This is how Canada’s inflation rate could be reduced

Year-on-year, CPI inflation was 6.7% in March. In other words, average prices for consumer goods and services in March were 6.7% higher than in March 2021 – a rate well above the 2% target and the highest since the start of 1991.

Under pressure from economists and financiers, Bank of Canada Governor Tiff Macklem seems determined to get inflation back on target. To this end, he expressed his determination to raise the policy rate as much as necessary from its current level of 1% to levels even beyond the estimated 2 to 3%. Natural rate – that is, at levels above the rate that “does not stimulate or burden the economy”.

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

But he is not concerned about this temporary high inflation rate – even if it is prolonged – since it will subside on its own once commodity markets stabilize and the disruptions in the supply chain will be resolved. Rather, he is concerned about the possibility of high inflation taking root, that is, he is concerned about inflation expectations exceeding the 2% target.

Let me explain. Inflation expectations are the euphemism economists use for the wage increase that workers can demand when negotiating with their employers. And if the inflation rate is 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 ensue. For orthodox economists, the solution is to weaken the bargaining power of workers by increasing the unemployment rate. And that is what a sufficiently high interest rate can achieve: it can cause a recession deep enough to prevent workers from obtaining a wage increase similar to the price increase that has already taken place. .

Therefore, it seems that a restrictive 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 interest rate is a very crude instrument. It cannot be increased just a little to reduce 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 inflation today is not the job of the Bank of Canada. And while implementing tight monetary policy isn’t an effective way to curb current inflation, that doesn’t mean the government is completely helpless – it can still use fiscal policy.

In fact, I would suggest the government reduce the GST from the current 5% to 2%. This GST cut will automatically reduce inflation — and inflation expectations — by three percentage points. Therefore, workers would need a nominal wage increase of slightly more than 3% to keep the purchasing power of their wages unchanged. In this way, inflation expectations would remain anchored at around 3% in the short term and decline further in the medium term as commodity markets and supply chains stabilize.

But can we “afford” such a reduction in public revenue? Total GST revenue was $32.4 billion in 2021, and a three percentage point cut would represent a $19.5 billion revenue loss for the government. That’s a significant amount, but it represents less than 1% of Canada’s GDP — and let’s not forget that the 2021 deficit was $312.4 billion or 15.5% of GDP. So, of course, we can afford this revenue cut – even though the deficit hawks will always claim otherwise.

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

To illustrate, consider an increase in total corporate taxes of $9.75 billion — half of the $19.5 billion decrease in GST revenues — and a similar increase in total personal income.

The current corporate tax rate in Canada is 15%, one of the lowest among OECD countries. For example, the corporate tax rate is 21% in the United States, 30% in Mexico, 30% in Australia, 28.4% in France, 19% in the United Kingdom and 23.2% 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% – still one lowest of all OECD countries. So there is no reason to claim that this will lead to a loss of competitiveness for Canada in the international economy.

In turn, total personal income taxes amounted to $174.8 billion in 2021, which is about 8.6% of GDP. A $9.75 billion increase in personal income tax, especially for those at the top of the income scale, would raise its share of GDP to about 9.1%. So not a significant increase to be funded by those who are best placed to contribute to the common good.

In short, it is entirely possible to reduce inflation without destroying the economy in the process. What is needed is strong political will on the part of the Liberal minority government. I hope this is a progressive and inexpensive solution that the government — with the support of the NDP — could be asked to adopt in its fight against inflation.

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

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