Opinion – Ezra Klein: Progressive consumption tax could attack US inflation

Inflation usually starts as a mismatch between supply and demand. But if people get used to rising prices, it becomes related to expectations. And so the task of eliminating it gets more confusing: you have to use politics not only to manage the economy, but also to change psychology. The arid language of economics obscures the brutality that this entails. You need to hit the economy hard enough to intimidate everyone who makes decisions within it.

Because that’s what prices are: decisions. These decisions, even when mediated by algorithms, are made by people trying to predict the decisions others will make. When you start to believe that others are raising prices, they raise them.

“Inflation can be completely self-fulfilling,” Emi Nakamura, an economist at the University of California at Berkeley, told me.

How can you convince people to expect something different? Ideally, you would do this by increasing the supply. By 2021, cars and some home appliances have become scarce, and prices have soared. Instant production of many more cars and dishwashers would have lowered prices, but we cannot deliver that kind of abundance quickly: workers are difficult to retrain; factories take time to build. There are limits to the people, resources and land we can use.

What the Fed can do quickly is cut demand by raising interest rates. It can also change expectations: if companies think their customers will have less money next year, they will price more cautiously.

But again, let’s not mince words. The Fed reduces demand by making it more difficult to borrow money and buy houses and driving people out of jobs. “We have to leave inflation behind,” said Jerome Powell, the organization’s president, in September. “I wish there was a painless way to do this; there isn’t.”

In the late 1970s, Paul Volcker, then head of the Fed, ushered in the modern era of central banking by raising interest rates enough to break stagflation. But the cost was terrible. In August 1979, when he assumed the presidency, unemployment was 6%; in December 1982, it was 10.8%.

Volckler wanted to shock the economy into a new normal — and he did. Early in his tenure, as interest rate hikes wreaked havoc on stock markets, he gave an interview to PBS. Asked about the turmoil, he said: “I think the point might be that we captured their attention, and that’s constructive in a sense.”

Inflation is a scourge, but interest rates are a blunt tool. Adam Posen, chairman of the Peterson Institute and a former member of the Bank of England’s Monetary Policy Committee, calls them a “sledgehammer” — as a compliment. “When you have a rising inflation trend, the sledgehammer is the right tool. It’s blunt. It leaves a mess. There are human costs. But you’re demolishing expectations.”

As Posen suggests, however, interest rate hikes demolish much more: not just demand, but supply. When people lose their jobs, they stop producing the goods and services the economy needs. When mortgages rise, developers build fewer homes — despite the fact that high housing costs are often caused by a lack of homes. When borrowing money becomes expensive, people stop borrowing and stop making the investments that generate future productivity.

And the deepest pain falls, as it often does, on the poor and unemployed. High interest rates can change the decisions that the richest make about spending. If it’s a bad time to buy a house, even a multimillionaire can wait a few years. But higher interest rates won’t change how many children’s services they buy or switch phones or how much they spend on clothes. And it is spending by the wealthiest that drives the economy: in 2021, the richest 20% accounted for almost 40% of total spending; the expenditure of the poorest 20% represented less than 10%.

It would be nice to have policies that work alongside interest rates so that adjustments are less severe. It would be particularly good to have a policy that targets the rich rather than the poor — and does so in a way that doesn’t harm long-term investment. That policy exists.

For years, Robert Frank, an economist at Cornell, has advocated a progressive consumption tax that would discourage the wealthy from spending on luxuries and give them more reason to save and invest. The way this works is simple: instead of reporting your income to the IRS and being taxed on it, you report your income minus your savings and are taxed on it.

It’s a consumption tax: your taxable income is what you spend, not what you save. Congress can make it progressive by adding a large standard deduction and applying a much higher rate to people earning much more, as we do now.

Frank didn’t write at a time of high inflation, so his argument focused elsewhere: he considers much of the spending of the rich to be harmful, not just wasteful. Look at wedding expenses: rich people compete with each other to hold increasingly luxurious parties.

Competition hits the near-rich, who want to look rich, and so also increases spending. The pressure then shifts to the next group on the income scale, and so on, until everyone spends more on weddings, because the benchmark for how much they “should” spend has changed. You can find similar dynamics in spending on everything from houses to schools to cars and jewelry.

I’ve always liked Frank’s argument, but now I’m more interested in another feature of the progressive consumption tax: the ability to scale up and down to respond to different economic conditions.

In times of recession, we could lower taxes on new spending, giving the rich and poor more reason to spend. In times of inflation, we could raise taxes on new spending, particularly among the rich, giving them a concrete reason to cut back immediately and save and invest more at the same time.

Better yet, we could make it automatic, as Posen suggested. Perhaps for every percentage point increase in unemployment above 5%, the rate would drop by 3 points, and for every point increase in inflation above 3%, it would increase by 4 points. Other rules may apply for periods when unemployment and inflation go hand in hand. The tax code would become responsive to the economy by default, not just through new acts of Congress.

Are we inclined to create a progressive consumption tax today? Of course. Congress probably won’t do much now. But the last two decades have had a massive recession during which Congress passed very little stimulus, and now an inflationary crisis that Congress and the Fed took too long to address. Perhaps it is time to think about policies that move at the speed of economies and psychology rather than the pace of institutions.