Here’s How Inflation Can Be Challenged In Canada

On an annual basis, CPI inflation stood at 6.7 percent in March. That is, average prices of consumer goods and services were 6.7 percent higher in March than in March 2021 — a rate well above the two percent target and the highest since early 1991.

Under pressure from economists and financiers, Tiff Macklem, governor of the Bank of Canada, seems determined to bring inflation back to target. To that end, he has expressed his determination to raise the key rate as much as necessary from the current one percent to levels even above the estimated two to three percent. naturally rate – that is, to levels higher than the rate that “neither stimulates the economy nor weighs on the economy”.

But Macklem understands that higher interest rates won’t magically lower inflation, since, as he acknowledges, “most of the factors driving inflation come from outside our borders.”

But he is not concerned about this temporary – even if prolonged – high inflation, as it will subside on its own once commodity markets are settled and supply chain disruptions are resolved. Instead, he is concerned about the possibility of high inflation becoming entrenched, that is, he is concerned about inflation expectations rising above the two percent target.

Let me explain. Expectations of inflation is the euphemism economists use for the wage increase that workers can demand when negotiating with their employers. And if inflation is at 6.7 percent, workers would have to demand a similar wage increase to maintain the purchasing power of their wages – and so a wage-price spiral could start. For orthodox economists, the solution is to weaken workers’ bargaining power by increasing unemployment. And this is what a high enough interest rate could achieve: It could create a recession deep enough to prevent workers from getting a pay rise comparable to the price rise that has already taken place.

Therefore, it appears that tight monetary policy can be used to reduce inflation over time. Yes, but at a very high cost—costs that workers have to bear in the form of higher unemployment and lower real wages. Unfortunately, the interest rate is a very blunt instrument. It cannot be increased just a little bit to reduce inflation only marginally. To be effective, it must be increased significantly and cause a deep recession.

For this reason, I believe that fighting current inflation is not a task for the Bank of Canada. And while tight monetary policy isn’t an efficient way to curb current inflation, it doesn’t mean the government is totally helpless – it can always use fiscal policy.

I would even propose to the government to lower the GST from the current five percent to two percent. This GST cut will automatically lower inflation — and inflation expectations — by three percentage points. Therefore, workers would need a nominal wage increase of just over three percent to keep the purchasing power of their wages unchanged. In this way, short-term inflation expectations would remain at around three percent and decline further in the medium term as commodity markets and supply chains settle.

But can we “condemn” such a cut in government revenues? Total GST revenues were $32.4 billion in 2021, and a three percentage point cut would mean a $19.5 billion loss of revenue for the government. This is a significant amount, but it represents less than one percent of Canada’s GDP — and let’s not forget that the 2021 deficit was $312.4 billion, or 15.5 percent of GDP. Therefore, of course, we can afford this revenue cut – although the deficit hawks will always argue otherwise.

But we don’t need to increase the deficit to lower the GST rate. I propose adopting a more progressive tax structure: to offset this reduction in GST income with a similar increase in corporate and personal income taxes. This option would kill two birds with one stone: it would lower inflation and reduce income inequality in society.

To illustrate, let’s look at a $9.75 billion increase in total corporate income taxes — half the decline in GST revenues from $19.5 billion — and a comparable increase in total personal income taxes.

The current corporate tax rate in Canada is 15 percent, one of the lowest among OECD countries. For example, the corporate tax rate is 21 percent in the US, 30 percent in Mexico, 30 percent in Australia, 28.4 percent in France, 19 percent in the UK, and 23.2 percent in Japan. Total corporate taxes were $54.1 billion in 2021, and an increase of $9.75 billion would require an increase in the corporate tax rate from 15 to 17.5 percent — still one of the lowest of any OECD country. So there is no reason to argue that it will lose Canada’s competitiveness in the international economy.

In turn, total income taxes were $174.8 billion in 2021, representing about 8.6 percent of GDP. Raising personal income taxes — especially for those at the top of the income scale — by $9.75 billion would increase its share of GDP to about 9.1 percent. So no significant raise to be financed by those better suited to contribute to the common good.

In short, it is entirely possible to reduce inflation without destroying the economy. What is needed is strong political will on the part of the liberal minority government. I trust that this is a cheap, progressive solution that the government – with the support of the NDP – could recommend in its fight against inflation.

Gustavo Indart is Professor Emeritus of Economics at the University of Toronto.

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