It May Not Be Our Fault After All

I was heading into work when it finally hit me: I had been thinking about this situation all wrong. And worse, it’s been under my nose the whole time. 

Barry has been questioning the Fed’s capability to squash this inflation problem alone here and here.

My question is this: What if we coupled these unnecessarily high rate hikes with fiscal policy by raising the corporate tax rate?

I understand that Mr. Wonderful, aka Kevin O’Leary, said political gridlock is good. “No more bills. No more spending. No more taxes,” we just need to wait two more years for the last round of fiscal policy to run its course. But, of course, there’s a camp that believes the latest round of fiscal stimulus was the key driver in this inflation problem in the first place. 

So, if you believe the actual cause is from the excess cash in circulation, a tax increase to the real offenders would help take some money out of circulation.

Up to this point, I feel that most of the blame for the current inflation rates has been pointed at us consumers and our “excessive” spending and increasing demand to be paid more. That, in turn, has been causing unsustainable price hikes.

The Fed, which controls monetary policy, has its dual mandate to protect prices and employment. So, ultimately, we know this means that they can only affect one side of the equation: the demand side. Letting the supply side run rampant in the streets. 

“What [the Fed] can control is demand, we can’t really affect supply with our policies…so the question whether we can execute a soft landing or not, it may actually depend on factors that we don’t control” – Fed Chair J. Powell

Now, this is where things get juicy — I perked up when Barry said that the Fed may lack the appropriate tools to address this inflation problem.

Quickly pivoting to where monetary policy does help, the Federal Reserve can react and adjust quickly. Fortunately, they are “insulated from political pressures” and time constraints. This is particularly important when it comes to cases like the build-up in the housing market.

However, it is Congress that controls government spending and tax law. If Congress had a dual mandate similar to the Fed’s, it would probably be to promote sustainable growth and reduce poverty.

Besides, everyone hates tax increases. Therefore, implementing a bill on corporate taxes at a time like this could spend eternity on the ethernet.  

However, what needs to be said more is that the fight against inflation, or at least back to stability, may not solely be an interest rate story but also a fiscal story. In October, The Committee for a Responsible Federal Budget (CRFB) wrote, “Given the severity of the current inflation crisis … both fiscal and monetary policy may be needed.”

Again, I think we should seriously consider raising taxes on corporations to help fight inflation. Here are three reasons why Congress might warrant a corporate tax hike:

1. Corporations are fat with cash. 

Look at corporate cash on hand.

I understand this could be primarily due to low sentiment and higher expectations of a recession ahead. Still, one of the primary reasons wages have been so sticky could be traced back to how corporations didn’t want to go through 2020 again—firing employees to rehire them months later.

“One effective way to prevent corporate power from being channeled into higher prices … would be a temporary excess profits tax”  Josh Bivens

2. Corporate profits and net cash flows are at all-time highs, despite “inflation.”

In addition to corporate cash on hand being as high as it is, corporate profits and net cash flows are at all-time highs.

Josh Bivens, director of research at the Economic Policy Institute, found that “over half of this increase (53.9%) can be attributed to fatter profit margins, with labor costs contribution less than 8% of this increase.” Albeit EPI is a fairly left-leaning organization, the data still stands.

As Barry alludes to, a light has been shed on how not all the price increases can be blamed on higher input costs but “are the result of specific tactics used to create higher profit margins.” Greedflation, as he describes. 

U.S. Corporate Profits

source: tradingeconomics.com

In the June Economic Letter from the Federal Reserve Bank of San Francisco, Adam Shapiro says, “Demand factors are responsible for about a third of the difference [between current 12-month PCE inflation and pre-pandemic inflation levels].”

 

High interest rates also discourage personal and business investment, which in turn slows long-term income and economic growth. Fiscal policy that lowers inflationary pressure allows the Fed to raise rates more slowly and by less. CFRB

3. Higher interest rates are causing the Federal Reserve to lose money.

This has never happened consistently, but the Central Bank is losing money due to these rapid-paced rate hikes. September was the first month the Fed began to dish out more interest than the income it was bringing in from its assets.

“The losses can grow over time if they keep raising short-term interest rates, which it seems like they will, because the mismatch between interest income and interest expense will rise,” Seth Carpenter, a former Fed economist at Morgan Stanley, says.

“The central bank’s operating losses have increased in recent weeks because the interest it is paying banks and money-market funds to keep money at the Fed now exceeds the income it earns on some $8.3 trillion in Treasury and mortgage-backed securities…” – Nick Timiraos

Albeit, it won’t break anything. Due to the Fed’s accounting practices, it can operate at a loss. A “deferred asset” is what they call it.  However, operating at a loss “doesn’t impede the monetary policy that we’re doing, but I do think it poses a communications problem,” Cleveland Fed President Loretta Mester tells us.

“Inflation-reducing fiscal policy reduces the magnitude of needed interest rate hikes, thus reducing the increase in net interest cost.” CRFB

Still, A Long Way to Go

I’m not the only one who shares this line of thinking. Bonnie Hogue, a listener of The Marketplace Podcast, asks, “Why not encourage taxes on luxury items, corporate profits and the like to curb inflation rather than hitting the average American’s ability to buy a house, pay for a car, purchase groceries and the like?” Granted, the car and housing market did go a little too far, still, she’s got a point.

So, what if we raised corporate taxes from 21% to 27% or, at least, brought back a tiered income structure?

Again, the blame for inflation is, so far, being pointed at consumers and our spending. It’s time to look at the whole picture. As of three weeks ago, the market has anchored to the latest CPI print of 7.7%, down from September’s 8.2% reading, as proof that the Fed’s last six hikes are working. And we know that the Inflation Reduction Act wasn’t designed to be an inflation-fighting policy today, or we more than likely would have soon felt its effects after going into action. The CRFB says, “the IRA isn’t going to fix inflation on its own, but having fiscal and monetary policy row in the same direction is an important step forward.”

But, all the reasons to introduce fiscal policy (the right way) are there: Corporations are flush with cash, profits and net cash flow are at all-time highs (despite the inflation we’re trying to bring down), and higher interest rates are causing the Fed to run yet another American deficit. 

I suppose it’s fair to ask, what would be the repercussions of changing the corporate tax rate?

In the short term, it may help curb inflation. But we know that government intervention typically has adverse long-term effects. Garrett Watson and William McBride at The Tax Foundation suggest that an increase to 28% could harm U.S. competitiveness, eliminate hundreds of thousands of jobs, and reduce long-run economic output. You could also argue that because such a proposal would take so long to move through Congress, it may not even be worth it. A change in corporate tax rates also affects business revenue. Once the markets get word of that, we could continue to see more volatile red days. 

Now, I’m by no means a Charleton for team “tax the rich” or anti-big corporations. But what if the Fed is trying to continue inflicting “pain” on an otherwise healthy, recovering economy?

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