The Twitter spat between Jeff Bezos and Joe Biden over tax policy and inflation has attracted the attention of no less an authority than Larry Summers, who says that the Amazon founder is “mostly wrong.” I hesitate to disagree with Summers — he was right last year, and I was wrong, about how Covid stimulus would result in persistent inflation — but: Bezos is mostly right.
On Friday, the president’s Twitter feed suggested that the best way to bring down inflation was to “make sure the wealthiest corporations pay their fair share.” Bezos responded that it was “fine to discuss” raising corporate taxes and “critical to discuss” taming inflation. But “mushing them together is just misdirection.”
It’s clear why raising corporate taxes might be an attractive strategy for Democrats facing potentially devastating midterm elections. The more sensible alternatives are politically painful.
As Summers has pointed out — and even most left-of-center commentators now admit — excessive fiscal policy is at least one factor behind surging inflation. To counteract that, the Biden administration needs to either cut spending or raise taxes.
Cutting spending is almost out of the question, given that a Democratic Congress is still groping for ways to pass a stripped-down version of its multitrillion-dollar Build Back Better plan. Tax increases, however, are equally fraught.
Higher taxes reduce disposable income, shrinking overall demand and thus easing inflation pressure. Summers, who served as Treasury secretary and top economic adviser to former presidents Bill Clinton and Barack Obama, respectively, says that the tax increases “should be as progressive as possible.”
But there is another effect of higher tax rates: They discourage workers from taking on extra hours, or employers from making productivity-enhancing investments. These effects shrink supply and tend to make inflation worse.
The most effective anti-inflation tax increases are those that raise a lot of revenue, thereby reducing demand, without large increases in marginal tax rates that could discourage workers to put in extra hours or small businesses to boost production. This could be achieved by broad-based but low rate increases, such as a 2% surcharge on all income from all sources.
An obvious objection to such a tax is that it would hit the poorest Americans, who are struggling the most with rising food and gas prices. And an obvious rejoinder is that, if the tax helped arrest the growth of inflation, it could end up helping the poor, whose real incomes are collapsing under current economic conditions. At any rate, it’s safe to say that this kind of tax is a non-starter among Democrats.
There is another tack the Democrats could take, one that would have been quite attractive to them not too long ago: They could eliminate the tax loopholes for affluent Americans, specifically the deductions for state and local income taxes as well as mortgage interest.
The effect on supply from eliminating deductions, as opposed to raising rates, is minimal. Moreover, such a tax increase would primarily target affluent taxpayers, who could absorb the hit. It is also just good policy. Yet the Democratic Party has become increasingly beholden to affluent voters, who have been pressing it to expand rather than shrink their special deductions.
So with both broad-based and more narrow tax increases ruled out, what are Democrats to do? This explains the administration’s interest in raising corporate taxes.
It is worth thinking through exactly how such increases would restrain inflation. Corporate income taxes are levied on earnings after accounting for payroll, supplies and depreciation of past investment. That leftover cashflow is what businesses use for expansion and new investment.
Higher taxes would reduce it, discouraging expansion and decreasing supply. Higher corporate taxes would also reduce the profitability of new investments, further dampening the incentive to increase production. It’s true that less investment means less business spending, but because less investment also leads to less supply, the net effect could be to increase inflation pressures.
One possible hope, if you can call it that, is that increases in the corporate tax rate could lead to decreases in corporate share prices. Investors would then feel poorer and reduce their spending, thus reducing demand. This is similar to how rising interest rates reduce overall demand — only less efficient, because of the direct effect that corporate taxes have on investment.
Corporate tax increases, despite their appeal to Biden and congressional Democrats, are a poor way to fight inflation. Democrats would be better off letting the Federal Reserve tackle inflation than adopting a fiscal policy that adds shrinking supply to already overheated demand.
More From Bloomberg Opinion:
• Biden Should Tax the Rich to Shrink the Deficit: Matthew Yglesias
• The SALT Tax Debate Is Changing American Politics: Karl Smith
• This Is What Living With Long-Term High Inflation Feels Like: Allison Schrager
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina.
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