President Joe Biden’s Build Back Better plan is stalled, and the next steps are unclear. Some Democrats are talking about the need for new pandemic-relief measures, even as the White House is reportedly looking at a stripped-down version of the original proposal. Meanwhile, most analysts are giving short shrift to an issue that deserves more thought: how Build Back Better would make it harder to fight inflation.
True, some of the same economists who (presciently, as it turns out) warned last year that the $1.9 trillion American Rescue Plan Act would increase inflation remain worried about inflation. But economists such as Larry Summers and Jason Furman also support Build Back Better.
That’s because the stimulus in Build Back Better is not that big. According to the Penn Wharton Budget Model, a project at the University of Pennsylvania that analyzes the fiscal impact of public policy, it would increase spending by around $250 billion in 2022, mainly due to the big single-year expansion of the child tax credit and the lifting of the cap on the state and local tax deduction. Revenues would rise by around $50 billion, thanks to higher taxes on firms and rich households. This would add a bit less than 1% of GDP to the budget deficit this year, for a total of less than 6% of GDP, compared with a deficit of roughly 15% in 2020 and 13% in 2021.
With reasonable assumptions about how much of this 1% would feed through to demand, and how that increase in demand would divide between output and prices, the modelers conclude that Build Back Better would increase inflation by between 0.1 and 0.2 percentage points this year and next. If the tax and spending changes were made permanent instead of being phased out, as they are in the current bill, the boost to inflation would be a bit bigger.
Would that be a problem — as, for instance, Senator Joe Manchin keeps saying? The Penn Wharton economists think not. “BBB’s impact on near-term inflation is small relative to baseline uncertainty around the near-term outlook for inflation,” they write. “In this context, changes in inflation of a few tenths of a percentage point would likely be indistinguishable from variation in inflation expected whether the legislation is enacted or not.”
That’s doubtless true — and, at least as the Federal Reserve is concerned, beside the point. The Fed is now scrambling to correct a policy based on its assumption that the pandemic-induced rise in inflation would be small and “transitory.” Instead, it is big and potentially persistent. But the Fed has to be cautious about how quickly it alters course: Tightening monetary policy too abruptly could cause markets to crash, exposing all manner of financial fragilities across the economy, and could push the country back into recession.
Economists are trained to discount the effect of fiscal policy on inflation, because their models tell them that — except in the short run — the rate of inflation is the result of decisions made by the central bank. But monetary policy is actually pretty complicated. For one thing, it has to contend with highly changeable expectations, which can be influenced by fiscal policy and the signals it conveys — such as the claim that excess demand is not the cause of the current spike in prices. As the Fed struggles to rein in demand and get monetary policy back on track, the last thing it needs is a fiscal package that pushes, even modestly, the other way.
Why make the Fed’s difficult job any harder? It would be straightforward to make Build Back Better fully paid for, as opposed to purportedly paid for. Target a permanently expanded child tax credit on those who need it most; bolster the climate-change elements by gradually raising taxes on carbon-based fuels; scrap the changes to the SALT deduction; and dial back the other additions to spending.
Would such a bill stand a better chance of passage? Who knows? But it’s hard to believe its prospects would be any worse than the current bill. And there’s no doubt it would be better fiscal policy.
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