"Would a massive tax break increase inflation?" I saw this question on Yahoo Answers. This is a good general question because there is a lot of discussion concerning this issue.
Yes, a massive tax cut coupled with deficit spending would result in a small increase in (price levels) inflation with a caveat. The caveat is that the change in price level depends upon whether the government borrows to finance the deficit or it creates money. If money creation is the means of financing the deficit then yes a tax cut could increase inflation dramatically. A tax cut coupled with no deficit spending would no impact on inflation.
Fiscal policy is the use of government taxation and expenditure policies for the purpose of achieving macroeconomic goals.1
Inflation is an increase in the average level of prices of goods and services. Inflation can either be due to an increase in price level caused by excessive aggregate demand (demand-pull inflation) or due to an increase in the price level caused by an increase in the cost of production [supply-side] (cost-push inflation). In the case of demand-pull inflation the Aggregate Demand (AD) curve would shift rightward from AD0 to AD1 establishing a new equilibrium point that has shifted upward along the Aggregate Supply curve from equilibrium point E0 to E1 that would represent a higher equilibrium price with a higher level of output. In the case of cost-push inflation, the Aggregate Supply (AS) curve would shift leftward from AS0 to AS1 establishing a new equilibrium point that has shifted upward along the Aggregate Demand curve from equilibrium point E0 to E1 that would represent a higher equilibrium price with a lower level of output (as price increased demand decreased on the AD curve).2
Would a massive tax cut bring inflation? All things remaining the same, in the short run if the tax cut is coupled with a budget deficit, the budget deficit should lead to an increase in demand and thus in output. In the long run, changes in fiscal policy have no effect on output. The continuing need to borrow may increase long-term interest rates. The increase in interest rates offset the direct expansionary effect of lower taxes. The “crowding out” effect of government borrowing requiring a larger share of monies available for investment from the capital markets would reduce capital available for investment in the private sector. This lessens the opportunity for the growth of output in the private sector. This lowers output in the long run. 3
Deficit spending impact on demand is less than one would anticipate because expectations concerning future tax increases have changed. People should save more in anticipation of higher taxes in the future.4 This saving leads to a reduction in consumption leading to a decrease in demand over time.
The net effect of an increase in government deficits financed by borrowing due to a tax cut in the short run is: 1. Increase in output, 2. Small increase in price level, and 3. increase in interest rates. The net effect of an increase in government deficits due to a tax cut in the long run is: 1. No impact on output (return to normal level), 2. Small increase in price level, and 3. Increase in interest rates.
Money creation as the means of financing could actually lead to hyper inflation. Money creation is really more of a monetary policy issue.
My though is that reducing government spending wisely (we need services the government provides) coupled with decreases in taxes would be good for our economy and way of life.
Note 1: Bradley R. Schiller; The Economy Today 4th Edition, 1989; Chapter 7, p 149
2: Schiller, Chapter 7, p 170
3: Blanchard, Oliver; Macroeconomics, 1997, Chapter 29, p 588, 589
4: Blanchard, Chapter 29, p 589
