Tax increases and the price level

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  • I explain in this article that the impact of a taxincrease on the price level depends on how theFederal Reserve reacts to the tax.

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The policy debate features considerable confusion about what kinds of tax increases may cause the overall price level to rise and the consequences of any such price increases. One view mistakenly holds that any business tax increase results in higher prices because businesses must pass on their costs. A related misconception holds that the rise in prices shifts the burden of the tax increase to consumers as a group. Although these views may seem plausible, they are invalid because they fail to recognize that the overall price level is determined by monetary policy.

I explain in this article that the impact of a tax increase on the price level depends on how the Federal Reserve reacts to the tax. The Federal Reserve's response is likely to be determined by how the tax increase affects the labor market. The Fed has no reason to raise the price level in response to increases in employee payroll taxes, personal income taxes, and business income taxes. The Fed may increase the price level in response to increases in employer payroll taxes, VATs, and retail sales taxes, but only if the tax increases are large. Any price increase leaves the distribution of the tax increase's underlying burden largely unchanged, but it has some impact on particular groups.

The only current tax proposals for which a potential increase in the price level is a serious issue are those that would introduce large VATs or retail sales taxes. I offer some thoughts on whether and how the price increases could be avoided if they were undesired, and the implications of any price increases that might occur.

I begin the analysis by considering the potential effects of employee and employer payroll taxes on the overall price level, which offer a simple illustration of the basic principles. 

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Alan D.
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