Krugman is confused about whether inflation or taxation is more contractionary!

Krugman writes:

…a deficit ultimately financed by inflation is just as much of a burden on households as one ultimately financed by ordinary taxes, because inflation is a kind of tax on money holders. From a Ricardian point of view, there’s no difference. …I’m confused – [¡¿]and I hope it’s not because I’m stupid[¡]

Krugman uses a lot of sarcasm and he definitely doesn’t think he is stupid, so he really should use sarcasm marks in that sentence.  But I don’t know why he is confused about the difference between the contractionary effects of taxes and the relatively stimulative effects of inflation.  Taxation is contractionary to different degrees.  Income (& payroll) taxes discourage working and sales taxes  (& VAT & excise taxes) discourage spending.  In contrast, inflation is more stimulative than taxation because, as Krugman says, inflation is like a tax on money holders and this discourages the unproductive hoarding of money and encourages people to lend or spend their hoardings which stimulates production.   That is exactly what is needed during a recession.  Most recessions are caused by hoarding money and a stimulus only works when hoarded money gets loaned out or spent again.

When the US government spends money, that generally increases GDP, but the government has to get the money from somewhere and some sources of revenue are more contractionary than others.  For example, the estate tax is relatively benign during a recession because it only affects estates that are so large that the money is difficult to spend (a problem examined in the story of Brewster’s Millions).  Whereas people who inherit large estates have hoarding tendencies, the government spends the money immediately which stimulates the economy.

But if the government gets its spending money by taxing poor people who spend everything that they get, government spending would have no stimulus effect at all.

But most taxation is at least partially contractionary which is why fiscal stimulus mainly happens via borrowing.  The government borrows money from hoarders and spends it thereby stimulating the economy.  If the government would get spending money by printing it and creating inflation, that would also be more stimulating than taxing people because it is more like borrowing the money.   When printing money creates inflation, that is a bit like borrowing a certain percentage of everyone’s money holdings without paying them any interest.  Krugman’s confusion seems to stem from a version of the Ricardian Equivalence fallacy and he even uses the word ‘Ricardian’ to show that he is using that kind of (fallacious) logic.  That is ironic because he is one of the people who is most consistent in arguing that it is a fallacy.

Posted in Inequality, Macro, Public Finance

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