Redistributive policy

The role of fiscal policy in fighting inflation

Macroeconomic policy is divided between monetary policy, controlled by the Federal Reserve Board, and fiscal policy, controlled by Congress and the Administration. When formulating fiscal policies, the government can change (a) public spending, (b) taxes, and (c) transfer payments.

Taxation, of course, is well understood, but the distinction between government spending and transfer payments may not be so clear. Government expenditures are explicit expenditures by state, local, or federal agencies for goods or services. Transfer payments, as the name suggests, involve a redistribution of wealth, where government payments are made to businesses or consumers (households), but the government does not directly receive a good or service. Some of the most common transfer payments include grants paid to support education and training, social security payments, unemployment insurance payments, and health insurance benefits.

Deficits arise when government spending and transfer payments exceed taxes collected. Whether fiscal policies are expansionary or restrictive, however, is reflected in the way the deficit is changing. A growing deficit is indicative of an expansionary fiscal policy; and conversely, a shrinking deficit is indicative of a restrictive policy.

Nowadays, with inflation being our primary economic concern, the classic remedy calls for restrictive policies, usually by fiscal and monetary authorities. So, in addition to seeing the Fed tighten, some measure of fiscal restraint would also be deemed appropriate. It turns out that the federal deficit increased significantly after the enactment of the 2021 U.S. bailout, but spending on many provisions of the law has since been exhausted (e.g., expanding child tax credits, checks to families, various grant programs and increased unemployment benefits). As a result, in recent months deficits have started to narrow slightly.

Some will say that despite the recent reduction in the deficit, it is still too high and that an even more aggressive budgetary policy is necessary. If so, at this point I consider further reductions in transfer payments and government spending to be ill-considered. The safety net derived from the various transfers that had targeted low-income Americans under the American Rescue Act disappeared. Damn. Should we shrink the safety net further, now, when inflation is making life much harder for those at the bottom of the economic ladder? Likewise, is it time to start laying off educators and municipal employees? Or maybe in this time of war in Ukraine, it’s just time to reduce purchases of military equipment. None of these choices seem appropriate to me.

While cuts in public spending and transfer payments are largely ruled out, the remaining fiscal lever available to further limit deficits is taxation. If we are to pursue a more restrictive fiscal policy, I am particularly in favor of higher taxes, implemented gradually to ensure that high-income households bear the greatest financial responsibility. In a way, this effect would offset the fact that the burden of inflation falls most heavily on our most vulnerable.

It seems to me that the future course of action for fiscal policy is predetermined. The prospect of orchestrating a fundamentally restrictive fiscal policy seems virtually impossible, no matter who sits in the Oval Office. While Democrats could reasonably coalesce around the idea of ​​raising taxes, passing this legislation in the Senate would require a 60-vote majority. It will not arrive. Besides lining up behind Trump, perhaps the next biggest point of unanimity for the Republican Party is the idea of ​​“no new taxes.” Given this reality, the responsibility for fighting inflation will continue to rest almost exclusively with the Fed.

This legislative deadlock is not necessarily a bad thing. The Congressional Budget Office currently projects that deficits will decline over the next two years in the absence of any new legislative initiatives, suggesting that at least some modest contractionary fiscal effects are expected regardless. . A more aggressive contraction policy could jeopardize the realization of the soft landing that the Fed hopes to obtain. It is possible, however, that a soft landing would prevent the reduction in inflation. It may take a recession to really fix the problem. If so, failure to introduce more restrictive fiscal policies could prolong the duration of our current inflationary episode. The appropriate policy path is not at all clear, nor is it clear how soon this issue will be resolved.