How Canada’s inflation rate could be brought to heel
ECONOMY
Year-over-year, CPI inflation was 6.7 per cent in March. That is, average prices of consumer goods and services were this March 6.7 per cent higher than in March of 2021— a rate quite above the two per cent target, and the highest since early 1991.
Pressured by economists and financiers, Bank of Canada governor Tiff Macklem seems committed to bringing inflation down back to the target. To this end, he has expressed his determination to raise the policy rate as much as necessary from its current one per cent to levels even beyond the estimated two to three per cent natural rate — that is, to levels higher than the rate that “neither stimulates nor weighs on the economy.”
But Macklem understands that higher interest rates will not magically bring down inflation since, as he acknowledges, “most of the factors pushing up inflation come from beyond our borders.”
But he is not concerned with this temporary — even if prolonged — high rate of inflation since it will subside by itself once commodity markets are settled, and supply chain disruptions are resolved. Rather, he worries about the possibility of high inflation becoming entrenched, that is, he is concerned about expectations of inflation rising above the two per cent target.
Let me explain. Expectations of inflation is the euphemism economists use for the wage increase workers may demand when negotiating with their employers. And if the rate of inflation is 6.7 per cent, workers should demand a similar wage increase to maintain their wages’ purchasing power — and thus a wage-price spiral may ensue. For orthodox economists, the solution is to weaken workers’ bargaining power by increasing the rate of unemployment. And this is what a sufficiently high rate of interest may be able to achieve: It may cause a deep enough recession to prevent workers from obtaining an increase in wages similar to the increase in prices that already took place.
Therefore, it appears that tight monetary policy could be used to reduce inflation over time. Yes, but at a very high cost — a cost to be borne by workers in the form of higher unemployment and lower real wages. Unfortunately, the rate of interest is a very blunt instrument. It cannot be raised just a bit to reduce the inflation only marginally. To be effective, it must be raised significantly and cause a deep recession.
It is for this reason that I consider that fighting today’s inflation is not a job for the Bank of Canada. And while implementing tight monetary policy is not an efficient way of curbing today’s inflation, it does not mean that the government is totally helpless — it can always use fiscal policy.
Indeed, I would suggest the government to reduce the GST from the current five per cent to two per cent. This GST reduction will automatically lower inflation — and expectations of inflation — by three percentage points.
Therefore, workers would require a nominal wage increase slightly above three per cent to keep the purchasing power of their wages unchanged. This way, inflation expectations would remain moored at around three per cent in the short run and decrease farther in the medium run as commodity markets and supply chains are settled.
But can we “afford” such a reduction in government revenue? Total GST revenue was $32.4 billion in 2021, and a three-percentage point reduction would represent a revenue loss of $19.5 billion for the government. This is a significant amount, but it represents less than one per cent of Canada’s GDP — and let’s not forget that the 2021 deficit amounted to $312.4 billion or 15.5 per cent of GDP. Therefore, of course we can afford this revenue reduction — although deficithawks will always claim otherwise.
But we don’t need to increase the deficit to reduce the GST rate. I propose the adoption of a more progressive tax structure: to compensate this reduction in GST revenue with a similar increase in corporate and personal income taxes. This option would kill two birds with one stone: It would achieve a lower inflation rate and reduce income inequality in society.
As an illustration, let’s consider an increase in total corporate taxes of $9.75 billion — one-half of the $19.5 billion decrease in GST revenue — and a similar increase in total personal income taxes.
Canada’s current corporate tax rate is 15 per cent, one of the lowest among OECD countries. For instance, the corporate tax rate is 21 per cent in the U.S., 30 per cent in Mexico, 30 per cent in Australia, 28.4 per cent in France, 19 per cent in the U.K., and 23.2 per cent in Japan.
Total corporate taxes were $54.1 billion in 2021, and an increase of $9.75 billion would require an increase of the corporate tax rate from 15 to 17.5 per cent — still one of the lowest among all OECD countries. So, no reason to claim that it will cause a loss of Canada’s competitiveness in the international economy.
In turn, total personal income taxes were $174.8 billion in 2021, representing about 8.6 per cent of GDP. Increasing personal income taxes — particularly to those at the top of the income scale — by $9.75 billion would increase its share in GDP to about 9.1 per cent. So, not a significant increase to be funded by those better suited to contribute for the common good.
In short, it is quite feasible to reduce inflation without destroying the economy in the process. What is needed is strong political will on the part of the minority Liberal government. I trust that this is a lowcost, progressive solution that the government — with NDP support — might be advised to entertain in its fight against inflation.