Prices are rising, the economy is threatening to collapse – high time to raise taxes. Or? At least in the world of Modern Monetary Theory (MMT) one has to see it that way, because according to this theory – which critics refuse to give it the status of a theory at all – this would now be necessary, because taxes serve in the world of MMT especially the fight against inflation. How would you describe that?
It starts with the budget constraint, which is ultimately why there are economists—without budget constraint there would be no scarcity, and without scarcity there would be no economists. But if one follows MMT, at least the state has no budget restrictions. He can expand his spending at any time and without limits simply by creating new money.[1] Since it is a monopoly on money, it cannot go bankrupt either, it just issues new money. One could now argue that the state collects taxes and uses them to finance its expenditure, and the rest with loans. No, say the protagonists of the MMT, such as Stephanie Kelton in the USA[2]in Germany for example Dirk Ehnts[3], that’s not true. According to the MMT mantra, the state only finances itself with the money it creates itself. Behind this are economic theories of the past, in particular Georg Knapp’s “State Theory of Money” from 1905 and those of the American economist Abba P. Lerner from the 1940s. Now, these theories need not be entirely wrong. Still, there are good reasons why they have not survived the passage of time. All fail because of an economic fact called inflation.[4]
Inflation occurs when the nominal demands on the overall economic value added, measured with the gross domestic product (GDP), are higher than this value added. Since the goods and services produced are not sufficient to meet aggregate demand at a constant price level, the latter increases. This in turn creates a balance between added value and aggregate demand. At least that’s the analysis for a one-off inflation shock. However, the initial inflationary shock is followed by further rounds, and things are becoming dynamic. A rising price level means a real wage loss for a given nominal wage and the rising input prices lead to profit losses. Both can be compensated for by passing on the increased price level through wage and price increases. If this dynamic is not counteracted with economic policy, the dreaded wage-profit-price spiral can occur or economic stagnation – as was the case in the 1970s, for example.
The measures of an orthodox anti-inflationary policy can currently be observed at all central banks of the major economies: It consists of a – more or less – aggressive interest rate policy. According to the current version of New Keynesian macroeconomics, the central bank interest rate would have to be increased to about the level of the inflation rate.[5] At the moment the central banks seem to be working towards bringing the central bank interest rate closer to the inflation rate. The consequence will be that further moderate interest rate increases will be necessary in order to bring the inflation rate back to the target level – at the ECB of two percent.
But what would be necessary according to the ideas of the MMT? According to this theory, interest rate policy has no independent influence on the inflation rate. It is recognized that inflation is an indicator that aggregate demand exceeds value added at a given price level. To reduce this demand and fight inflation, MMT plans tax increases. In the conceptual framework of the MMT, this makes perfect sense. As already mentioned, the state basically finances itself with MMT by issuing new money and not by taxes. In the world of MMT, the latter only serve to achieve other goals, in particular redistribution policy and influencing allocation decisions. However, inflation is also seen in the MMT concept as an indicator of excess aggregate demand. Taxes are ultimately intended to deprive companies and private households of the money that they could use for investment and consumer spending – the idea is that the deprivation of purchasing power through taxes reduces private demand and consumers’ claims to the domestic product, which has an inflation-dampening effect. Therefore, taxes are seen as the relevant instrument for combating inflation. This seems logical within the MMT concept.
However, the link between taxation and inflation is a bit more complicated than the MMT world makes it out to be. It starts with the fact that inflation itself must already be viewed as a form of taxation – the holding of money. It can be argued that this is more of a semantic than an economic issue. However, there are other effects hidden behind it. In the older macroeconomic literature, especially in the 1970s, these effects were already examined in detail, only to be forgotten in the decades with very low inflation rates and fears of deflation.[6] In this literature, the phenomenon of “tax-push inflation” is examined theoretically and empirically: According to this, in addition to the wage-price spiral, there is also a tax-price spiral, caused by a tax-induced cost-wage spiral. This occurs when taxes can be fully or partially passed on to prices.
It is empirically largely undisputed that this transfer of indirect taxes is not only possible on a large scale, but also takes place (it is also intended for many indirect taxes). More interesting is the question of whether and to what extent profit and personal income taxes can be passed on to prices. In the case of taxes on profits, it must be assumed that they will not be passed on completely, but to a large extent on prices or back on wages and salaries.[7] Indications of “net-of-tax wage bargaining” were also found for the more distant past.[8] Such wage and salary negotiations on after-tax income mean that even parts of the personal income tax, which in principle cannot be passed on, can ultimately be passed on to prices via collective bargaining via correspondingly increasing gross wages. A progressive income tax increases the inflationary effect of such a tariff policy. In view of the tense situation on the labor market, whether such a transfer is currently possible does not seem impossible. In addition, if inflation were fought with increases in the income tax rate, such a pass-through could become more likely.
The result shows that combating inflation with taxes most likely will not solve the inflation problem, but on the contrary can even exacerbate it. Taxes can therefore not be regarded as an effective instrument for combating inflation, apart from the fact that raising taxes when inflation rates rise is likely to be political suicide. The reference to the anti-inflationary effect of this policy is likely to be met with incomprehension by the majority of voters.
[1] See Beck, H. and Prinz, A. (2022) for details on this and the following (with corresponding references). Risk to our money? The new prophets of money and the future of our currency system. Munich: Vahlen, in particular Chapter 3, pp. 41-62 and this. (2023). Money and how the state deals with it: Modern Monetary Theory and the (possible) consequences. In: Norbert Berthold, Jörn Quitzau (eds.), The business world is upside down. Farewell to illusions – concepts for a new economic policy. Munich: Vahlen, pp. 37-45.
[2] Kelton, S. (2020). The Deficit Myth. Modern Monetary Theory and How to Build a Better Economy. London: John Murray.
[3] Ehnts, D. (2022). Modern Monetary Theory. An introduction. Wiesbaden: Springer Gabler.
[4] The idea that a state cannot become insolvent, since it can always print its own money, on the one hand ignores the institutional conditions of independent central banks, on the other hand it vanishes as soon as one assumes an open economy – on this criticism cf Beck, H. and Prinz, A. (2022), op.cit
[5] Vgl. z.B. Cochrane, J. (2023). Expectations and the Neutrality of Interest Rates. Working Paper, S. 2, Equation (1), verfügbar unter: [22.06.2023].
[6] See the overview article by Nowotny, E. (1980) on this and the following. Inflation and Taxation: Reviewing the Macroeconomic Issues. Journal of Economic Literature 18, 1025-1049, especially Section IV, pp. 1034-1035.
[7] For the passing on of profit taxes, see Quitzau, J. (2004). Who bears the burden of corporate taxes? Deutsche Bank Research No. 288 of January 20, 2004; Gravelle, JC (2010). Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis. Working Paper Congressional Budget Office, Washington DC For the pass-back to wages, see Fuest, C., Peichl, A. and Siegloch, S. (2018). Do Higher Corporate Taxes Reduce Wages? Micro Evidence from Germany. American Economic Review 108(2), 393-418 and this. (2017). The incidence of corporate taxation and its implications for tax progressivity. VoxEU.org, 10/10/2017.
[8] See Nowotny (1980) with findings from OECD Committee on Fiscal Affairs (1976). The Adjustment of Personal Income Tax Systems for Inflation: A Report. Paris: OECD.
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