Cutting Taxes on the Rich Causes Inflation

James Kroeger has an interesting website that puts forth some unique arguments, particularly in favour of progressive taxation. The thrust of Kroeger’s argument is as follows:

When individual lottery winners collect their millions, they enjoy a dramatic increase in their purchasing power.  Suddenly, they are able to make a claim on the scarcest goods & services that the economy makes available.  But what if our politicians in Washington were to decide one day to simply hand out a million dollars to every household in America?  We’d all be able to share the same great experience of luxury living then, wouldn’t we?  Well…no.

By re-framing marginal tax cuts as simply ‘giving’ rich people a certain amount of money, he exposes somewhat of a right wing contradiction: though RWers are often keen to scream inflation when money is doled out, they do not seem to hold the same opinion when the money is doled out to the rich. Now, you might say that taxed money doesn’t disappear; it is spent on other things, and this is true. However, if we consider the ‘Cantillion‘ effects of the distribution of spending, we might expect there to be more of a problem as the goods and services purchased by rich people become more esoteric.

I’d also like to add something to Kroeger’s thesis. As marginal tax rates decrease, people will be more inclined to ask for pay rises, as they have more to gain. If, for example, marginal tax rates were actually lower than the ones that preceded them, we’d be highly likely to experience higher wage inflation (and therefore higher general inflation).

Ultimately, of course, it is an empirical question whether cutting marginal tax rates simply inflates the price of luxury goods, thus benefiting noone but damaging the public purse. So what has happened to the price of luxury goods over the last 30 or so years, when marginal tax rates have done this:

For comparison, Forbes have an incredibly useful ‘Cost of Living Extremely Well Index’, which is shown along with the CPI here:

Clearly, the relative price of luxury goods has taken off as marginal tax rates have plummeted. Now, I don’t want to infer correlation-causation, but this seems like evidence for Kroeger-Unlearningecon effects (!), and I am having a hard time coming up with other explanations for the CLEWI rise.

But perhaps I just have a bias in favour of my new hypothesis.

Addendum: If anybody has any further evidence that is relevant to this argument, I’d be grateful.

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  1. #1 by Ryan Langrill on January 6, 2012 - 7:25 pm

    Wouldn’t this be the trend you see if there’s simply an increase in population and rich people consume more fixed resources? Say it takes owning a Picasso to join the cool rich people club. The number of Picassos is fixed. There were ~200 million people in the US in 1970, and ~300 million today. Assuming the income distribution stays fixed, what happens to the price of Picassos? They probably rise at a much faster rate than goods that can be reproduced. Rich people (I would guess) consume more things that have “Picasso” characteristics than non-rich people do, thus an increase in population would increase the price of rich people’s consumption bundle at a faster rate.

    The Cantillon effect on tax changes is interesting though, and something I hadn’t thought fully about.

    I’m not sure about the cost-push inflation argument. If marginal tax rates decrease, there’s an increase payoff to asking for a raise – but also an increase in income, which makes the cost of leisure drop. People are more likely to ask for a raise, but also more likely to retire earlier, take more unpaid vacation, take jobs they enjoy more for less pay, etc., – in other words, ask for their raises in non-pecuniary ways. Only if people solely care about monetary gain will the cost-push inflation argument be strictly true. Otherwise there will be opposing forces, making the net effect ambiguous.

    • #2 by Unlearningecon on January 6, 2012 - 7:33 pm

      That is an interesting idea, and unfortunately the index only goes back to 1976; around the time marginal tax rates started to decline. Obviously I’ll need to assemble more data before I can draw a definite conclusion either way.

      ‘People are more likely to ask for a raise, but also more likely to retire earlier, take more unpaid vacation’

      Hmm this a possibility but the whole idea of work as a trade-off for leisure ignores the fact that most simply have no control over the amount they work. I can see the retirement thing as a possibility but I doubt the average worker would push it too much with unpaid vacation.

      ‘take jobs they enjoy more for less pay, etc., – in other words, ask for their raises in non-pecuniary ways.”

      This is counteracted by my initial argument – taking a lower paid job will mean higher taxes, so people will be more inclined to accept or ask for higher paid ones.

      • #3 by Johnny on January 11, 2012 - 5:52 pm

        “This is counteracted by my initial argument – taking a lower paid job will mean higher taxes, so people will be more inclined to accept or ask for higher paid ones.”

        Huh? While top marginal tax rates have fallen in the US, the rates have always been progressive. A worker taking a lower wage job will always pay less (or even negative) income taxes. Payroll taxes like social security are indexed to benefits too, so the same fixed rate below a cap actually provides more benefit to the low wage worker than the higher wage one.

      • #4 by Unlearningecon on January 11, 2012 - 6:17 pm

        Johnny, the point is that people are more inclined to ask for pay rises with lower marginal tax rates – they don’t have to be declining.

        The declining part of the argument is purely theoretical and abstract. If you know of any instances with declining marginal tax rates, though, I’d be interested to look at the data.

  2. #5 by Brendan Lowe on January 8, 2012 - 2:37 am

    Kroeger’s arguments are “unique” probably because they’re extremely bad. His argument for why taxation doesn’t hurt the rich assumes that the government burns the money it takes, but his argument for why taxes are desirable assumes that the government spends, not burns, the money it takes. He reads like a charlatan and a quack. I can’t believe you linked to this guy and his dreadful argument approvingly. Please tell me that the only part of that ridiculous argument you believed was that cutting taxes on the rich causes inflation, which is wrong in any case.

    Obviously, the more money rich people have, the more they’ll spend on luxury goods, which will cause the price of those goods to rise in response to the rise in demand. This is not inflation, which is a general rise in prices. By this argument, anything that causes the demand for any bundle of goods to increase causes inflation. Cutting taxes on the poor would cause inflation too. Raising taxes on the rich might cause inflation as well. Almost anything could cause inflation. This is dreadfully bad stuff.

    • #6 by Unlearningecon on January 8, 2012 - 10:25 am

      Did you even read the post? I had a prebuttal to that objection, and my main point was that as the rich purchase more esoteric goods it will have more impact on the price level of those goods.

      I put forward a thesis, provided some evidence and noted the limitations of that evidence, whilst your last point goes off on a red herring about terminology. At least address my points properly.

      • #7 by Brendan Lowe on January 8, 2012 - 6:37 pm

        No, you’re simply wrong. The demand for luxury goods increasing is not inflation. That’s why terminology matters. Because you’re using terms wrong.

        Your point about rich people having more money causes them to buy more rich person things is trivial and obvious.

      • #8 by Unlearningecon on January 8, 2012 - 9:24 pm

        My point: cutting marginal tax rates simply inflates the price of luxury goods, making it pointless from the perspective of rich people.

        It may be obvious and trivial but I have rarely seen it highlighted before. You also have yet to refute it – please engage my points instead of going off on red herrings, I don’t tolerate crap in my comments.

      • #9 by Brendan Lowe on January 8, 2012 - 9:37 pm

        Your argument works under the assumption that the government burns the money it taxes. If it spends the money–if it buys up resources–then lowering taxes frees up more resources for the rich to bid on.

        Kroeger plainly doesn’t understand economics. I’m becoming increasingly skeptical of you as well. What is the nature of your economics education?

      • #10 by Unlearningecon on January 8, 2012 - 9:51 pm

        I don’t understand, surely you’ve contradicted yourself by saying:

        ‘Your point about rich people having more money causes them to buy more rich person things is trivial and obvious.’

        then saying:

        ‘Your argument works under the assumption that the government burns the money it taxes.’

        My point is that the distribution of income alters the ‘Cantillion’ nature of demand created – past a certain point, ‘giving’ the rich money simply increases the price of luxury goods and as such they do not benefit as much as if the money were spent on infrastructure or whatever else.

        The nature of my economics education is irrelevant to this argument, particularly since by ‘economics’ you mean neoclassical theory. If it helps you then you can act like I have never had a formal economics education.

        e: also note that Mike Kimel has a lot of work on marginal tax rates and economic growth – seems the optimum is around 60-70%, which corroborates with my evidence as it suggests the increased demand from cuts is inflationary rather than stimulating production and hence RGDP growth.

      • #11 by Brendan Lowe on January 8, 2012 - 10:46 pm

        Look:

        If the government reduces taxes, UNLESS IT WAS NOT SPENDING THE TAX DOLLARS, BUT INSTEAD BURNING THEM/DROPPING THEM IN A BOTTOMLESS PIT, then it also FREES UP RESOURCES for consumption. Therefore, the people who now have more money due to the lower taxes not only have more money to bid but MORE THINGS TO BID ON. Therefore, although demand is up, and therefore prices are up, the real wealth of those whose taxes have lowered must have increased.

        Ignoring this is Kroeger’s mistake, and yours.

        An economics education helps you avoid mistakes like that.

        Dave Altig is being awfully polite to Mike Kimel, who’s being awfully lazy and sloppy. But it’s a blog, so that’s not a slam on Mike.

      • #12 by Unlearningecon on January 8, 2012 - 10:54 pm

        Are you working under the implicit assumption that capital is homogeneous and can simply be reallocated from government programs to the production of luxury goods? Obviously this is not the case, which is reflected in the data.

      • #13 by Brendan Lowe on January 8, 2012 - 11:00 pm

        No, I’m not. Are you assuming that capital is fixed and completely immobile, such that markets are completely incapable of responding to increased demand and supplying more goods accordingly?

      • #14 by Unlearningecon on January 8, 2012 - 11:27 pm

        Obviously there is no middle ground. The evidence suggests that the price of luxury goods *is* inflated by tax cuts after a certain point, and also that tax cuts after a certain point are bad for RGDP growth.

  3. #15 by Unlearningecon on January 8, 2012 - 10:28 am

    The last time a progressive consumption tax was introduced – around 1990 in the U.S. – it was disaster and destroyed the industries of those goods.

  4. #16 by James Kroeger on January 9, 2012 - 4:15 am

    Nice blog you have here, Unlearning Person. :)

    If I may, I would like to ignore Brendan Lowe’s vitriolic blather for now to simply respond to his unwarranted misrepresentation of my arguments.

    Without further explanation, he offered the following summarization of my claims:

    “His argument for why taxation doesn’t hurt the rich assumes that the government burns the money it takes, but his argument for why taxes are desirable assumes that the government spends, not burns, the money it takes.”

    It’s not clear precisely why Lowe is given to speaking such nonsense, but at least part of his comprehension problem can be blamed on his ignorance of (1) the fact that different rates of inflation are experienced by different income-earning groups, and (2) how and why resource allocation occurs in market economies.

    Someone needs to explain to Lowe that the commonly accepted measurement of inflation, the CPI, provides only an AVERAGE rate of inflation (one that is actually experienced by only a particular segment of income-earners). Current methods of calculating inflation hide the fact that it is possible for some income-earning groups to experience disinflation or even deflation at the same time that other income-earning groups are experiencing double-digit inflation.

    If the BLS could be persuaded to calculate the different rates of inflation that are experienced by different income groups (by tracking changes in the prices of a ‘spectrum of different market baskets’ that reflect the typical purchases of different income-earners, including the purchases of assets) we would have ample empirical evidence that inflation rates do vary across income groups.

    Now I confess to being baffled at Lowe’s statement that I could only be claiming that taxation doesn’t hurt the rich if I’m assuming that the government burns the money it collects from tax-payers. He might have at least stated the actual reasons I give for the claims that I make.

    Taxation does not hurt the rich because (A) markets work, and (B) even after paying taxes at steeply-progressive rates, the wealthy would still have all the disposable income they’d need to be able to obtain the scarcest goods/services/luxuries that the economy is able to produce. They would still be able to outbid all those who earned smaller pre-tax incomes than they.

    The sellers of luxuries would simply be forced to lower their prices to a level that the wealthy could afford.

    This predictable market outcome would occur no matter what the government did with the money it collects from taxpayers. (The one exception I can think of would be those times when The Government competes with the Upper Class for luxury goods and services. If the government were to burn the money it collects from taxpayers, it would no longer have the $$ it needs to participate in those markets, which would cause prices to drop even further.)

    The only time a reduction in the tax rates of the wealthy can be expected to produce a non-inflationary effect is when the extra disposable dollars thrown at luxury industries causes the kind of reallocation of productive resources that results in larger quantities of luxuries being brought to market. Unfortunately, this is something that seldom happens in such markets.

    The standard resource-reallocation model seldom applies to the markets that serve the top 5% of income earners. This, because the Top 5% are typically interested only in goods/services that are either difficult or impossible to duplicate. They want one-of-a-kind works of art specifically because there will never be another one of them produced. They are permanently scarce. No amount of money thrown at luxury markets is going to increase the number of Rembrandts produced for sale.

    It is true that some of the luxuries consumed by the Top 5% are not permanently scarce, but the question remains, will an increase in the disposable incomes of all wealthy people cause a significant increase in the quantity of luxury goods/services made available to wealthy consumers?

    My claim is that it generally will not, simply because the sellers of luxuries have always enjoyed higher profit margins than the industries that serve the Bottom 95%; this was true even before the Republicans succeeded in getting the taxes of the Top 5% reduced over the past few decades.

    With their higher profit margins historically, they have always been able to outbid producers in other industries for the resources they’ve needed to bring luxuries to market, even before Ronald Reagan threw huge amounts of money at their best customers. This is why, when even MORE money was provided to them, the law of diminishing returns in the resource markets they participate in was already in play.

    No matter how much additional money is thrown at the typical luxury market, the actual returns are usually quite meager. Quantities of luxuries available remain quite limited, which is precisely what wealthy consumers want.

    That is the ultimate reason, Brendan, why tax cuts for the Top 5% are almost always purely inflationary: more $$ thrown at a relatively fixed amount of luxury goods and services = a rise in prices that matches and follows a concomitant rise in disposable incomes.

    • #17 by Unlearningecon on January 9, 2012 - 11:04 am

      Excellent comment, thanks.

    • #18 by Brendan Lowe on January 9, 2012 - 10:09 pm

      You are laboring under two delusions:

      1) Luxury goods are fixed in nature. This is so obviously wrong I’m not even sure what to say. But that’s with the economic definition of the term “luxury goods.” I think when you say “luxury goods” you mean something like goods that are valued precisely because there cannot be a competitive market in them, such as rare paintings. It’s true that something valued for its rarity cannot be profitably duplicated, but it’s completely wrong to assume that just because new Mona Lisas cannot be brought to the market, therefore new “luxury goods” cannot be brought to the market. The rich can and so far have found new rarities and luxuries to buy, and you have no evidence that this trend will stop.

      Essentially, you are confusing the market for a TYPE of product with the market for the product itself.

      2) That rich people only buy these “luxury goods” and nothing else.

      • #19 by James Kroeger on January 10, 2012 - 1:17 am

        >>I think when you say “luxury goods” you mean something like…<<

        By 'luxury' good I am referring to those goods/services that are so scarce, only the very wealthy can afford them.

        I avoid using the term 'positional' good, which is actually more precise, because extraordinarily few people know what the term means (which usually means that yet another explanation is required…).

        Of course the wealthy consume non-positional goods, but it is actually quite ridiculous to bring the Top 5%'s consumption of those goods into the discussion, because they represent only a tiny fraction the total number of buyers who participate in those markets.

        Even if the typical rich person was to double the quantity of positional goods she buys in response to a tax cut (why would she do so?) the extra spending would only comprise a tiny fraction of the total amount of $$ that are spent on such goods.

        They have a lot of money, but they do not typically spend enough of it on non-positional goods that their decisions to purchase or not purchase will move prices.

        The Top 5% have so much money coming in, the last thing on their minds is whether they should change the amount of money they spend on non-positional goods. They get what they want, period.

        That is why it is reasonable to 'factor out' the money that the Top 5% spends on non-positional goods. Almost all of the EXTRA money they would get from a tax cut would be directed at the purchase of positional goods, and that includes ASSETS.

        Keep in mind that we are talking about GENERALIZATIONS here. There are always exceptions that one can point to, but simply mentioning them does destroy the value or validity of a mostly accurate generalization.

        You have to establish that the exceptions you are pointing to are substantial enough to invalidate the generalization that is made.

        Note: Even the hallowed Law of Demand is 'merely' a generalization that was not utterly discredited once certain exceptions were identified. It is useful because it is generally true.

  5. #20 by yorksranter on January 9, 2012 - 10:56 pm

    The industrial economics of extreme wealth is an interesting subject. It’s often been observed that a lot of the spending of the rich goes into positional goods, and by definition, these are in fixed supply. More spending on them can only inflate their prices – in so far as more of them are produced, their positional value decreases relatively.

    The quintessential positional good is land. A lot of land is useful in itself, but it is true everywhere that owning x amount of land gives you more positional utility than an equivalent position in cash or securities, and the most sought-after land by area isn’t farmland or building plots near a container terminal or an oil well, it’s billionaires’ row, whose value is entirely positional. Land is the classic case of economic rent, and that’s what I’m driving at.

    Just as rent doesn’t reflect costs of production, but only a monopoly position, the price of positional goods reflects only their positional nature and the income of those competing for them. Let’s now switch to the economics of the firm; if the price of X is dominated by economic rent, an increase in the price is mostly an increase in profit. If profits rise in some sector, capital should be preferentially allocated to it.

    Clearly, you can’t manufacture Hampstead or Palo Alto or the Prinzregentenstrasse, or only with great difficulty and the risk of destroying its positional quality. You can easily manufacture more iPhones, which therefore are gradually becoming less positional. You can manufacture Vertu phones by sticking diamonds on mid-2000s down-ticket Nokias, essentially creating purely positional items. Joseph Schumpeter would of course point out that it is the aim of all enterpreneurship to be able to claim the economic rents of monopoly,

    In order for capital to be reallocated to the positional sector, then, it’s necessary to invent new forms of positional competition, and ideally, ones which escape from the temptation to just be a good product that can be produced on a big scale like iPhones or VW Golfs or my trainers. And indeed, we see a sizeable economy devoted to just that.

    (Schumpeter: one of my favourite economists, an Austrian who wasn’t a total ass-clown and who had a sense of humour.)

    • #21 by Unlearningecon on February 29, 2012 - 7:59 pm

      How have I not read this before? I’m hopeless. Good comment anyway.

  6. #22 by Unlearned on January 12, 2012 - 5:20 pm

    @James Kroeger: I understand your point which works well in a closed economy. What happens when the market for positional goods is global and the top 5% of one country have to compete with others not linked to the same tax rates? Would a tax cut for them impact that country inflation?

    • #23 by James Kroeger on January 14, 2012 - 9:17 am

      Well, it does matter, of course. Steep domestic tax hikes on America’s Top 5% would give their international rivals a boost in purchasing power.

      Generally speaking, this would be a much bigger concern for Belgium’s Top 5% compared to America’s Top 5%, given (1) the percentage of domestically-produced ‘positionals’ that are a part of the world’s total supply, and (2) the large percentage of the world’s total number of rich people who live in America and are subject to its laws.

      Of course, the purchasing power of America’s Top 5% (vis-a-vis foreign billionaires) could be protected to a certain degree if the tax obligations of foreign purchasers of domestically-produced ‘positionals’ were increased (by imposing tariffs, etc.) at the same time that we increase the income-tax rates of America’s Top 5%.

      Ultimately, proponents of steeply-progressive income taxes in America would be able to guarantee America’s Top 5% that, although their purchasing power to buy foreign ‘positionals’ would be compromised, their purchasing power re: all domestically-produced positional goods would be ‘protected’ (by both the marketplace and the government),

      As for their ‘losses’ in global purchasing power, it would be a loss that ALL of America’s Top 5% would suffer equally, which means that—with respect to each other—it would still be true that none of them is worse off.

      It is the ONLY sacrifice that would actually be imposed on them, but it is one that they would all experience equally and it would not affect their rankings within the hierarchy of all disposable incomes within America’s borders.

      Indeed, if they could somehow find a way to be content to consume only domestically-produced (and tariff-protected) positionals, then they wouldn’t lose out at all, would they?

      What kind of ‘suffering’ would THAT impose on the typically multi-millionaire?

      Maybe we can’t do anything about the fact that America’s billionaires will not be able to outbid the billionaires of other countries for THE WORLD’S scarcest positional goods, but should that really matter to us if we can still guarantee that they will continue to occupy the highest rungs on our economic ladder?

      Because I see this concern to be of such minor consequence, I still think it is reasonable to ‘generalize’ that the wealthy would lose ‘nothing’ in terms of purchasing power (only absolutely true in a closed economy), at least as an introductory salvo in economic policy discussions. :)

  7. #24 by chuck roeschen on February 29, 2012 - 7:25 pm

    The one problem I see with your argument is if you look up what it in the CLEWI market basket they are all production items not item of which they are fix amout of like famous paintings So this stat would not show what effect tax rate had on the price of fix suplie luxtury items and there for would repoind to norm suplie and demand incresses and decess in production

    • #25 by Unlearningecon on February 29, 2012 - 7:55 pm

      This is a fair point but they don’t have to have fixed production to gain at least some of their value from being prestigious and only affordable by the richest few, however rich they may be.

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