Inflation

Stabilisation through subsidisation

R.C. BeIlan

R. C. BeIlan, Professor of Economics at the University of Manitoba, is on sabbatical leave In London researching the inflation problem in the UK and Western Europe. The Spectator publishes his paper as a controversial contribution to debate on the crucial issue of the day.

A settled conviction appears to have quite generally developed that there are only two possible strategies for dealing with inflation — fiscal-monetary restraint and price-income control. And since it is now widely conceded that fiscal-monetary restraint is not politically possible — certainly not to the extent that would be necessary — price-income control seems to many people to be the only means whereby the government might prevent a price explosion. But the attempt at income control has already brought one massive, paralysing confrontation between government and defiant workers — and would be likely to bring more. Such travail may not be necessary; there is a third possible strategy for keeping prices down, one which admittedly contains drawbacks and hazards but could prove to be far preferable to what has been attempted thus far. The strategy is a very simple one: subsidisation by the government on such a scale as to keep the aggregate of all prices constant, whatever increase occurred in the aggregate of all firms' production costs. The subsidy could be given in a manner which uniformly assisted all firms and therefore did not affect their competitive relationships or reduce the pressure on each one to keep its costs to a minimum; e.g. a subsidy might be given to all firms in the form of a percentage of sales — a negative VAT — or as a cash grant per employee — a nationwide Regional Employment Premium. Individual prices would still shift about in response to market forces but the price level would remain steady. Firms which experienced very large cost increases would, despite the subsidy, have to raise their prices; firms which experienced only slight cost increases or none at all would, thanks to the subsidy, reduce their prices — competitive pressure would see to that. If the total paid out in subsidy were of exactly the right magnitude, increases in the prices of some products would be exactly offset by decreases in the prices of others. The average of prices — the price level — would be stable.

Proposals for much more modest programmes of subsidisation have been dismissed as impractical because of the increase in taxation that they would require. The stock view is that large scale subsidisation simply cannot be considered because it would require intolerably high rates of taxation. There is no more to be said. As a strategy for stabilising prices subsidisation'is in several critical respects enormously superior to the alternatives of fiscal-monetary restraint and price-income control. It is true that subsidies carry the very great disadvantage of having to be paid for but it should not be conceded as a matter of course that they therefore cannot be considered. A careful assessment should be made of all the benefits that would accrue from a programme of subsidisation and of all the costs that would be involved. It might well turn out that the benefit exceeded the cost — and by a substantial margin.

The dazzling attraction of a programme of subsidisation to keep prices down is that it is free of absolutely intolerable defects in the alternative anti-inflation strategies. Fiscalmonetary restraints in effect apply brakes to the national economy, giving rise to large scale unemployment—and with little discernible effect on prices. When applied in recent years such restraints certainly slowed down the economy; it is much less certain that they slowed down the rate of inflation. In principle strictly enforced price-income controls could prevent inflation but in fact they cannot be strictly enforced and, even when feebly administered, are tolerable only for short periods of time. Necessarily they must take the form of rules or guidelines which are uniformly applied across the entire economy; almost inevitably there will be persons in strategic occupations who adamantly insist that they are a special case and should be exempted from the general regulation. If this demand is refused they proceed to cripple the economy; if it is granted a stampede of like claimants

promptly follows that shatters the fragile control apparatus. If, miraculously, the cor, trols are not liquidated by erosion or des' troyed in a head-on clash, their retention over a lengthy period is likely to cause gross die,' tortion in the distribution of the countrY5 productive capacity. Firms which, by violating the 'letter or al. least the spirit of the law, manage to max' employment in their establishments More rewarding, will be able to attract staff. Firra5, which cannot or will not evade the contr° regulations will lose staff. The prime deter minant of whether a firm expands or co5. tracts will not be the public's desire for it5 product but the firm's capacity and will evade the control regulations. The result WI': be cruelly ironic. Public services, nationaliset industries, and municipal enterprises will al virtuously abide by the government'i regulations regarding pay — and cot sequently have their staffs melt awaY precisely those functions which were deemee to be so vital to the national interest that the could not be left in private hands will now tl; inadequately performed because of star shortages. The economy becomes afflicted a creeping paralysis as strategic goods arl‘, services are produced in ever diminishint amount. A programme of stabilising prices by sub. sidisation is tree ot these crippling adversitieSi Whereas the intent of controls is to preveel: increases in cost, subsidies offset increases al cost. The difference is of the profoundest SI nificance. Because they are not prohibitorY In character subsidies do not virtually assure their own destruction by rousing angrY challenges; they do not substitute bureaucra' tic decisions for private judgement and privated negotiation; they do not reward evasion arl penalise compliance; they do not interfer,e with desirable redeployments of the nations,' productive capacity. A subsidy allows cost 0,1 production to move upward in unfettereo, response to the changing balance of mark el forces but insulates selling price from cost ol production. In effect the higher cost is nt paid partly by the purchaser and partly by tIl taxpayer from whom comes the money for the subsidy. The arrangement is not of course ideal ill every respect. It is unjust to compel taxpayet' to contribute toward the cost of goods 011 tamed by others and the higher rate of taxa. tion now being levied will have disincentive, effects that lead to curtailment of the natiotla; output. A tax on income is after all a kind penalty imposed on productive effort; eac,!, addition to the rate of taxation enlarges it deterrent effect,

This is an imperfect world. No policy that 15.1 attempts somehow to regulate the behaviour of millions of individuals in a society corn' nutted to the principle of individual liberty Can be free of anomalies, inequities, deficieni cies. A policy must be judged as workable if

its drawbicks are of tolerable dimensions; it I ' should be reckoned as superior to the availa nie alternatives if the margin by which its 5 benefits exceed its burdens is larger than the Corresponding margin yielded by those alter natives. Judged by these workaday criteria an ' anti-inflation programme of subsidisation ap 5 Pears highly promising, particularly if it is 0 applied, as it can be, in a manner which would Minimise some of its adverse consequences. di t The inequity of making taxpayers conribute to the cost of goods purchased by Others could be substantially reduced by im

,! PoSing a tax not on income but on increases

,ifl income. An increase in the ordinary income

X that was levied to obtain the funds needed or subsidies could be grossly unfair and

e, Might defeat the essential purpose of the rsti-inflation programme. Such a programme

adopted, after all, in order to protect People's purchasing power — to ensure that , they do not find themselves unable to buy as

' Much goods and services as heretofore. But if

across-the-board increase were introduced In the income tax those people who had obtained little or no increase in money income Would be left with smaller post-tax incomes than they had had before. , If, however, the money required were obiained through a tax on increases in income no one would, because of government policy, stiffer a reduction in income below its Previous level. The funds needed for the Programme would come only from people Whose incomes were larger than before and Would take away only part of their increases; a Certain rough justice would be achieved in that most of these increases in income would have been responsible for the higher costs Which made an anti-inflation programme necessary.

The tax on increases in income could be tevied in either of two ways. Each income earner (with appropriate exceptions) could be „required to pay a special levy on the amount oY which his current year income exceeded previous year income, or an across-the-board Increase in tax rates might be introduced but With the proviso that it must not cause raYone's post-tpx income to be lower than it

d been in previous years. Either procedure Would ensure that no one would, because of the subsidisation programme, suffer a decline In real income below its previous level.

Both procedures would in a general way arrange that the cost of preventing inflation Was borne mostly by the people who were responsible for the inflationary pressure. Adnlittedly the justice would be pretty rough. Some people would have gained their Increases in income for superior effort, as levels for working harder, longer, at higher teVels of skill, with a greater burden of resPonsibility — and would be taxed equally with Persons who were obtaining larger incomes for doing exactly what they had done before. 'he inequity would simply have to be accePted; it probably would be too difficult adIninistratively to prevent it. (It should be noted that this kind of inequity would not be something totally new; it exists under present tax arrangements which do not distinguish between earnings received for superior performance and earnings which are larger :Payments for the same thing. A tax on Increases in income wbuld not introduce a new inequity; it would merely aggravate an existing one.)

Another inequity might occur. Taxation applied to increases in income would not reach capital gains — whose recipients certainly should contribute to the cost of an anti-inflation programme. However, if the Programme were successful capital gains would be far smaller than they are today. For the major source of present day capital gains is the prospect of continuing inflation. The capital values of physical properties have been soaring because of the promise that they will yield ever-increasing returns in a future of escalating price levels. Removal of the prospect of inflation would end that promise and would correspondingly deflate the value of physical properties.

Even if its inequities could be swalloWed a programme of stabilisation through subsidisation would be subject to a number of serious objections. If the subsidies were applied only to a specific group of goods their relative 'cheapness might encourage excessive and wasteful use. This difficulty would of course, be minimised if (a) the only goods subsidised were necessities the demand for which was highly inelastic (e.g. bread) so that a reduced price did not in fact induce a great increase in the amount purchased or (b) if subsidies were paid across the entire spectrum of national output — or given toward strategic goods and services whose prices were part of the cost of practically all products.

An increase in the rate of taxation on incremental income would aggravate the disincentive effect inherent in present tax arrangements. A large number of people might deliberately refrain from putting forward the full effort of which they were capable; national output might suffer severely. This certainly is a possibility but it should be weighed with care. It may indeed be that some people will be deterred from putting in more hours or applying more physical energy; it is most unlikely that many people who have the opportunity of applying greater skill or holding a position of greater authority will refrain simply because of the high tax levied on any increase in earnings. And it is practically certain that people in executive positions will do the best they can regardless of the rate of income tax; the company director who slacks off because additional effort would bring him little additional income is unlikely to remain a company director for very long. In short, higher income taxes may indeed exercise deterrence in respect of the quantity of effort that people apply to their work; it is unlikely to exercise deterrence in respect of the quality ot the effort that they apply. And, over the long pull, improvement in the quality a industrial ettort is likely to be a far more important determinant of the economic growth rate.

Another objection is that once everybody knew that an increase in income was to be subject to a high rate of tax they would insist on much larger pay increases in order to realise a preconceived net gain. In such case wages and production costs would keep spiralling upward and it would be necessary to keep increasing the amounts being paid in subsidy and collected in taxation. Normal market forces would eventually become practically irrelevant; prices would depend almost entirely on the size of the subsidies being provided and incomes would depend primarily on the amount of tax levied. The danger certainly exists but there are reasonable grounds for confidence that this kind of spiral would not occur.

For one thing, the largest portion of current wage demands reflects the anticipated rate of inflation. If indeed the price level were firmly stabilised — as it could be if large enough subsidies were paid — wage demands would unquestionably relapse from their present bloated levels. Secondly, while workers may indeed demand very large wage increases it does not follow that they will automatically get all they demand. Firms do not blithely give workers everything they ask for today and, if the price level were reliably stable, would resist inordinate demands far more determinedly than they do now. Whereas at present an employer who grants a large wage increase can assume that the general inflation will soon swallow up the effect on his selling price, once the price level promises to be steady he cannot expect such deliverance from submission to excessive demands.

(It should not be forgotten too that the current programme of price-income control which permits large annual increases, is already giving rise to spiralling advance of prices and incomes, along its own route. Because prices are rising rapidly workers are naturally insisting on wage increases of at least corresponding magnitude; costs of production are thereby being pushed up and prices will soon have to rise again. It is a moot point whether in a regime of stable prices, increases in income tax would provoke larger wage demands than those being provoked now by rises in the price level.) A programme of subsidisation to offset increases in costs of production and financed by taxes levied on increases in income would , certainly require a good deal of administrative arrangement. However, it would involve nothing of a sort that is not being done already. The government pays out a variety of subsidies now and taxes incomes; there is no reason to worry that increases in the scale and range of subsidisation coupled with increases in the tax imposed on year to year increments to income would produce overwhelming administrative problems.

Finally, the programme would be marked by a glaring omission. It would not effectively counter inflation of external origin, i.e. a rise in import prices caused either by an increase in world prices or by a devaluation of the pound. But the plain fact is that no national programme can effectively counter externally originating inflation. Domestic inflation is due to increase in the level of payments made by Britons to Britons; the government can aid the prospective victims of higher production costs, using funds obtained through taxation of the recipients.of those higher payments. When external prices rise, however, there are no British beneficiaries; all Britons are victims and the government cannot tax the foreigners who are now receiving larger payments for whatever they sell in the UK. The government might indeed subsidise imports in order to keep their prices down on the British market, but this would not genuinely reduce the burden of higher costs that the British people were now obliged to carry; it would merely mean that the larger payments that now had to be made to foreigners were composed partly of the prices paid by individuals when they bought the goods and partly of the additional taxes they paid to the government — which the government in effect handed over to the foreign sellers. Some redistribution of the burden would occur wherever there was disparity between the taxes that incUiduals paid and the imports that the/ bought; bat the total burden on the country wonlretnain unchanged. (The ' other anti-inflation strategies, it should be noted, are equally powerless against externally derived inflation; the British government could not impose fiscal-monetary restraints or price-income controls upon foreign nations.) A programme of price stabilisation through subsidisation would not be a panacea. Administration would not be easy; the programme could involve inequities and disincentive effects; it would give rise to the hazard of wasteful consumption of particular products; the increased taxation that it required might provoke wage demands that drove up production costs which required more subsidisation and taxation; it would offer no genuine antidote to externally derived inflationary pressure. The strategies so far attempted have proven to be absolutely disastrous, however, A different programme could be significantly superior despite the severe drawbacks and hazards that it might contain.