Note To Governors: Cutting Taxes Will Make Inflation Worse, Not Better

Even as Republican governors blast President Biden and congressional Democrats for both causing inflation and failing to address it, they are promoting their own tax cuts that likely will add to consumer demand and raise prices.

Putting more money in people’s pockets will increase demand for goods at a time of supply shortages. That will drive up prices and worsen the inflation that the governors claim to be so worried about. And it will increase pressure on the Federal Reserve to raise interest rates even more than it planned.

What a deal: In exchange for modest tax savings, people will pay higher prices and interest costs.  

Trending tax cuts

True, GOP governors are not the only ones clamoring for tax cuts. Proposals for state motor fuel tax holidays, for example, have become a thing in both red and blue states. But decrying federal fiscal policy for putting too much money in the hands of consumers while pushing aggressively for tax cuts is rank hypocrisy, even by today’s political standards.

To the degree some of these tax cuts end up in the hands of oil companies, rather than consumers, the short-term effects on demand could be more modest. But that probably is not what the pols have in mind. They are looking to hand out cash to voters just months before the coming elections. That “I feel your pain” moment may win some votes. But it won’t enhance the well-being of their constituents.  

That seems just fine to the pols.  

Watch what they do, not what they say

Here is Florida Governor Ron DeSantis, a 2024 presidential hopeful:  “You look at what’s happening with our country, this inflation is just unbelievable. I mean, just think about how much gas has gone up.”

His response: a $1 billion five-month suspension of  the state’s motor fuel taxes and $156 million in a series of sales tax holidays on purchases of hurricane, school, and recreation supplies. That tax break is explicitly aimed to encouraging people to buy more. And at least while many goods remain in short supply, it inevitably will drive up pre-tax prices.

The legislature adopted many of his proposals, including tax holidays on sales of products such as kayaks and personal computers.

Then there is Iowa Governor Kim Reynolds, who gave the GOP response to Biden’s State of the Union Address. She said, “It feels like President Biden and his party have sent us back in time — to the late ’70s and early ’80s, when runaway inflation was hammering families.”

Her response: About $1.9 billion in personal and corporate tax cuts.

And here is newly elected Virginia governor Glenn Youngkin: “President Biden took office in January of 2021, and to understand why we are in this current state of record-high inflation and costs to the average American family, people can simply track his first year of misguided policy decisions.”

Youngkin’s response: A gas tax holiday among $4.5 billion in tax cuts included in his new budget.

A potpourri

Truth is, elected officials can’t do much to slow inflation. The Fed can address the problem by raising interest rates, as it will start doing this week. But the best lawmakers can do is not make the problem worse by throwing more money at consumers, either in the form of tax cuts or new spending.

Some research suggests that consumer responses to tax cuts can be quite variable. People are most likely to spend those cuts if they are visible. But not until the money is in their pockets. They also may be more likely to spend permanent tax cuts than temporary ones.

The tax cuts on the table in most states are a potpourri. Gas tax cuts are highly salient—everybody knows how much they pay for gas. Sales taxes on other goods also are quite visible. But tax holidays are temporary. So are the tax rebate checks some states are sending.

The income tax cuts, on the other hand, are designed to be permanent. But because they would be distributed over a long time through modest reductions in tax withholding, they may have less impact on short-run spending.

Income tax cuts also can encourage people to work more. But those incentives are modest and more likely to boost employment for lower-income people. Yet many of the income tax cuts being debated in state legislatures are rate reductions that would largely benefit high-income households.   

Bottom line: It is hard to know how much these tax cuts will boost consumption, but they will boost consumption.

If there is a role for policy, it should be to increase the supply of goods such as gasoline. That really would drive prices down and slow inflation. Cutting taxes, by contrast, will boost demand for products already in short supply. And that is likely to only increase prices—exactly the opposite effect of what these pols claim to want.



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