Time for the UK to tax inflation

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The author is Chief Investment Officer at PGIM Wadhwani and a member of the Chancellor’s Economic Advisory Council. This article is written in a personal capacity.

There has been a notable relief that headline inflation in the UK has fallen sharply in recent weeks. However, wage growth and core inflation remain well above what is needed to achieve the 2% inflation target. While lower price inflation should lead to lower wage inflation, the Bank of England policymakers’ panel survey still showed wage growth and price inflation were expected to exceed 5% next year.

We seem to be seeing “tit for tat” behavior, with workers trying to maintain living standards while businesses try to maintain profit margins. This now correlates with higher intrinsic inflation expectations. In order to reduce the degree to which each business and each worker expects prices and wages to rise in general, we may choose to leave it entirely to the Bank of England, so that even if unemployment rises, the Bank of England may slowly cut interest rates.

When I appeared before the Treasury select committee in July, they asked how the government could help the Bank of England reduce inflation while keeping unemployment at a minimum. Increasing supply clearly helps at a time when high wage growth is linked to labor shortages. Also, it would be desirable if the government followed through on its pledge to keep the inflation target unchanged until the end of this sitting, saying it would do the same for the next term if re-elected (the opposition should make the same decision) of. promise).

The government may also consider a measure that would directly lower inflation expectations without increasing unemployment. This would be a tax on inflation. For example, they might announce a baseline reference level for average hourly earnings growth of 3% next year. They could then implement a tax whereby every company that allowed wage increases of more than 3% would need to pay 100% of the excess.

Specifically, if a company agrees to a 5% wage increase, its costs will increase by 7% because it will have to pay additional taxes equal to the difference between the wage increase and the baseline reference level.

Such a statement would likely reduce inflation expectations, thereby easily reducing wage and price inflation without the unemployment rate needing to rise. The Bank of England could reward such policy by ensuring interest rates are lower than they would otherwise be. To be clear, this tax is not designed to tighten fiscal policy – income can be redistributed, for example as a per worker subsidy.

When seeking to tax inflation, a “tax on excessive price increases” could in principle be introduced instead of wage increases. Society already considers it appropriate to tax the activities of individuals or companies that do not take adequate account of the adverse effects on others. Tobacco consumption and polluting practices are examples of this. When a company raises the prices of goods it sells, it doesn’t fully take into account the economy-wide inflationary effects, so an inflation tax seems desirable.

Appropriate tax rates change over time. It could easily be much lower (in fact close to zero) when inflation expectations fade. This way, one minimizes any associated distortions. In fact, if the measure is always revenue-neutral (and thus has no direct fiscal impact), one might even consider handing over the setting of appropriate interest rates to the Bank of England as an additional policy tool.

Of course, one would need to grapple with the administrative difficulties of any new tax and the inevitable problems of implementing such a plan. But governments that have implemented more complex furlough schemes during the lockdown should not be deterred by initial difficulties. It has a long history as a policy prescription dating back to the early 1970s, with previous advocates suggesting it could become part of the standard PAYE process. There is some evidence that inflation taxes have helped in the transition to market economies in some former Soviet economies, and some recently published research by the IMF suggests that inflation taxes deserve more attention.

With inflation expectations dispelled and the prospect of another series of supply shocks ahead, now is the time to do more to help the BoE in its pursuit of low and stable inflation. Taxing inflation and using interest rate tools should improve their chances of success.