Angry at the investor class? Lower/index their taxes

[Note: The first four paragraphs are an ‘econ for poets’ style background introduction. My idea starts in paragraph five.]

The title is a bit flippant, but my idea is relatively modest. One thing we’re hearing a lot of in the econosphere is that the U.S. would benefit from a more inflationary monetary policy from the Federal Reserve to drag us out of our current economic doldrums. (The reasons why moderate inflation can help a depressed economy include: (1) If firms expect higher prices in the future, they’ll want to ramp up production now to position themselves to profit form that [giving us a nice a supply boost]; (2) If consumers [both individuals and firms] expect higher prices in the future, they’ll want to purchase things now, rather than delay till then [giving us an immediate demand boost];  (3) Higher inflation should make it easier to pay off debts that are owed in nominal terms, accelerating the process of “deleveraging”; and (4) Since wages are sticky in nominal terms, inflation is the only way to allow real wages to fall, which we need to make it easier for firms to retain and hire new employees [which will lower unemployment, which in turn brings a demand boost, etc.].)

Indeed, such a consensus among otherwise ideologically opposed economists has coalesced behind the idea that the U.S. needs higher inflation that this consensus has itself generated a new debate: Why, then, isn’t the Federal Reserve doing the thing that all the outside experts seem to agree it should do? And one explanation that is voiced, most loudly by Paul Krugman, but by others as well, is that the Fed is protecting the interests of, the “rentier class” (the pejorative term for financiers) — i.e., those of us whose primary source of income is the accumulation of dividends and interest payments and capital gains on assets we own. The idea is that our Fed governors spend their days hanging out with and working with financiers and, thus, either subtly absorb their ideologies or are more directly corrupted by their desire to help their pals.

Suppose that it’s true that the Fed is failing to hike inflation due to the influence of the investor class. Next question: Why do investors hate inflation so much? (And, the newsletters that end up in my inbox, forwarded from my finance-world friends, confirm just how intensely many of them hate inflation.) Partly it’s ideological — the finance world has historically aligned itself with political conservatism/libertarianism and conservative/libertarian intellectuals have traditionally been more anxious about the costs of inflation. But surely it’s also partly a matter of self-interest. Inflation would make it easier for you to “deleverage” by paying off your mortgage (provided your mortgage is in nominal terms) because it would mean you owed less real value to the bank — and obviously the bank doesn’t like that, all else equal, for the same reason you do like it. This generalizes — debtors love inflation if their debts are owed in nominal terms, while creditors (their lenders) hate it.

Now, we need to step back and remember something very basic: Inflation is only a good thing when it helps boost real growth in the real economy. It is not a good thing per se. I.e, there’s no point in going from a world with 0% inflation and 0% nominal growth (meaning 0% real growth) to a world with 4% inflation and 4% nominal growth (meaning 0% real growth). It’s only worth inflating at 4% if that will bring you to 5% nominal growth (meaning 1% real growth). So (sorry to belabor the point) this means that the interests of society as a whole are neutral with respect to inflation per se; though society has a positive interest in inflation that boosts real growth. Now, financiers also have an interest in the real growth of the real economy — as the economy as a whole starts doing better, fewer corporations risk defaulting on their bonds (increasing bonds’ real value) and the expected future profits of companies increase (raising their share prices). The key difference is that financiers have a negative interest in inflation per se  — i.e., they prefer the world of 0% inflation and 0% real growth to the world of 4% inflation and 0% real growth (while society as a whole is neutral), and so they are ambivalent about the choice between a world of 0% inflation and 0% real growth versus one with 4% inflation and 1% real growth.

So here’s my idea: If we really think the interests of financiers are the major barrier to sensible monetary policy, then what we need to do is to bring their interests in inflation into alignment with those of society as a whole. This, very simply, means making the investor class’s interests neutral with respect to inflation per se, and keeping them positive with respect to growth. The way this could happen on the bond side is if more, ideally all, bonds were indexed to inflation. Now, the government obviously can’t just mandate that all bonds issues be inflation-indexed. But we could use a variety of tax incentives to encourage it; if, as a result, the vast majority of bonds were indexed to inflation, investors would support inflation that actually boosted growth, because that would mean bring lower default risk without any erosion of the bonds’ real value. (The disadvantage of this is that we could no longer use inflationary monetary policy to help debtors deleverage — and I’m curious to learn from others how serious this disadvantage is.) But we would also — and here’s something that I haven’t seen talked about at all — need to change the tax treatment of capital gains. Right now, in my understanding, we are taxed on the nominal value of our capital gains (i.e., gains we make from increases in the prices of stocks we hold, as opposed to what we earn from their dividends). This gives stock-holders a strong bias against inflation. Consider the example above, in which we have to choose between a world with no inflation and no growth, versus a world with 5% nominal growth and 4% inflation and 1% growth. Suppose that in both worlds, equity portfolios track the nominal growth of the economy. Well, if capital gains are taxed above 20%, in nominal terms, then stockholders would actually prefer the world with no growth to the world with 1% growth. (I’ll do the math for you: If your stock portfolio gains 5%, but more than 20% of that is taxed away, you’re left with less than a 4% nominal gain — which is a loss in real terms, when inflation is 4%.) Now, obviously we can change the growth, inflation, and tax numbers I selected. According to the number we choose, there are many worlds in which stockholders still prefer growth-boosting inflation to none. (In the example I chose, when the capital gains tax is lower than 20%, stockholders prefer the world with 4% inflation and 1% real growth.) But it is always, necessarily, the case that the taxation of capital gains in nominal terms gives stockholders a bias against inflation per se, whereas (once again) society is neutral with respect to inflation per se. Were it not for this tax treatment — that is, if capital gains were taxed in real, inflation-adjusted terms — stockholders would always have an unambiguous interest in growth-boosting inflation, and their interests would be fully aligned with society’s as a whole.

Now, one obvious objection to my idea is that it’s simply irrelevant — this tax change wouldn’t be significant enough to move the meter for investors at all. Removing the anti-inflationary bias in the taxation of capital gains wouldn’t come close to compensating bond-holders for how inflation would erode the real value of their fixed-income investments. But is this necessarily correct? Since investors hold both bonds and stocks, the former mostly for security; since stocks are the major source of growth and profit in investors’ portfolios; and since the easing of corporations’ nominal debt obligations should be reflected in higher future cash flows, hence higher share prices — is it not, then, plausible that changing the tax treatment could be a major step toward aligning financiers’ interests in inflation with those of society? And if not, would indexing more and more bonds to inflation have this effect? If so, how can we speed that process?

It seems to me that if financiers are currently blocking policy changes that would be in the interest of society as a whole, the thing to do is to use the political process to bring their incentives in line with ours (rather than just rage against the oligarchy), and then let their rapacious self-interest work to our benefit.

***

(N.B. I don’t claim any expertise on this. It really is just a stab–concordant with the function and purpose of this blog. I think it’s very probably that these ideas are (1) obviously wrong for some some obvious, stupid reason I am blanking on, or (2) extremely obvious to some people, having been advocated dozens of times by others.)

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One thought on “Angry at the investor class? Lower/index their taxes

  1. I’ve misplaced your email address, so I’m going to leave this long comment here–hope you don’t mind.

    Dear Matthew,

    Your tweet asked what I, as an “inflation booster,” think about your post. The first thing I think is that “inflation booster” is not a label I’d embrace. I prefer higher inflation to subpar nominal income growth; but the policy I favor is stable nominal-income growth, and I would like as much of that nominal growth to take the form of real economic growth as possible.

    For the rest of this note I’ll just go through your paragraphs in order. Note that the four beneficial effects of inflation you note in your first paragraph would all accrue from higher nominal income, regardless of what proportion of that higher income comes from inflation. (Even the lower labor cost: In context what matters here is wages divided by NGDP.)

    I am not sure I buy the argument about investors (which you have accurately reproduced) in paragraphs 2-3. One of the market-monetarist bloggers, I forget which one, has noted that in recent years stocks and inflation expectations have been positively correlated after having been negatively correlated for many years. And I suspect that a bigger factor inhibiting central banks is the unpopularity of inflation. People don’t distinguish between demand-side and supply-side inflation and assume that more inflation would reduce living standards. This is incidentally another practical advantage of nominal income targeting: It would go over easier.

    I would amend some of the statements in paragraph 4. In the long run it’s true that a world with 4% inflation and 0% real growth is not preferable to one with 0% inflation and 0% real growth. (The latter I’d say is slightly preferable due to menu costs and the like.) In the short run however the former might be preferable as a way of returning to a sustainable and predictable trend of nominal income growth. (In the real world, I think any time you have subpar nominal growth you are likely to generate a significant amount of real growth by returning toward trend.)

    I am not sure about the question of encouraging bonds to be indexed to inflation. I quite agree with indexing capital gains taxes for inflation, both because it would change political incentives in the way you suggest, however important those incentives may be, and because it would substantially reduce the costs of inflation.

    Best,

    Ramesh

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