The surging price pressures that brought inflation to four-decade highs in the United States have many causes. Some are truly external to the economic system: for instance, plants that produce semiconductors or their inputs in Korea and Malaysia shut down during Covid, causing a manufacturing bottleneck in cars and appliances. But others are due to wildly misguided fiscal and monetary policy.
Politicians have tried to blame the supply side for inflation, treating inflationary supply shocks as accidents outside government control. For example, in one speech last year, President Biden blamed Vladimir Putin, port disruptions, Covid, the supply chain, licensing delays for truckers, monopoly power, foreign investors, pharmaceutical companies, and the lack of energy investment for price increases. That’s just about everything . . . except the trillions of dollars of unnecessary fiscal expenditures his administration pumped into the economy while it was near full employment, or the Fed’s recklessly loose monetary policy in 2021. The administration spent $1.9 trillion on the American Rescue Plan, $1 trillion on the Infrastructure Investment and Jobs Act, and roughly $300 billion on the so-called Inflation Reduction Act.
No doubt the supply side has been a significant driver of inflation. Basic economics indicates that the steeper the supply curve, the more inflation a given demand shock generates. If the supply side has been as tight as the Biden administration thinks, then hitting the fiscal gas pedal was an especially bad idea. The current inflationary mess owes to a steeper supply curve interacting with government-driven demand shocks, but what is less well appreciated is that the steeper supply curve is itself a result of poor government policy.
First, consider labor supply. After the pandemic, much of the country experienced “labor shortages,” in which certain industries couldn’t find enough workers. These shortages drove up wages and pushed inflation higher. But the reduction in labor supply didn’t just occur by chance. Many older workers on the margin of retirement were able to leave the workforce a few years earlier than expected because their housing wealth blossomed; home prices rose by nearly 40 percent since the pandemic, owing much to both monetary and fiscal policy. Research indicates that if housing returns in 2021 had been more typical, labor-force participation among older workers would not have declined at all. Meantime, how many younger workers decided that staying home to trade cryptocurrencies and meme stocks was more fun—and financially rewarding—than working a real job? Those activities could be profitable only in an environment in which the Treasury gave people bags of poker chips and the Federal Reserve transformed securities markets into a casino. While economists think of monetary and fiscal policy primarily affecting aggregate demand, they have clearly affected labor supply, too, through nontraditional wealth and financial channels.
New programs have gone out of their way to twist the supply side. A bipartisan consensus maintains that the country needs to invest in better infrastructure and in critical technologies like semiconductors. But legislation for these ends is laced with provisions to make the supply side less efficient. For example, to receive CHIPS Act funding, semiconductor manufacturers have to provide affordable childcare for their workers, achieve worker diversity goals, “consult, engage and coordinate” with such stakeholders as labor unions and local nonprofits, use certain quantities of union labor, and pay sufficiently high wages. Each of these provisions, along with the compliance burden of fulfilling them, raises the cost of production. Irrespective of the worthiness of any of those goals, they shouldn’t hamper actions to shore up semiconductor resilience. Indeed, the cost to firms of complying with all these requirements will eat up part of the subsidies, resulting in an inefficient use of taxpayer funding meant to boost semiconductor capacity. The Infrastructure and Jobs Act is similarly loaded with provisions that will make infrastructure building significantly more inefficient and costly than it needs to be.
Finally, regulations make the supply side more brittle, and the Biden administration has expanded the regulatory state across most domains of government. The registry of new rules ranges from boosting minimum wages for immigrant workers, to lightbulb efficiency standards, to requirements that publicly traded companies monitor, audit, and disclose climate risks and impacts. With every regulation increasing the cost of doing business and slowing the entry of new firms, demand shocks produce more inflation than they used to.
That political actors have sought to blame inflation on the supply side is no surprise. If they can convince the public that Covid or Russia is to blame for inflation, then they can avoid electoral consequence for poor public policy. More surprising is that, after two years of howling that inflation was driven by the supply side, prominent figures continue to propose more supply distortions.
President Biden’s proposed budget for fiscal year 2024 calls for higher taxes on several fronts. For example, it would raise the tax on corporations from 21 percent to 28 percent. This would not only discourage investment but also provide a massive benefit to large conglomerates. Multinational corporations can afford high-powered lawyers and accountants to help them shift their profits abroad and lower their effective tax rates to rock-bottom levels. But smaller corporations that still pay the corporate tax rate and have little international footprint cannot do so, making them less competitive than larger firms. High statutory rates serve as a barrier to entry for smaller businesses and competitors generally, protecting incumbents.
The budget proposal would lift the capital-gains rate for high-income households to almost 40 percent. However, because capital gains taxes apply to nominal and not real returns, high inflation rates can drive real tax rates in excess of 100 percent of shareholder returns. If more than 100 percent of the real return is taxed, there’s no incentive to hold equities, since investors have all the downside risk and none of the upside. A country whose companies struggle to raise equity capital will not be able to undertake the necessary investments to maintain, let alone improve, its standard of living.
Biden is not alone in proposing steep tax hikes. Prominent economist Larry Summers has proposed raising taxes to control inflation, while Treasury Secretary Janet Yellen has called for higher income taxes on the rich. Unfortunately, higher taxes would further aggravate supply constraints: to levy a tax, the government has to target some activity that taxation inevitably discourages. Taxing investment means less investment. Taxing labor income means less labor income. It’s hard to see how higher taxes will help provide more labor supply or ease the worker shortage. At a time when the supply side is already on tenterhooks, further distortions are the last thing we need.
Policymakers should instead reform the supply side to help control inflation. For starters, the most powerful thing they can do is remove regulatory red tape, which prevents businesses from responding to the needs of the marketplace. Every rule is a compliance burden that increases the cost and time requirements of doing business, reducing competition and ultimately resulting in higher prices. Overly burdensome occupational-licensure rules keep people from switching jobs quickly to fill gaps in local labor supply or moving across state lines to respond to demand changes; excessive environmental regulations impede the development of new facilities. A less dynamic supply side leads to more inflation from demand shocks.
Second, the government should cease all expenditures from the Infrastructure Investment and Jobs Act and the Inflation Reduction Act until the economy has cooled sufficiently to accommodate them. When a wildfire is burning, stop pouring fresh oil on it. The Biden administration can delay these outlays until there’s sufficient economic slack such that the spending doesn’t produce further price pressures.
Finally, tax reform can help unleash the supply side, as well. Since taxes distort the efficient choices of economic agents, reductions in taxes can help reduce those inefficiencies. Lower rates, combined with a broader base—simplifying the tax code by removing tax expenditures and deductions—could provide a lot of help.
The current inflationary brew is a toxic mix of both supply and demand shocks. Politicians have bent over backward to argue that the supply side has contributed most of the price pressures, because they believe that it exonerates them of responsibility. Those claims are false. Even if supply were the exclusive driver of inflation, many supply problems can be traced directly back to government fiscal, regulatory, and monetary policy. And if public officials sincerely believed that the supply side was the root problem, they wouldn’t be proposing new supply distortions. They’d be proposing ways to improve the efficiency of the supply side and removing roadblocks that prevent firms from dynamically responding to the economy’s needs.
Photo: Shisanupong Khankaew/iStock