The Federal Reserve has been trying to create inflation for several years now without very much success. Paul Krugman explains the liquidity trap the best, but to describe the problem briefly: when prices and wages are rising, people are more likely to buy things or invest their money, because otherwise, their money will gradually lose value. Paying off old loans is easier, too, because they are worth relatively less as time passes. When prices are relatively stable as they are now, the opposite is true, and economic activity is slower, which is why Ben Bernanke and other central bankers have been working to stimulate inflation.
Legislatures around the world are part of the problem. They keep cutting their budgets (or in our case, clumsily hacking the budget to pieces), which has done serious damage to the economy around the world. These policies have also suppressed prices. When governments borrow and spend on a large scale, the amount of money in circulation in absolute terms increases, and prices rise.
If simply increasing prices were the only goal, then legislatures could achieve it while reducing their deficits by instituting some kind of tax on consumption, such as a sales tax. In other countries, value-added taxes routinely contribute to inflation. The problem is that people might respond simply by buying less, so the tax wouldn’t do anything for the economy as whole. For inflation to stimulate economic activity, incomes must rise along with prices.
But what if the government returned the money from the tax to citizens through a refund? Then not only would prices increase, but so would incomes. This way, legislatures could aid central banks in their inflationary efforts without adding to their deficits.
Of course, something along these lines has already been proposed: a revenue-neutral, tax-and-dividend carbon fee, which would have the added benefit of discouraging fossil fuel combustion.
Estimates for the total value of a national carbon tax depend on how much would be charged per ton of emissions, but they vary between about 0.5 and 0.8 percent of gross domestic product. If all of that revenue were distributed through a dividend, price indexes would presumably increase by about the same fraction. Since inflation remains at 2 percent or below, that’s a substantial effect. The increase might be slightly less, since firms would find ways of producing many goods using less carbon and thus avoiding some of the tax. On the other hand, if the redistribution scheme were somewhat progressive — if the poor received proportionally more of the refund than the the wealth — the economic stimulus would be exaggerated, because the poor spend more of their money than do the rich.
Maybe such a policy would be politically infeasible, but I’m holding desperately to the hope that this month’s catastrophe in Congress might somehow create an opportunity for new coalitions to present their ideas. A carbon tax would not only mitigate global warming, it would also help to end the economic recession. In other words, it would be like pad thai, fireworks, and motherhood all at the same time.