Optimal Taxation of Inflation
What this paper finds — and why it matters
This paper analyzes the effectiveness of a tax on inflation policy (TIP)—a fiscal instrument that would require firms to pay a tax proportional to the increase in their prices—as a complement to conventional monetary policy in a New Keynesian framework with multiple sources of inflation. The central result is that combining TIP with conventional monetary policy can implement the first-best allocation in which inflation is zero and the output gap is closed at all times under any path of shocks. Policy instruments should completely specialize: monetary policy should track the neutral rate of interest (addressing demand and productivity shocks by keeping output at its efficient level), while TIP should rise with markup and inflation expectation shocks. Unlike the 1970s view that saw TIP as a substitute for monetary policy, TIP is shown to be a complement. TIP corrects an externality in firms’ pricing decisions without exacerbating relative price distortions. Calibrated simulations suggest a reasonably calibrated TIP could lower the variance of inflation by 45% and of output by 44% relative to a Taylor-rule-only regime.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. What is TIP and what externality does it correct?
TIP (tax on inflation policy) is a fiscal instrument that requires firms to pay a tax proportional to the increase in their prices, and it corrects an externality in firms’ pricing decisions created by markup and inflation expectation shocks that cause private and social returns to price increases to diverge. When shocks to markups or inflation expectations create strategic price-setting incentives, firms’ individually optimal price increases exceed the socially optimal level; TIP re-aligns private with social valuations by making price increases costly. The proposal originated with Wallich and Weintraub (1971) and was widely discussed in the 1970s, but was absent from recent policy discourse until this paper revived it in a microfounded framework.
Q2. What is the complete-specialization result?
Monetary policy and TIP should completely specialize: monetary policy should track the neutral rate of interest—varying with aggregate demand and productivity shocks to keep output at its efficient level—while TIP should respond to markup and inflation expectation shocks, addressing the externalities those shocks create in firms’ pricing. This sharp division of labor arises because each instrument is best suited to a different source of inflation: monetary policy’s power lies in aggregate demand management, while TIP directly corrects the pricing externality. Under complete specialization, the first-best allocation with zero inflation and zero output gap can be implemented under any shock path.
Q3. Does TIP exacerbate relative price distortions?
In contrast with price controls, TIP is found not to exacerbate distortions in relative prices, because TIP is linear in price increases and symmetric across firms, so it does not prevent efficient relative price adjustments across sectors. In an extension with sector-specific TFP shocks requiring relative price adjustments, the paper shows analytically (under some conditions) and numerically (more generally) that TIP has no effect on relative prices across sectors. Firms that face negative productivity shocks moderate their price increases, while firms that otherwise would not change prices are incentivized to decrease them to earn a subsidy, keeping the relative price structure broadly intact.
Q4. How large are the stabilization gains from TIP?
Calibrated simulations show that the stabilization gains from using TIP alongside a Taylor rule are substantial: a reasonably calibrated TIP could lower the variance of inflation by 45% and of output by 44%, with gains especially large for markup and inflation expectation shocks. Welfare gains from TIP are smaller for TFP and demand shocks because the reduction in inflation volatility is partially offset by higher output gap volatility. These quantitative results are based on a calibrated New Keynesian model and are presented as illustrative magnitudes rather than precise empirical estimates.
Q5. What equivalent instruments does the paper consider?
The paper shows a formal equivalence between TIP, production/payroll subsidies (the more traditional tools for markup distortions), a feebate (combining a tax on price increases with a rebate to all firms), and a market for inflation permits. Subsidies can also implement the first best but entail large and persistent fiscal costs; the feebate provides incentives without increasing the average tax burden; the market for inflation permits (proposed by Lerner, 1978) minimizes fiscal authority involvement. TIP is distinguished from these alternatives by its directness and its non-distortionary effect on relative prices.
Key concepts
tax on inflation policy (TIP) : a fiscal instrument requiring firms to pay a tax proportional to the increase in their prices, designed to internalize the externality that individual firms’ price increases impose on aggregate inflation; first proposed by Wallich and Weintraub (1971). inflation externality : the divergence between private and social returns to a firm’s price increase created by markup or inflation expectation shocks; private returns include the markup gain, while social costs include the contribution to aggregate inflation, which TIP is designed to correct. complete specialization : the optimal policy regime in which monetary policy exclusively addresses demand and productivity shocks (by tracking the neutral rate) while TIP exclusively addresses markup and inflation expectation shocks; enables the first-best allocation. feebate : an instrument equivalent to TIP that combines a tax on price increases with a rebate distributed to all firms, providing anti-inflation incentives without increasing the average firm tax burden.