Unlocking the Economic Potential: Why it’s Vital for the UK to Implement Inflation Taxation

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The writer is Chief Investment Officer at PGIM Wadhwani and on the Chancellor’s Economic Advisory Council. This article is written in a personal capacity.

In recent weeks, there has been a collective sigh of relief regarding the decline in the headline rate of inflation in the UK. However, it’s crucial to note that wage growth and core inflation still exceed the desired level for achieving a 2 per cent inflation target. Despite the decrease in price inflation, the Bank of England’s Decision Maker Panel survey reveals that the expected wage growth and price inflation for the next year remain above 5 per cent.

It seems that we are witnessing a “tit-for-tat” scenario where workers strive to maintain their living standards while companies aim to safeguard their profit margins. Consequently, this behavior has contributed to higher embedded inflation expectations. To curb the anticipation of rising prices and wages among firms and workers, we could contemplate leaving the responsibility solely to the BoE, even though they might hesitate to reduce interest rates as unemployment rates rise.

During my appearance before the Treasury select committee in July, they inquired about how the government can assist the BoE in lowering inflation while keeping unemployment at a minimum. At a time when labor shortages have been associated with high wage growth, increasing the labor supply would undeniably be beneficial. Furthermore, it would be advantageous if the government solidifies its commitment to maintaining the inflation target unchanged until the end of this parliament by extending it to the next term if re-elected (the opposition should make the same commitment).

The government could also consider implementing a measure that directly reduces inflation expectations without causing unemployment to rise. One such measure could be an inflation tax. For instance, they could establish a baseline reference level of 3 per cent growth in average hourly earnings over the next year. Subsequently, they could introduce a tax where each firm granting a wage increase surpassing 3 per cent would face a 100 per cent tax on the excess amount.

Concretely, if a company grants a 5 per cent wage increase, it would cost them 7 per cent as they would have to pay extra taxes equivalent to the difference between the granted wage increase and the baseline reference level.

An announcement of this nature is highly likely to reduce inflation expectations, effectively bringing down wage and price inflation without necessitating an increase in the unemployment rate. The BoE could incentivize such a policy by ensuring that interest rates remain lower than they would have otherwise been. It’s worth noting that this tax is not designed to tighten fiscal policy – the revenue could be redistributed, for example, as a per-worker subsidy.

When considering a tax on inflation, one could theoretically introduce a “tax on excess price increases” rather than wage increases. Society already acknowledges the appropriateness of taxing activities where individuals or companies fail to consider the adverse impact on others. Examples include tobacco consumption and polluting actions. When a company raises the price of a product it sells, it fails to fully account for the economy-wide inflationary effect, making an inflation tax desirable.

The appropriate tax rate would fluctuate over time. It could potentially be much lower, even close to zero, when inflation expectations subside. This way, we could minimize any associated distortions. Furthermore, if the measure is always revenue-neutral and has no direct fiscal implications, we could even consider granting the BoE the authority to determine the appropriate rate as an additional policy tool.

Of course, any new tax entails administrative difficulties and inevitable challenges in implementation. However, a government that successfully implemented the more complex furlough scheme during a lockdown should not be deterred by initial obstacles. As a policy solution, the notion of an inflation tax has a distinguished history dating back to the early 1970s, and previous proponents have suggested that it could be incorporated into the standard PAYE process. There is evidence indicating that an inflation tax played a role in the transition of certain formerly Soviet economies to market economies, while the IMF has recently conducted research recommending that it deserves further attention.

With inflation expectations disrupted and the potential for future supply shocks, it is time to provide greater support to the BoE in their pursuit of low and stable inflation. A tax on inflation, combined with the use of interest rates as a tool, should enhance their chances of success.