Wadhwani's "100% inflation tax"

Another flawed case for soft price and wage controls

Back to 1970s thinking on inflation…

Dear The War On Prices subscribers,

The parade of misguided solutions to inflation seems never-ending. Just yesterday, the Financial Times published an op-ed by Sushil Wadhwani, a former member of the Monetary Policy Committee and a current member of the UK Chancellor Jeremy Hunt’s Economic Advisory Council. Remarkably, Wadhwani advocated for a price controls-like system to quell the country’s high inflation expectations.

Here’s his central idea:

The government might also consider a measure that would directly operate to bring inflation expectations down without necessitating a rise in unemployment. This would be a tax on inflation. For example, they might announce a baseline reference level of the growth of average hourly earnings over the next year of 3 per cent. They could then implement a tax whereby each firm who grants a wage increase above 3 per cent would be required to pay a 100 per cent tax on the excess. 

Concretely, if a firm awards a wage increase of 5 per cent, it would cost it 7 per cent as it would have to pay extra tax equivalent to the difference between the wage increase granted and the baseline reference level…

… When looking for a tax on inflation one could, in principle, introduce a “tax on excess price increases” rather than wage increases. Society already believes that it is appropriate to tax activities where the individual or firm does not fully take the adverse impact on others into account. Tobacco consumption and polluting actions are both examples of this. When a firm increases the price on a good it sells, it does not fully allow for the economy-wide inflationary effect and so an inflation tax seems desirable. 

Where to start?

A 100 percent tax on “excess” wages or prices above the “baseline reference level” effectively amounts to a soft form of price control. The aim, clearly, is to create a ceiling each year such that any individual price cannot increase by more than 3 percent without a severe penalty.

Let’s presume this was rolled out as a comprehensive system across the economy. Official measured wage or price growth would certainly fall, but such a system would severely distort the workings of the economy, not least through creating significant shortages of certain products or types of workers. What's worse, as the policy does nothing to address the root monetary causes of inflation, it would create massive incentives for companies to find alternative means of raising prices or wages, while setting the stage for a sudden resurgence of official inflation once the policy was inevitably lifted.

A Tax on Relative Price Changes

The fatal flaw in this policy is its suppression of the market price system that helps efficiently allocate goods and services.

While the UK's official inflation target aims for a 2 percent increase in the price level each year, it's essential to understand that, even when hit, this 2 percent rate is a weighted average of changes to hundreds of thousands of individual prices. Some prices may still rise by 5 percent, 10 percent, or even 20 percent, while others fall by 5 percent, 10 percent, or even 20 percent.

That’s because individual product price changes (or indeed wage changes) across a year are not just determined by the underlying rate of inflation (a monetary phenomenon reflecting the value of money), but also by supply and demand conditions for particular goods and services. Once all prices have adjusted to inflation, a price change for say, a TV, is the sum of inflation plus the relative price change of the TV in question compared to other goods and services.

The problem with the policy is clear: imposing a 100 percent tax on price or wage rises above 3 percent deters price increases beyond this indiscriminately, whether caused by a monetary inflation or product-specific factors, like a surge in demand or a supply-shock. The policy thus suppresses market-driven relative price changes too. Take, for example, the surge in demand for face masks during the pandemic. If such a policy had applied then, the 100 percent tax would have deterred the necessary relative price increase dictated by market forces, resulting in even larger facemask shortages. The price signal for producers to supply more to meet demand would have been suppressed.

As such, calling Wadhwani’s proposal an “inflation tax” is a misnomer. It will be a tax that will deter the likelihood of thousands and thousands of relative price changes that would otherwise have occurred too. That’s important, because relative price changes are what provide the signals and incentives that make a market economy work effectively in reallocating resources in ever-changing conditions. By snuffing out many of these price signals, such a tax would create all sorts of economic dysfunction.

The Effects of Price and Wage Controls

For goods that would have otherwise seen sharp price rises, the primary result will be shortages - as the tax creates a soft price cap at which the quantity demanded of the good exceeds the quantity supplied. This is why when comprehensive systems of price and wage controls have been decreed during wartime, rationing typically accompanies them.

Such shortages themselves could create downstream problems: imagine if petrol prices being constrained resulted in shortages of fuel, leading to certain deliveries then not being made. This would reduce the supply of other consumer goods, which would ordinarily raise prices. But the tax would deter these adjustments too. Dis-coordination caused by the absence of price signals would develop across the economy.

In reality, firms in markets affected will likely seek other ways to conceal price increases that circumvent the tax, whether by reducing the quality of the product, eliminating discounts, or stripping away complementary services like free returns. In the case of workers and wages, they might look to find new ways to remunerate employees outside of the controls, perhaps through increasing non-wage benefits, one-off signing on fees or bonuses, or giving workers fake promotions to notionally different jobs to avoid the controls.

I’ve written before about these sorts of side-effects in the U.S. under harder price controls during WW2. Rationing ensued, food came mixed with cheaper products, consumers had to search extensively for certain goods, and employers started paying workers more in healthcare benefits to circumvent wage controls (a practice that stuck). With a 100 percent tax on price increases beyond 3 percent, we’d see many of these effects too.

Wadhwani acknowledges “the administrative difficulties that come with any new tax and the inevitable problems of implementing such a scheme.” This is a severe understatement. In WW2 America it took more than 64,500 bureaucrats backed by over 100,000 volunteers to police completely fixed prices.

With such a policy, some buyers will be willing to pay more than the suppressed price, and some sellers will risk breaking the law to make a larger profit by selling above it. Rampant black markets will therefore develop. To get a sense of the scale of illicit sales in early 1940s America, historian Hugh Rockoff has shown that evasion generated “nearly as many civil [court] cases as the rest of the federal statutes combined.”

These effects, combined, mean that price controls (hard or soft) result in official measures of inflation becoming an unreliable guide to what is truly happening to underlying prices. That is: actual inflation tends to get understated in government statistics during the period when such policies are enforced. Furthermore, because such controls fail to address the monetary factors driving inflation, the policy’s eventual removal tends to result in a surge in official inflation as economic reality asserts itself once more.

Inflation Expectations

Wadhwani's central argument for such a policy revolves around the necessity of anchoring inflation expectations. He’s worried that the UK’s inflation expectations are too high, and that this will feed through into higher inflation today, presumably through a higher velocity of money.

However, it's crucial to recognize that in the long run, inflation and inflation expectations tend to converge. To lower inflation expectations, one must credibly commit to lowering actual inflation. As we've explored, price controls or similar taxes don't effectively achieve this; they merely obscure or suppress the underlying inflationary pressures. Consequently, taming inflation necessitates the Bank of England's commitment to a monetary policy consistent with its desired inflation expectations.

Historically, some economists have suggested that price controls or taxes like this could serve as useful transitionary tools during the shift from high to low inflation. The idea is that workers and suppliers might not fully grasp the extent to which policy is already tightening, causing their inflation expectations to be “too high” relative to the Bank of England’s policies. If wage demands are too high, workers might price themselves out of jobs, causing unemployment. In this context, price controls to reduce expectations “may limit these temporary costs of disinflation,” according to Rockoff.

Yet he concludes that even this argument is weak, because in reality the public tends to see such controls as an alternative to tightening monetary policy. Richard Nixon’s 1971 price controls, for example “were justified on the grounds that they were being used to “buy time” while more fundamental cures for inflation were put in place, monetary policy continued to be expansionary, perhaps even more so than before.” Wadhwani’s op-ed even says: “The BoE could reward such a policy by ensuring that interest rates are lower than they might otherwise have been.”

In essence, while Wadhwani's proposal is justified as addressing inflation expectations, it could inadvertently encourage a looser monetary policy stance, ultimately exacerbating longer-term inflation, even aside from the host of economic distortions and complications such a policy would likely bring.

The resurgence of 1970s-style thinking in response to this inflationary surge remains nothing short of astonishing. But then, in this case that appears to be the desired model. Wadhwani claims [my emphasis] “As a policy prescription, it [the 100% inflation tax] has a distinguished pedigree dating back to the early 1970s.”