Investment in infrastructure, taxes and inflation


On August 23, Jared Bernstein and Ernie Tedeschi, two members of the Presidential Council of Economic Advisers, published a blog post claiming that the Biden administration’s spending program would help keep inflation under control in the long run. Their theoretical argument is solid: in the long run, productivity gains should exert downward pressure on prices. However, the main financing options contradict this framework by reducing productivity growth.

The central point of Bernstein and Tedeschi’s argument is that the infrastructure bill is a supply-side policy that will increase economic productivity. Shifting the supply curve outward means higher production and lower prices. In real terms, this means either an increase in the supply of labor, an increase in capital, or technological improvements. In the case of infrastructure, better roads could reduce vehicle wear and tear, thereby making investments in vehicles (a type of capital) more productive.

Meanwhile, other proponents have argued for infrastructure from a more demand-driven perspective: by increasing government spending, consumers will have more income to spend. When they spend more, the businesses and individuals from whom they buy goods will have more money to consume or invest. This is called the Keynesian multiplier effect. In the context of the infrastructure bill, advocates argue that spending on a variety of services, whether conventional infrastructure or so-called “human infrastructure” programs such as expanded funding of long-term care in Medicaid, would have this effect.

This debate has an important mirror in the economics of fiscal policy. As my former colleague Scott Greenberg described in 2017, there are two theories of tax reform, as described by politicians.

The first theory is the “popular theory”, which is close from the point of view of demand. According to popular theory, tax cuts can stimulate the economy by “putting more money in people’s pockets.” Lowering taxes increases disposable income, leading to more consumption and investment; at the same time, higher taxes reduce disposable income, and therefore consumption and investment. All that matters is the net change in government revenue. In this regard, temporary tax cuts are just as useful as permanent tax cuts because they end up increasing income immediately. And revenue-neutral tax reform, achieved through a combination of tax increases and cuts, will not produce growth because it will not inject more money into the economy.

The second theory is the neoclassical theory, generally understood as the supply point of view. According to the neoclassical theory of tax reform, taxes impact the economy by changing marginal incentives, not by increasing the amount of income available to spend. In other words, the benefit of a lower tax rate is not to increase spending, but to change the returns to labor: with a lower tax rate, the returns to labor and labor. investment are higher, and therefore people and companies choose to work and invest more.

According to neoclassical theory, temporary tax cuts are not useful economic policies because they do not alter long-term returns to labor and investment. At the same time, revenue-neutral tax reform can stimulate economic growth, as some tax bases are more or less sensitive to changes in tax rates. For example, replacing a corporate income tax (an investment tax) with a value added tax (a consumption tax) in a revenue neutral manner would generate economic growth because consumption is much less sensitive to taxation than investment.

As Greenberg wrote in 2017, these theories are not mutually exclusive. Tax changes can influence both supply (by changing marginal incentives) and demand (by changing disposable income). Popular theory is useful at a time when the economy is “below its potential,” such as a recession when demand is depressed. However, when designing a long-term ‘normal’ policy, the neoclassical framework is a better model.

The White House’s case for the infrastructure package is more in line with the neoclassical framework: increasing the capacity and productivity of labor and capital, not reducing demand with higher spending. They should design the tax policies used to finance it along the same lines. For example, if the goal is to stimulate long-term economic growth, increasing the corporate tax rate would be counterproductive, given the sensitivity of private investment to tax changes.

Instead, it would make sense to finance infrastructure with user fees, such as tolls, gasoline tax, or a tax on kilometers driven by vehicles. These sources of finance would have less impact on long-term private investments and, in some cases, would encourage infrastructure investments to target where they will be most productive in terms of use.

The Biden administration has an update on how certain elements of the infrastructure bill could put downward pressure on inflation in the long run. However, the taxes chosen to pay for these investments would offset these effects, reducing investment and productivity growth.

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About Darnell Yu

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