<p>One problem with raising taxes to combat inflation is that the increased tax rates really don't translate into much, if any, additional revenue for the government. This is for three main reasons. First, when taxes are too much, they discourage more production of goods and services, after all, what is the point of producing more things, working harder and innovating if the government is going to confiscate the majority of the proceeds? Also, after a certain point, tax increases essentially encourage cheating and the exploitation of loopholes among those who can, because again, the government robbing people of their earnings (whether for investments, conventional 9-5 jobs, business ventures, freelancing, etc) doesn't actually promote economic growth. Also, high levels of taxation basically tell the market the lie that the government knows better than the private sector about where (and on what) money is best spent.</p>

CC BY-SA 4.0
2024-05-24T08:28:09.067Z
"increased tax rates really don't translate into much, if any, additional revenue for the government".  Surely that depends on what the rate was before the increase?
Adam Bailey
CC BY-SA 4.0
2024-05-24T01:15:36.557Z
2024-05-24T01:15:36.557Z
Aristocratic Jack
<blockquote>
<p>The standard economics story, as I understand it, is that deficit spending increases inflation because it is increasing demand chasing limited supply.</p>
</blockquote>
<p>Yes this is more or less correct. In standard mainstream New Keynesian models, besides other things like expectations, inflation is result of increases of aggregate demand, or decreases of aggregate supply or some combination of these.</p>
<blockquote>
<p>Wouldn't the MMT suggestion also be valid since taxation also removes money from the economy so that there is less demand for limited supplies? It makes sense to me that taxation is deflationary.</p>
</blockquote>
<blockquote>
<p>Am I misunderstanding MMT?</p>
</blockquote>
<p>There isn't an rigorous accepted model of MMT that someone can point to so its difficult to know what MMT as a theory is saying. MMT would not strictly speaking be considered 'separate' theory, in fact multiple authors pointed out its indistinguishable from old Keynesian models with some very 'strange' assumptions about parameters that old Keynesians did not accept e.g. it implicitly assumes kinked aggregate supply and so on <a href="https://link.springer.com/article/10.1007/s11293-021-09713-6" rel="nofollow noreferrer">(Prinz &amp; Beck, 2021</a>, <a href="https://www.tandfonline.com/doi/full/10.1080/09538259.2014.957466?casa_token=01QJkCJvAzkAAAAA%3A90GWhDykSbGT3biQ5HhnWwiSiNPlcWlkHayEkDnIThb7soiwu_QrqrFVE2sVPBDRBx3QsTgW3xYnyw" rel="nofollow noreferrer">Palley 2014)</a>).</p>
<p>However, some MMT proponents like Kelton do claim that (e.g. see her book Deficit Myth).</p>
<blockquote>
<p>If I am understanding MMT correctly, is this point accepted by establishment economists?</p>
</blockquote>
<p>It is not generally accepted for taxation to be deflationary a priory. Taxation does not affect just aggregate demand but also aggregate supply. So the overall effect is ambiguous. However, if you only look at demand side, it is accepted that taxation itself suppresses aggregate demand provided government does not spend that money. That is another point of contention, where MMT proponents like Kelton advocate for large government spending at the same time (again refer to the Deficit Myth). In mainstream models taxing and spending the money does not reduce inflation.</p>
<p>As a consequence of this and other claims, MMT is generally not accepted neither by mainstream or also other heterodox strands of economics like post-Keynesians (e.g. see  <a href="https://www.aeaweb.org/articles?id=10.1257/pandp.20201102" rel="nofollow noreferrer">Mankiw 2020;</a> (Prinz &amp; Beck, 2021]<a href="https://link.springer.com/article/10.1007/s11293-021-09713-6" rel="nofollow noreferrer">1</a>; <a href="https://www.tandfonline.com/doi/full/10.1080/09538259.2014.957466?casa_token=01QJkCJvAzkAAAAA%3A90GWhDykSbGT3biQ5HhnWwiSiNPlcWlkHayEkDnIThb7soiwu_QrqrFVE2sVPBDRBx3QsTgW3xYnyw" rel="nofollow noreferrer">Palley 2014)</a>.</p>
<blockquote>
<p>If not, what is the argument against taxation being deflationary?</p>
</blockquote>
<p>There are several problems here;</p>
<ul>
<li><p>Yes taxation does reduce aggregate demand but it also affects supply side. It is well documented that increases in sales/VAT, and increases in corporate taxes, and other taxes as well <em>empirically</em> lead to higher prices and hence at least temporary inflation (see few random examples like (<a href="https://scholar.google.com/scholar?hl=en&amp;as_sdt=0%2C5&amp;q=vat%20increases%20and%20inflation&amp;btnG=" rel="nofollow noreferrer">Carare &amp; Danninger, 2008</a>, B<a href="https://www.nber.org/papers/w27058" rel="nofollow noreferrer">aker, Sun &amp; Yannelis 2020</a>)., this is generally well empirically established). This is despite the fact hat they also suppress aggregate demand. The reason for this is that these taxes ultimately increase costs of production and hence firms are willing to supply less goods at the same prices (supply shifts to the left) and this is inflationary.</p>
<p>You would need to suppress aggregate demand more than aggregate supply which is possible, but you have to go through 'vicious' cycle, where you are trying to suppress demand more than the damage you are doing to supply. In MMT this does not happen because under the translation of MMT rhetoric to models like in Palley, their AS is first completely flat (hence changes in AD do not result in any inflation) and then once you hit full employment you get perfectly vertical AS and only then you get inflation and it is unaffected by taxes. In mainstream models you have increasing AS in short run and vertical in long run and both move to the left as a response to higher tax rates. Hence in the MMT model you only need to suppress AD up till you get to the point of full employment, but in mainstream models with upward sloping short run and vertical AS in long run that responds to inflation you will always get some inflationary pressure when you raise taxes.</p>
</li>
<li><p>In micro models taxes create deadweight loss to the economy whereas changes in interest rates (provided they reflect market forces) do not. As a result, even if we can suppress AD more than AS, this method of controlling inflation is less optimal then monetary policy.</p>
<p>Even if you do not believe in mainstream theory, its just empirical fact that tax hikes on corporations, goods, wages and other economic activity generally result in higher prices than otherwise. Hence even if you do not believe in mainstream synthesis of New Keynesian macro and neoclassical micro economics, your theory still has to somehow account for this observed fact.</p>
</li>
<li><p>MMT also ignores various public choice problems. Usually economists support monetary policy over fiscal policy because central banks are technocratic institutions governments aren't. Even in MMT you must ensure you do not go beyond point of full employment with government spending or you will get inflation. It is unrealistic to believe that democratically elected politicians will be able to somehow find this right balance.</p>
<p>From mainstream perspective this also crates double whammy, not only that taxes suppress AS which leads to higher prices but also government spending cancels off at least some of the impact that taxes have on AD. In fact depending on parameters of the economy, it could even further stimulate AD.</p>
</li>
</ul>

CC BY-SA 4.0
2024-05-26T07:36:39.083Z
"In micro models taxes create deadweight loss to the economy whereas changes in interest rates (provided they reflect market forces) do not. As a result, even if we can suppress AD more than AS, this method of controlling inflation is less optimal then monetary policy."

Have you got a source for this?

My intuition is that (even before considering distributional effects) interest rate hikes do cause some deadweight loss, since they cause people to deviate from the 'optimal' smoothed consumption path. But I don't have a model.
matthewoulton
CC BY-SA 4.0
2024-05-26T10:01:25.580Z
@matthewoulton you can check that in models presented in standard textbooks such as Mankiw's principles of economics, or Blanchard et al Macroeconomics. Deadweight loss is created by taxes because they drive a wedge between marginal social/private benefits and marginal social/private costs. Interest is just a price. Provided CB selects interest rate at which S=D for money, and given they can exert control over supply, they can in principle select virtually any interest rate as long as they support it, as long as central bank does not actually mess up there is no deadweight loss.
1muflon1
CC BY-SA 4.0
2024-05-26T10:08:16.743Z
Of course, if CB would pick i that is above/below the rate at which supply of money equals demand for money there would be DWL, but they can also manipulate supply. There are some exceptional situations like zero lower bound where S and D intersect at negative interest rate etc when it does not work, but I assumed in my answer we are not talking about exceptional situations
1muflon1
CC BY-SA 4.0
2024-05-27T13:23:56.160Z
Are you assuming that there is no relationship between monetary variables and the real side of the economy?

My intuition is that in selecting the interest rate, the Central Bank influences individuals' price of present consumption. I think manipulation of this rate is exactly equivalent to imposing a tax wedge on consumption today (vs tomorrow) except insofar as a tax wedge results in government revenues rather than bank (or CB) revenue in the case of an interest rate.
matthewoulton
CC BY-SA 4.0
2024-05-27T13:26:37.003Z
Suppose that the CB set a very high interest rate for a single period. Wouldn't there be welfare loss (relative to the situation before raising rates) because agents can't consumption smooth as much as they would like?
matthewoulton
CC BY-SA 4.0
2024-05-28T02:13:14.053Z
@matthewoulton 1. It is not my personal assumption, that is implicitly assumed in standard IS-LM models even those that have micro-foundations. 2. There won't be any analogous DWL wedge if interest rate is set to the level where supply for money equals demand for money. Microeconomically you can think of money market as having price (interest) fixed by central bank. This would lead to DWL like regular price fixing, if CB would not be willing to adjust money supply which it has control over. In that case CB can always fix the price at equilibrium rate (at least in theory) without any DWL
1muflon1
CC BY-SA 4.0
2024-05-28T02:22:24.437Z
3. Welfare loss is not the same as DWL. For example, suppose you have perfectly competitive micro market for lets say apples. If there is severe reduction in supply of apples (supply shifts to the left) while demand stays constant, there will be welfare loss (loss of Marshallian surplus) for both consumers and produces (their surpluses shrink). However, the market in this case is still allocatively efficient, its just new equilibrium (with lower welfare). 4. If you introduce liquidity constraints at certain levels of interest then of course that would change the analysis.
1muflon1
CC BY-SA 4.0
2024-05-28T02:26:34.990Z
However, the same holds for taxes, once you start to add various imperfections, informational asymmetries etc, even taxation can have more negative effects. For example, once we start adding public choice issues, in my opinion, any serious discussion of controlling AD through taxation, outside perhaps special cases,
pretty much flies out of window...
1muflon1
CC BY-SA 4.0
2024-05-28T11:08:14.283Z
Ok, I understand the distinction you're drawing, but suppose that we have two equilbria:
1. Consumption taxes are raised.
2. Interest rates are raised. Money market is still in equilibrium, though.
Such that both equilibria involve the same consumption in the goods market. Don't these two markets entail exactly the same welfare for everyone (except the bank)?
matthewoulton
CC BY-SA 4.0
2024-05-28T15:59:08.743Z
@matthewoulton right but you are talking about different situation. I agree in principle there is some tax rate $t$ that will yield the same reduction in consumption that some interest rate $i$. But we are talking about trying to control inflation. If markets are perfect and CB does its job raising interest rate does just affect AD. Even with perfect markets taxes do affect supply side negatively which is inflationary. Hence to get the same reduction in inflation you would have to do more work with taxes than with interest rate. Hence, you would have to pay more in welfare for reducing
1muflon1
CC BY-SA 4.0
2024-05-28T16:01:42.287Z
Inflation, since to achieve the same level of inflation you need to suppress consumption and production more. Btw this is also why when it comes to fiscal macro policy it’s done through changes to government spending financed by borrowing rather than increasing/decreasing tax rates
1muflon1
CC BY-SA 4.0
2024-05-30T05:57:02.977Z
I don't think that this is true.

Consumption taxes affect supply because they affect individuals' labour supply decision (in the case of a tax increase, by making today's consumption more expensive). Interest rates also exert the same effect (agents who prefer to consume in the current period may work less in the face of a higher interest rate).

Admittedly, what I'm thinking about here is a change in consumption taxation taxation paid for by consumption tax in the future (so there should be no wealth effect).
matthewoulton
CC BY-SA 4.0
2024-05-30T06:01:30.023Z
Also, it's not true that governments only conduct macro fiscal policy via changes to government spending. Changes to sales taxes are also really common (e.g VAT cut in the UK in Dember 2008).
matthewoulton
CC BY-SA 4.0
2024-05-30T09:31:28.230Z
@matthewoulton 1. Regarding the policy I was actually talking in context of all the models, not real world. In real world lots of policies are pursued even if they don't make theoretical sense. 2. I am not sure that is correct. A) higher interest rate makes goods more expensive only implicitly because it makes intertemporal shifts of future consumption to present more expensive. However, by the same token it makes shift of consumption from present to future through saving cheaper. A priori I don't think you can claim that its obvious there would be reduction in work, because this might
1muflon1
CC BY-SA 4.0
2024-05-30T09:37:39.277Z
motivate some agents to work even more. B) Usually at least textbook macro models to get monetary policy to affect supply side you need to add some market imperfections. I will admit, that this is not what I often think about, so I am not sure if this is due to some simplification in the models that is completely unrealistic, but I know it at least holds in those models.
1muflon1
CC BY-SA 4.0
2024-05-30T10:38:40.753Z
I'm just saying that *if* a revenue neutral tax change caused supply side effects, I'd expect an interest rate change to cause the same.
matthewoulton
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2024-05-30T10:40:02.330Z
My current expectation is that neither would be expected to affect the supply-side.
matthewoulton
CC BY-SA 4.0
2024-05-30T13:54:20.973Z
@matthewoulton  but we are not talking about revenue neutral tax. Forget about supply side, if the tax is revenue neutral then you are automatically offsetting the disinflationary effect of tax depressing AD by inflationary effect of spending stimulating AD. Making the tax revenue neutral literally defeats the original purpose. Also I would agree with that statement for revenue neutral *lump sum* tax because lump sum tax is non-distortionary, I would not agree for distortionary taxes
1muflon1
CC BY-SA 4.0
2024-06-01T15:00:41.697Z
This isn't right. I'm talking about revenue neutral consumption taxes (i.e I impose a tax on consumption today and reduce the tax on consumption in the future).

That is, the effect is via a substitution channel, not via an income effect.
matthewoulton
CC BY-SA 4.0
2024-06-01T16:33:39.140Z
but in public econ literature revenue neutral tax is a tax where the income effect is offset by subsidy not lowering taxes in future. In this case, what you are suggesting I would maintain there will be extra negative effect caused by deadweight loss.
1muflon1
CC BY-SA 4.0
2024-06-02T11:42:25.330Z
What's the difference between reducing consumption taxes in the future and a future subsidy?

Regardless, I'm now convinced I'm correct. When I look at NK budget constraints, there is no difference between the role played by the interest rate and the role played by a consumption tax. I don't see how (more) deadweight loss could be generated in the latter case.
matthewoulton
CC BY-SA 4.0
2024-06-02T16:11:37.647Z
1. when people talk about revenue neutral taxes they typically talk about them being revenue neutral within a period not from a life time perspective, at least I didn't see that kind of usage a lot. 2. That can't be true if you are using model with distortionary taxation. Yes if you use $p_tc_t + q_t x_t + B_t = W_tn_t + R_{t−1}B_{t−1} + T_t$ you can achieve exactly the same outcome through $T$ or change in $R$, but when you have distortionary taxation, e.g. because government cant tax leisure (x), so consumption taxes are inherently distortionary you will get the following budget constraint
1muflon1
CC BY-SA 4.0
2024-06-02T16:15:28.870Z
$p_t(1+\tau_t)c_t  + q_t x_t + B_t = W_tn_t + R_{t−1}B_{t−1}$. In this case $\tau$ is distorting optimal choice between $c_t$ and $x_t$ whereas $R$ is not. Higher R is making borrower poorer and hence it reduces consumption, but higher $\tau$ is not just making consumer poorer and reduce consumption but it also distorts the choices between consumption of composite good c and leisure x, this should clearly lead to more welfare loss. And this is jut through distortions to goods markets, this has to distort factor markets as well.
1muflon1
CC BY-SA 4.0
2024-06-03T17:38:44.770Z
Ok, sure, I understand your argument and maybe we're getting caught up on semantics, but to be clear, I am talking about lowering (raising) a consumption tax in the present period and raising (lowering) a consumption tax in a future period.

So I don't disagree with you analysis above (which involves an increase in the total discounted value of taxation), but it's not the point I'm making.
matthewoulton
CC BY-SA 4.0
2024-06-03T22:55:56.680Z
No I perfectly understand what you mean. That is why I put there $\tau_t$ instead of just $\tau$, the point is still that because time varying $\tau_t$ changes consumption not just intertemporally (which interest rate does too) it in addition distorts intratemporal consumer choice whereas interest rate doesn't
1muflon1
CC BY-SA 4.0
2024-06-04T09:30:09.613Z
For it to be revenue neutral, though, you need a future $\tau_{t+1}$ to decline (reducing distortion in that period).
matthewoulton
CC BY-SA 4.0
2024-06-04T09:56:13.703Z
but there is still distortion, 0 distortion in both periods is clearly more welfare enhancing than having big distortion in period 1 and small distortion in period 2. Interest rate does not distort choices between x and c. It is not like the large distortion of optimal choices in period 2 is somehow compensated for with smaller distortion in period 2 it just means that DWL(t=1)> DWL(t+1). What matters is the total amount of distortions over both periods.
1muflon1
CC BY-SA 4.0
2024-05-23T12:12:59.993Z
2024-05-23T12:12:59.993Z
1muflon1
<p>Yesterday, I watched the MMT documentary <a href="https://findingmoneyfilm.com/" rel="nofollow noreferrer">Finding the Money</a>. <a href="https://en.wikipedia.org/wiki/Modern_monetary_theory" rel="nofollow noreferrer">Modern monetary theory</a> (MMT) provides an alternative viewpoint that sounds to me consistent with standard economic theory. Deficit spending and national debt reflect the amount of dollars available in the economy.</p>
<p>The standard economics story, as I understand it, is that deficit spending increases inflation because it is increasing demand chasing limited supply.</p>
<p>The standard approach to inflation is to increase interest rates which decreases the amount of money loaned, which decreases the amount of money in the economy, and therefore potentially reduces inflation by reducing demand.</p>
<p>Wouldn't the MMT suggestion also be valid since taxation also removes money from the economy so that there is less demand for limited supplies?  It makes sense to me that taxation is deflationary.</p>
<p>Am I misunderstanding MMT?  If I am understanding MMT correctly, is this point accepted by establishment economists?  If not, what is the argument against taxation being deflationary?</p>

<inflation><interest-rate><taxation><federal-reserve>
MMT suggests that taxation can be used to fight inflation. What would be an argument against this suggestion?
Larry Freeman
# MMT suggests that taxation can be used to fight inflation. What would be an argument against this suggestion?

(Asked by: username_0 on 2024-05-23)

Yesterday, I watched the MMT documentary [Finding the Money](https://findingmoneyfilm.com/). [Modern monetary theory](https://en.wikipedia.org/wiki/Modern_monetary_theory) (MMT) provides an alternative viewpoint that sounds to me consistent with standard economic theory. Deficit spending and national debt reflect the amount of dollars available in the economy.

The standard economics story, as I understand it, is that deficit spending increases inflation because it is increasing demand chasing limited supply.

The standard approach to inflation is to increase interest rates which decreases the amount of money loaned, which decreases the amount of money in the economy, and therefore potentially reduces inflation by reducing demand.

Wouldn't the MMT suggestion also be valid since taxation also removes money from the economy so that there is less demand for limited supplies? It makes sense to me that taxation is deflationary.

Am I misunderstanding MMT? If I am understanding MMT correctly, is this point accepted by establishment economists? If not, what is the argument against taxation being deflationary?

**Tags:** inflation, interest-rate, taxation, federal-reserve

---

## 2 answers

### Answer by username_3 on 2024-05-23. Score: 2 | Accepted answer

> The standard economics story, as I understand it, is that deficit spending increases inflation because it is increasing demand chasing limited supply.

Yes this is more or less correct. In standard mainstream New Keynesian models, besides other things like expectations, inflation is result of increases of aggregate demand, or decreases of aggregate supply or some combination of these.

> Wouldn't the MMT suggestion also be valid since taxation also removes money from the economy so that there is less demand for limited supplies? It makes sense to me that taxation is deflationary.

> Am I misunderstanding MMT?

There isn't an rigorous accepted model of MMT that someone can point to so its difficult to know what MMT as a theory is saying. MMT would not strictly speaking be considered 'separate' theory, in fact multiple authors pointed out its indistinguishable from old Keynesian models with some very 'strange' assumptions about parameters that old Keynesians did not accept e.g. it implicitly assumes kinked aggregate supply and so on [(Prinz & Beck, 2021](https://link.springer.com/article/10.1007/s11293-021-09713-6), [Palley 2014)](https://www.tandfonline.com/doi/full/10.1080/09538259.2014.957466?casa_token=01QJkCJvAzkAAAAA%3A90GWhDykSbGT3biQ5HhnWwiSiNPlcWlkHayEkDnIThb7soiwu_QrqrFVE2sVPBDRBx3QsTgW3xYnyw)).

However, some MMT proponents like Kelton do claim that (e.g. see her book Deficit Myth).

> If I am understanding MMT correctly, is this point accepted by establishment economists?

It is not generally accepted for taxation to be deflationary a priory. Taxation does not affect just aggregate demand but also aggregate supply. So the overall effect is ambiguous. However, if you only look at demand side, it is accepted that taxation itself suppresses aggregate demand provided government does not spend that money. That is another point of contention, where MMT proponents like Kelton advocate for large government spending at the same time (again refer to the Deficit Myth). In mainstream models taxing and spending the money does not reduce inflation.

As a consequence of this and other claims, MMT is generally not accepted neither by mainstream or also other heterodox strands of economics like post-Keynesians (e.g. see [Mankiw 2020;](https://www.aeaweb.org/articles?id=10.1257/pandp.20201102) (Prinz & Beck, 2021][1](https://link.springer.com/article/10.1007/s11293-021-09713-6); [Palley 2014)](https://www.tandfonline.com/doi/full/10.1080/09538259.2014.957466?casa_token=01QJkCJvAzkAAAAA%3A90GWhDykSbGT3biQ5HhnWwiSiNPlcWlkHayEkDnIThb7soiwu_QrqrFVE2sVPBDRBx3QsTgW3xYnyw).

> If not, what is the argument against taxation being deflationary?

There are several problems here;

* Yes taxation does reduce aggregate demand but it also affects supply side. It is well documented that increases in sales/VAT, and increases in corporate taxes, and other taxes as well *empirically* lead to higher prices and hence at least temporary inflation (see few random examples like ([Carare & Danninger, 2008](https://scholar.google.com/scholar?hl=en&as_sdt=0%2C5&q=vat%20increases%20and%20inflation&btnG=), B[aker, Sun & Yannelis 2020](https://www.nber.org/papers/w27058))., this is generally well empirically established). This is despite the fact hat they also suppress aggregate demand. The reason for this is that these taxes ultimately increase costs of production and hence firms are willing to supply less goods at the same prices (supply shifts to the left) and this is inflationary.

  You would need to suppress aggregate demand more than aggregate supply which is possible, but you have to go through 'vicious' cycle, where you are trying to suppress demand more than the damage you are doing to supply. In MMT this does not happen because under the translation of MMT rhetoric to models like in Palley, their AS is first completely flat (hence changes in AD do not result in any inflation) and then once you hit full employment you get perfectly vertical AS and only then you get inflation and it is unaffected by taxes. In mainstream models you have increasing AS in short run and vertical in long run and both move to the left as a response to higher tax rates. Hence in the MMT model you only need to suppress AD up till you get to the point of full employment, but in mainstream models with upward sloping short run and vertical AS in long run that responds to inflation you will always get some inflationary pressure when you raise taxes.
* In micro models taxes create deadweight loss to the economy whereas changes in interest rates (provided they reflect market forces) do not. As a result, even if we can suppress AD more than AS, this method of controlling inflation is less optimal then monetary policy.

  Even if you do not believe in mainstream theory, its just empirical fact that tax hikes on corporations, goods, wages and other economic activity generally result in higher prices than otherwise. Hence even if you do not believe in mainstream synthesis of New Keynesian macro and neoclassical micro economics, your theory still has to somehow account for this observed fact.
* MMT also ignores various public choice problems. Usually economists support monetary policy over fiscal policy because central banks are technocratic institutions governments aren't. Even in MMT you must ensure you do not go beyond point of full employment with government spending or you will get inflation. It is unrealistic to believe that democratically elected politicians will be able to somehow find this right balance.

  From mainstream perspective this also crates double whammy, not only that taxes suppress AS which leads to higher prices but also government spending cancels off at least some of the impact that taxes have on AD. In fact depending on parameters of the economy, it could even further stimulate AD.

> **Comments:**
> **username_4**: "In micro models taxes create deadweight loss to the economy whereas changes in interest rates (provided they reflect market forces) do not. As a result, even if we can suppress AD more than AS, this method of controlling inflation is less optimal then monetary policy."  Have you got a source for this?  My intuition is that (even before considering distributional effects) interest rate hikes do cause some deadweight loss, since they cause people to deviate from the 'optimal' smoothed consumption path. But I don't have a model.  
> **username_3**: @matthewoulton you can check that in models presented in standard textbooks such as Mankiw's principles of economics, or Blanchard et al Macroeconomics. Deadweight loss is created by taxes because they drive a wedge between marginal social/private benefits and marginal social/private costs. Interest is just a price. Provided CB selects interest rate at which S=D for money, and given they can exert control over supply, they can in principle select virtually any interest rate as long as they support it, as long as central bank does not actually mess up there is no deadweight loss.  
> **username_3**: Of course, if CB would pick i that is above/below the rate at which supply of money equals demand for money there would be DWL, but they can also manipulate supply. There are some exceptional situations like zero lower bound where S and D intersect at negative interest rate etc when it does not work, but I assumed in my answer we are not talking about exceptional situations  
> **username_4**: Are you assuming that there is no relationship between monetary variables and the real side of the economy?  My intuition is that in selecting the interest rate, the Central Bank influences individuals' price of present consumption. I think manipulation of this rate is exactly equivalent to imposing a tax wedge on consumption today (vs tomorrow) except insofar as a tax wedge results in government revenues rather than bank (or CB) revenue in the case of an interest rate.  
> **username_4**: Suppose that the CB set a very high interest rate for a single period. Wouldn't there be welfare loss (relative to the situation before raising rates) because agents can't consumption smooth as much as they would like?  
> **username_3**: @matthewoulton 1. It is not my personal assumption, that is implicitly assumed in standard IS-LM models even those that have micro-foundations. 2. There won't be any analogous DWL wedge if interest rate is set to the level where supply for money equals demand for money. Microeconomically you can think of money market as having price (interest) fixed by central bank. This would lead to DWL like regular price fixing, if CB would not be willing to adjust money supply which it has control over. In that case CB can always fix the price at equilibrium rate (at least in theory) without any DWL  
> **username_3**: 3. Welfare loss is not the same as DWL. For example, suppose you have perfectly competitive micro market for lets say apples. If there is severe reduction in supply of apples (supply shifts to the left) while demand stays constant, there will be welfare loss (loss of Marshallian surplus) for both consumers and produces (their surpluses shrink). However, the market in this case is still allocatively efficient, its just new equilibrium (with lower welfare). 4. If you introduce liquidity constraints at certain levels of interest then of course that would change the analysis.  
> **username_3**: However, the same holds for taxes, once you start to add various imperfections, informational asymmetries etc, even taxation can have more negative effects. For example, once we start adding public choice issues, in my opinion, any serious discussion of controlling AD through taxation, outside perhaps special cases, pretty much flies out of window...  
> **username_4**: Ok, I understand the distinction you're drawing, but suppose that we have two equilbria: 1. Consumption taxes are raised. 2. Interest rates are raised. Money market is still in equilibrium, though. Such that both equilibria involve the same consumption in the goods market. Don't these two markets entail exactly the same welfare for everyone (except the bank)?  
> **username_3**: @matthewoulton right but you are talking about different situation. I agree in principle there is some tax rate $t$ that will yield the same reduction in consumption that some interest rate $i$. But we are talking about trying to control inflation. If markets are perfect and CB does its job raising interest rate does just affect AD. Even with perfect markets taxes do affect supply side negatively which is inflationary. Hence to get the same reduction in inflation you would have to do more work with taxes than with interest rate. Hence, you would have to pay more in welfare for reducing  
> **username_3**: Inflation, since to achieve the same level of inflation you need to suppress consumption and production more. Btw this is also why when it comes to fiscal macro policy it’s done through changes to government spending financed by borrowing rather than increasing/decreasing tax rates  
> **username_4**: I don't think that this is true.  Consumption taxes affect supply because they affect individuals' labour supply decision (in the case of a tax increase, by making today's consumption more expensive). Interest rates also exert the same effect (agents who prefer to consume in the current period may work less in the face of a higher interest rate).  Admittedly, what I'm thinking about here is a change in consumption taxation taxation paid for by consumption tax in the future (so there should be no wealth effect).  
> **username_4**: Also, it's not true that governments only conduct macro fiscal policy via changes to government spending. Changes to sales taxes are also really common (e.g VAT cut in the UK in Dember 2008).  
> **username_3**: @matthewoulton 1. Regarding the policy I was actually talking in context of all the models, not real world. In real world lots of policies are pursued even if they don't make theoretical sense. 2. I am not sure that is correct. A) higher interest rate makes goods more expensive only implicitly because it makes intertemporal shifts of future consumption to present more expensive. However, by the same token it makes shift of consumption from present to future through saving cheaper. A priori I don't think you can claim that its obvious there would be reduction in work, because this might  
> **username_3**: motivate some agents to work even more. B) Usually at least textbook macro models to get monetary policy to affect supply side you need to add some market imperfections. I will admit, that this is not what I often think about, so I am not sure if this is due to some simplification in the models that is completely unrealistic, but I know it at least holds in those models.  
> **username_4**: I'm just saying that *if* a revenue neutral tax change caused supply side effects, I'd expect an interest rate change to cause the same.  
> **username_4**: My current expectation is that neither would be expected to affect the supply-side.  
> **username_3**: @matthewoulton  but we are not talking about revenue neutral tax. Forget about supply side, if the tax is revenue neutral then you are automatically offsetting the disinflationary effect of tax depressing AD by inflationary effect of spending stimulating AD. Making the tax revenue neutral literally defeats the original purpose. Also I would agree with that statement for revenue neutral *lump sum* tax because lump sum tax is non-distortionary, I would not agree for distortionary taxes  
> **username_4**: This isn't right. I'm talking about revenue neutral consumption taxes (i.e I impose a tax on consumption today and reduce the tax on consumption in the future).  That is, the effect is via a substitution channel, not via an income effect.  
> **username_3**: but in public econ literature revenue neutral tax is a tax where the income effect is offset by subsidy not lowering taxes in future. In this case, what you are suggesting I would maintain there will be extra negative effect caused by deadweight loss.  
> **username_4**: What's the difference between reducing consumption taxes in the future and a future subsidy?  Regardless, I'm now convinced I'm correct. When I look at NK budget constraints, there is no difference between the role played by the interest rate and the role played by a consumption tax. I don't see how (more) deadweight loss could be generated in the latter case.  
> **username_3**: 1. when people talk about revenue neutral taxes they typically talk about them being revenue neutral within a period not from a life time perspective, at least I didn't see that kind of usage a lot. 2. That can't be true if you are using model with distortionary taxation. Yes if you use $p_tc_t + q_t x_t + B_t = W_tn_t + R_{t−1}B_{t−1} + T_t$ you can achieve exactly the same outcome through $T$ or change in $R$, but when you have distortionary taxation, e.g. because government cant tax leisure (x), so consumption taxes are inherently distortionary you will get the following budget constraint  
> **username_3**: $p_t(1+\tau_t)c_t  + q_t x_t + B_t = W_tn_t + R_{t−1}B_{t−1}$. In this case $\tau$ is distorting optimal choice between $c_t$ and $x_t$ whereas $R$ is not. Higher R is making borrower poorer and hence it reduces consumption, but higher $\tau$ is not just making consumer poorer and reduce consumption but it also distorts the choices between consumption of composite good c and leisure x, this should clearly lead to more welfare loss. And this is jut through distortions to goods markets, this has to distort factor markets as well.  
> **username_4**: Ok, sure, I understand your argument and maybe we're getting caught up on semantics, but to be clear, I am talking about lowering (raising) a consumption tax in the present period and raising (lowering) a consumption tax in a future period.  So I don't disagree with you analysis above (which involves an increase in the total discounted value of taxation), but it's not the point I'm making.  
> **username_3**: No I perfectly understand what you mean. That is why I put there $\tau_t$ instead of just $\tau$, the point is still that because time varying $\tau_t$ changes consumption not just intertemporally (which interest rate does too) it in addition distorts intratemporal consumer choice whereas interest rate doesn't  
> **username_4**: For it to be revenue neutral, though, you need a future $\tau_{t+1}$ to decline (reducing distortion in that period).  
> **username_3**: but there is still distortion, 0 distortion in both periods is clearly more welfare enhancing than having big distortion in period 1 and small distortion in period 2. Interest rate does not distort choices between x and c. It is not like the large distortion of optimal choices in period 2 is somehow compensated for with smaller distortion in period 2 it just means that DWL(t=1)> DWL(t+1). What matters is the total amount of distortions over both periods.  

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### Answer by username_1 on 2024-05-24. Score: 0

One problem with raising taxes to combat inflation is that the increased tax rates really don't translate into much, if any, additional revenue for the government. This is for three main reasons. First, when taxes are too much, they discourage more production of goods and services, after all, what is the point of producing more things, working harder and innovating if the government is going to confiscate the majority of the proceeds? Also, after a certain point, tax increases essentially encourage cheating and the exploitation of loopholes among those who can, because again, the government robbing people of their earnings (whether for investments, conventional 9-5 jobs, business ventures, freelancing, etc) doesn't actually promote economic growth. Also, high levels of taxation basically tell the market the lie that the government knows better than the private sector about where (and on what) money is best spent.

> **Comments:**
> **username_2**: "increased tax rates really don't translate into much, if any, additional revenue for the government".  Surely that depends on what the rate was before the increase?  

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