Does Raising Taxes Lower Inflation? (How to Better Understand Common Inflation Questions)

Jul 5, 2023 | Business

Inflation has always been a fact of life. However, it’s worse now than it has been for a long time. Inflation is currently at its highest rate since 1982, and it seems to affect everything we do from making business decisions to buying groceries. 

In this post, we’re providing an accountant’s perspective that will hopefully help answer the question: “Does raising taxes lower inflation?” as well as some other common questions about inflation.  You may or may not agree, but since we’re all in this “inflation boat” together, it’s a conversation worth having.

do tax cuts cause inflation

What Causes Inflation?

Traditionally, the two biggest reasons prices go up are

  1. Increased production costs
  2. Increased demand 

When the costs of raw materials or wages within a particular industry rise suddenly, it becomes more expensive to deliver whatever widgets or services a company provides. Because businesses exist to make a profit, they aren’t usually in a position to absorb those added costs. Therefore, they pass them on to the consumer in the form of a price increase. This is known as “cost-push” inflation. 

If consumers suddenly demand more of a product than what is available, this also has the same effect. When something is scarce, people are willing to pay more for it. It can even get to a point where bidding wars break out and sellers can practically name their price. (Home sales in the past couple of years are a perfect example.) This is called “demand-pull” inflation.

While cost-push and demand-pull can be used to explain most inflationary situations, other factors can have a significant impact on inflation rates as well.

1. Wage-Price Spirals

Sometimes industries can create inflation without intending to. If workers’ pay becomes excessive or unreasonably high, business owners will end up passing the added costs along to their customers. The disposable income of workers leads to a higher demand for goods and services. The demand for goods and services puts added pressure on workers…who then push for higher wages. One factor feeds the other and the resulting spiral can lead to inflation.

2. Government Policy

Monetary policy by central banks like the Federal Reserve has a big impact on nationwide inflation. Such banks work to maintain a steady inflation rate–their goal is 2%–by adjusting how easy (or not) it is for banks to lend money. When they lower costs, banks make more loans to consumers, resulting in more spending and a higher demand for goods and services.

3. Monetary Devaluation

When the supply of money grows too large, it becomes worth less than it was before. If the supply of goods and services doesn’t increase to keep pace with the money being introduced into the economy, too many dollars begin chasing too few goods. The result is inflation.

Over the last few years, we have seen the US federal government print money at a record rate. Those new dollars in circulation have devalued all of the other dollars. So now it takes more money to buy the same amount of something than it did before.

Last summer, we did another article on “How Inflation Impacts Your Business (And 7 Things You Can Do About It)” that you might find interesting as well.

Is Inflation A Tax?

Technically speaking, inflation is not a tax. However, from a practical perspective, it may as well be since the impact on your financial bottom line is the same.

Only the government can impose taxes after passing specific laws. However, inflation can feel like a tax because it often comes from decisions made by the government. It just doesn’t go through a formal process the way a new tax bill does. 

Inflation has often been referred to as a “tax on the poor.” Unfortunately, inflation does tend to have a greater impact on the finances of low-to-middle-class wage earners than the rich since a bigger percentage of their wealth is “disposable” making them less likely to feel the pinch.

It’s not just individuals who feel that way. Lenders often feel like inflation is a tax since the loans they make today are repaid tomorrow in dollars that are worth less than what they handed out.

(For more reading on the topic of “inflation tax”, you might be interested in this article from the Tax Foundation.)

Does Raising Taxes Lower Inflation?

There is a thought among some economists that raising taxes could help lower inflation. We see how it could be possible, but it’s a decision that comes with significant consequences.

In a post on, Simon Bazelon and Milan Singh argue that the traditional method of lowering inflation (by raising interest rates) isn’t the best way to solve the problem. They believe that tax increases are the best cure for inflation

They say that combatting inflation through interest rates takes too long and discourages investment in businesses and the housing market. And when banks make risky decisions based on hopes that interest rates will stay low, they overexpose themselves and end up in trouble (like SVB recently).

They and NY Times opinion columnist Ezra Klein believe that there is a tax that could help with inflation. It’s called a “consumption tax” and it’s basically aimed at wealthy people who overspend (in their opinion) on unnecessary consumer items. 

One example that Klein uses is wedding spending. Rich people spend more and more on lavish weddings to “one up” their rich friends. This causes people in the middle class to overspend on weddings they can’t really afford because they want to keep up appearances. The trend continues to trickle down until the whole of society is wasting money on weddings. (The same idea applies to “everything from homes to schools to cars to jewelry.”)

A consumption tax would work like this: Instead of being taxed on income you report to the IRS and being taxed on that, you would report your income minus savings and be taxed on that.

Their point is that by consuming so much, people aren’t able to save and invest like they should to keep the economy strong. If their theory worked, a consumption tax would lower inflation. 

Does Raising Taxes On The Rich Cause Inflation?

However, these authors are leaving out some important consequences. When wealthy people spend money, those who provide goods and services to them tend to benefit greatly. In the lavish wedding scenario, a whole lot of florists, decorators, coordinators, designers, limo drivers, musicians, and venue owners make quite a bit of money. 

Beyond that, tax increases actually decrease the incentive for business owners to produce. When that happens, supply goes down. When that happens, prices go up…and inflation isn’t far behind. So one could argue that raising taxes on the rich actually helps create the environment for inflation.

Does Cutting Taxes Help Inflation?

On the other hand, cutting taxes has historically led to increases in spending. When people buy more goods and services, the businesses that produce them are motivated to make more. In order to do that, they spend more on capital improvements and hiring which also help boost the economy.

As Daniel Lacalle at points out, “Tax cuts do not cause inflation. Printing does.” Out-of-control government spending and reckless printing of new money drive down the value of the currency and lead to greater and greater inflation like we’ve been seeing. 

How Could The Government Fight Inflation?

The way our economy is set up, the Federal Reserve alone has the authority to adjust interest rates. However, there are things that Congress and the President could do to help. The Committee for a Responsible Federal Budget lists 6:

  1. Stop adding to the deficit. When you’re already in a hole, you should stop digging. All kinds of subsidies and COVID-related relief payments continue to contribute to the problem.
  2. Lower healthcare costs. The federal government has a lot of influence here. According to CRFB, “each percentage point in Medicare costs would reduce the inflation rate by 5 to 15 basis points.”
  3. Reform the tax code. CRFB and others think tax increases would help. Others believe tax cuts are the answer. Either way, the current system is too large and too complicated. A healthy debate and reasonable changes (along with a reduction in tax spending) would help reduce inflation.
  4. Limit discretionary spending. Just like your budget at home, if money is tight you take care of needs and wait on wants.
  5. Encourage work, saving, and investing.
  6. Lower energy, trade, and procurement costs. Not too long ago, the US was energy independent. Making it easier to produce our own fuel would dramatically improve our economy. The government could also reduce tariffs and change policies that drive up shipping costs as well as make sure that when we buy something we are getting the most “bang for our buck.”
how could the government fight inflation

Navigate Inflation With A Good Team of CPAs

No matter what the economy does, you need a good team of financial experts on your side to help you make sure that you are managing your resources as wisely as possible. 

We’ve got over 40 years of experience and CPAs at 7 locations, so we’ve seen it all. Schedule a call today to learn more.In the meantime, check out another post we did on how to calculate and adjust for inflation (and why it matters).

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