
Maybe. Maybe not.
How these additional resources will impact auditing probabilities of different types of households is, in the end, going to be determined by the IRS.
Here Imagination does seem important. As I read the bill it calls for about $440 billion in spending coupled with an estimated increase of nearly $740 billion in revenue. So a reduction in the 10 year deficit (ignoring discounted present values!!) of about $300 billion. A comparison of the CBO and Wharton models assessments is available. About half of the increased revenue is supposed to come in 2030 and 2031. Put differently, there is about $20 billion deficit reduction summed up (ignoring discounted present values) over the first five years.
If by chance you recall the post about stagflation, there the story did not go so well!