Will taxes have to rise?

That is the question addressed in this debate between Jonathan Portes and Bill Mitchell. I found the discussion very frustrating, because it is really a debate about medium term inflation forecasts dressed up as something more fundamental. Both Mitchell and Portes agree that there is no need for taxes to rise to ‘pay for’ the fiscal costs of the pandemic. In an age of ultra-low real interest rates, shocks to the debt to GDP ratio like the Global Financial Crisis and the pandemic should be allowed to gradually wither away as growth outstrips interest rates on that debt. Trying to reduce debt by running deficits close to zero, or even surpluses, as Osborne tried to do, threatens to derail a full recovery.

I think it would be fair to say that the argument from Jonathan Portes is that we should increase the share of current public spending in GDP in various ways over the next few years, and without higher taxes, or substantially higher interest rates, that will at some point lead to a permanent rise in inflation above target. To prevent that, taxes should rise. Bill Mitchell would agree that public spending should rise, but he doesn’t think inflation will rise as a consequence. If inflation did rise, it is standard MMT (at least according to Stephanie Kelton) that fiscal policy should be the “primary tool for macroeconomic stabilisation”. Thus the debate between the two on whether taxes should rise is essentially a disagreement about medium term inflation forecasts.

This point is illustrated in the final statement from Bill Mitchell. He writes:

“Should the government seek to command a far bigger share of productive resources—say, for a green transition—then, yes, perhaps tax rises would have a role in offsetting the extra spending and warding off inflation.”

Jonathan Portes might well respond that his argument is premised on just such a situation. In his opening statement he writes:

“And as well as more on the NHS and social care, structural economic shifts—from the aftermath of Covid-19 to decarbonisation—will mean more is needed for education and training. We don’t need higher taxes to pay for the virus; but the virus has exposed, economically, socially and politically, that we need them to build a better future.”

This illustrates that there is no disagreement in principle here, but just a disagreement about what levels of public spending increase would tend to lead to above target inflation. Indeed as these quotes suggest, there may not even be a disagreement here, but just a distinction between what should happen to public spending (Portes) and what is likely under current or prospective governments (Mitchell).

I want to argue that the whole debate about whether taxes should rise to pay for additional public spending is unnecessary. We can afford to wait and see. If inflation does appear to be permanently rising above target, you can be sure that the central bank will raise interest rates to bring inflation back down. Exactly when central banks should act is a live issue right now in the US, where the Federal Reserve has decided it will allow inflation above target for some time to ‘make up’ for inflation being below target in the past. But important though this change is, it remains the case that no independent central bank worth its salt is going to allow inflation to permanently rise above the inflation target.

It is only when central banks start raising interest rates in earnest that governments need to think about raising taxes. By raising taxes they reduce the pressure on aggregate demand and inflation, and therefore moderate the extent to which interest rates need to rise. It would be foolish for governments to make the same mistake that central banks made before the pandemic hit, and try and anticipate what might happen to inflation based on outdated ideas about the NAIRU. [1].

What about deficits? Isn’t good fiscal policy all about trying to achieve sustainable deficits (deficits that stabilise the government debt to GDP ratio)? As Jonathan Portes and I have argued, those rules should not apply when interest rates are stuck at their lower bound. When interest rates are at their lower bound, fiscal policy should become the primary tool for macroeconomic stabilisation. When interest rates are at their lower bound, standard academic macro and MMT should be on the same page.

While academic macroeconomists now generally accept that fiscal consolidation is a bad idea when interest rates are at the lower bound, the UK Treasury appears to think otherwise. There is much talk of tax rises or spending cuts to 'pay for the (fiscal) costs of the pandemic'. No doubt this will be justified by OBR forecasts and talk of structural deficits, just as it was in 2010. But whether its spending cuts or tax rises, fiscal consolidation coming out of a recession where interest rates are at the lower bound risks turning what should be a temporary downturn into a permanent fall in output.

[1] The changes at the Fed are welcome, because they address an error that central banks have been making since the Global Financial Crisis (GFC). Before that crisis, they tried to guess where inflation would go in the future by looking at forecasts and indicators like unemployment, and they were pretty successful at that. But, as some of us argued at the time, after the GFC it was foolish to continue in the same way, because the crisis had fundamentally changed the way the economy worked and because the risks of getting it wrong were asymmetric.