Subsidies on Interest Income to increase Aggregate Demand

File this one under "crazy ideas that might be worth thinking about, even if only to understand our own theories better".

It is generally agreed that an increase in expected inflation will increase Aggregate Demand. That's true for example in a standard ISLM model; expected inflation sticks a vertical wedge between the IS and LM curves, so the ISLM equilibrium is to the right of the point where IS and LM intersect. It's also true in New Keynesian models, where the policy instrument is a nominal interest rate rather than the nominal money supply; expected inflation lowers the real interest rate for any nominal interest rate set by the central bank.

The intuition, for a monetary disequilibrium theorist anyway, is that expected inflation is like a tax on holding the medium of exchange, so it creates an excess supply of the medium of exchange, which means people will want to spend their money.

A tax on holding money would be a good way to increase Aggregate Demand, except it's not very practical. And some economists doubt that central banks have the credibility to increase expected inflation by simply promising to increase inflation. OK, let's accept those assumptions, for the sake of argument.

It is also generally agreed that any policy that involves taxing one good can be replicated by subsidising all other goods, plus lump-sum taxes to restore the same budget balance and distribution of income. If people have a choice between consuming apples and bananas, a tax on eating apples or a subsidy on eating bananas would both have the same effect on choices at the margin -- people would substitute away from eating apples towards eating bananas.

So, if we want to tax money, but find it's impractical to do so, maybe we should subsidise alternatives to money.

In standard, grossly oversimplified, macroeconomic models, there are two assets: money; and "bonds", which represent all other assets. "Bonds" pay interest, but money does not. "The" nominal rate of interest is then the opportunity cost of holding our wealth in the form of non-interest-paying money instead of interest-paying "bonds". And we choose to hold some of our wealth in money, despite the foregone interest, because money is the medium of exchange, and so holding more money makes it easier to do the shopping. A tax on holding money increases the opportunity cost of holding money. A subsidy on holding "bonds" does exactly the same thing.

So any outcome that could be achieved by an increase in expected inflation (which is equivalent to a tax on holding money) could equally be achieved by a subsidy on holding "bonds".

So all economists who want an increase in Aggregate Demand, and who would support an increase in expected inflation if they thought it were feasible, should presumably support a subsidy to holding "bonds".

Now, remember, the "bonds" of our grossly over-simplified macroeconomic models are not the same as real-life bonds. "Bonds" is shorthand for "all non-money assets". So, as an alternative to an increase in expected inflation (i.e. a tax on holding money) those economists should support a subsidy on all non-money assets.

And remember too, most countries already tax the nominal (i.e. non-inflation-adjusted) returns of holding non-money assets. So they wouldn't need to actually subsidise the holding of non-money assets. They could simply reduce the pre-existing taxes on holding non-money assets.

So those economists who want to increase Aggregate Demand, and who would support an increase in expected inflation if they thought it could be achieved, should presumably support a reduction in the tax rates on interest income, dividends, capital gains, corporate profit taxes, land rents, and any other taxes on the returns from holding non-money assets.

OK, they are not quite the same thing. An increase in expected inflation, and a decrease in tax rates on non-money assets, will have different effects on the distribution of income, and on the overall budget balance. And it's hard to think of a practical set of lump-sum taxes which could offset those differences. But try to set that aside.

Think of it purely in macroeconomic terms, just as a thought-experiment. Why wouldn't a reduction in marginal tax rates on all forms of "nominal interest income" (i.e. all forms of "income" from deferred consumption) have exactly the same effect on Aggregate Demand as an increase in expected inflation?

What I am really trying to do in this post is smoke out some of the underlying differences between monetary disequilibrium theory and Neo-Wicksellian (New Keynesian) macroeconomics. Where is the economically-relevant dividing line between "money" and "non-money" assets? If it leads to policy conclusions that might help the US, European, and Japanese economies escape their funks, that's an added bonus.

Comments

[Adam P]

Nick,

I think you're exactly right if we add the caveat that we subsidize only non-government bonds. Then it becomes an investment subsidy which is a great idea right now.

One way to express the benefit of higher expected inflation is to encourage capital to move out of nominal, low risk assets (governmet bonds) and into real, higher risk assets like corporate debt and equity. So I think you're right.

[david]

Three goods: money, non-money assets, and current consumption; we argue that the money market equilibrium is achieved by equalizing the benefits of holding money vs. non-money assets. So when the money market is in disequilibrium due to a wrong price for money, conventionally we alter the price so that it is correct. But here we validate the wrong price by altering the return on holding non-money assets.

Thoughts: how are we doing this without altering real current consumption? There is the other balance of saving vs. consumption, which changes when we alter the return on holding non-money assets. And then there's the balanced-budget condition, which forces us to tax non-non-money-assets, i.e., consumption.

Also, if central banks can't set inflation expectations, what does? Is the inability of banks to set expectations due to an inability to credibly claim to influence inflation, or an inability to commit to a given inflation path? If agents believe that the Fed or the Bank of Japan really wants opportunistic disinflation, then (this expectation of) the central bank will continue to move last.

[Lee Kelly]

Excellent post. One quibble: for any given increase in aggregate demand, we want less inflation and more real growth.

[Bill Woolsey]

The implicit liquidity yield on money isn't taxed. The return on other sorts of assets are taxed. Lower the tax rate, and there should be a shift away from money. The demand for money rises. [Presumably that's a typo, and Bill means the demand for money falls. NR] Given the quantity of money, money expenditures rise.

Now, what happens to the natural interest rate? Well, the net rate of return received by households rises with lower taxes in investment income. On the other hand, the gross rate of return on real assets should decrease. Which is the "natural interest rate?"

If some market interest rate is relevant point of comparison, then doesn't it depend on whether the return paid or return received is taxed? So, lowering tax rates on capital income may increase the after tax return, but market rates should decrease.

Interesting.

[Jacques René Giguère]

In the modern economy,most wages, at least for the technical class, is a return on accumulated human capital ( plus the slow reimbursement of your capital before death).In effect, for a lot of us, we get an annuity in return for face-time.
Do you subsidize that too?

[Lee Kelly]

Bill,

You mean the the demand for money falls, right?

David,

Consumption spending remains constant by assumption. Additional investment spending is financed not by reducing consumption but reducing money balances -- a fall in money demand. Given the quantity of money, a fall in money demand increases aggregate demand. Perhaps more important for our present circumstances, lowering taxes on "bonds" would presumably provide an incentive to banks to spend reserves -- a fall in demand for base money.

[jesse]

Is it tautological to state that real growth is generated through... real growth? Changing the incentives on "bonds" in this way is unlikely to change underlying economic weaknesses. Let's say for argument that this is already happening to a degree. Look at prices for certain assets and goods. Where are many investors putting their money?

[RSJ]

I also think, with the caveat that the subsidy only goes to those who hold domestic non-government assets, that this would be stimulative.

It would effectively lower the return demanded of real, risky, capital -- that return is not zero now, and I would argue that it is too high. You could think of it as closing the gap between risky and riskless assets -- e.g. between capital and safe bonds.

A good example is the effect of the home-buyer subsidy on housing sales, or the auto subsidy on auto sales. Both of these subsidies generated more investment by subsidizing the purchase of real assets that, without the subsidy, were expected to perform poorly.

But when the subsidies were removed, house prices continued to fall. It's not clear what was actually achieved, in terms of closing the Lucas wedge, by these programs, even though they were stimulative when they were enacted, and your proposal would need to try to answer the same question.

[btg]

maybe i have this backwards...

there are 3 things - cash, goods, and bonds that pay interest.

if people expect inflation (the cost of goods is expected to increase more than previiously thought), then they are expecting the real return on the bonds to decrease - therefore they convert the bonds into cash and buy goods today.

however, a tax cut (subsidy) on bonds increases the real returns on the bonds - wouldn't that tend to discourage people selling them? after all, because of the subsidy on bonds, they can now buy more goods in future - the same amount or more than before the inflationary expectation increased.

my only quibble would be that if inflationary expections increase, the price of the bond will drop immediately... and the yield would increase

[Leroy Dumonde]

I think you're off the mark here Nick (at least for the current situation) because you're simple model is in effect assuming that consumers are hoarding money which seems to me to not be the case. Consumers are in fact spending every penny they get to pay down the debts they ran up during the debt bubble. It's the banks that are hoarding money: http://research.stlouisfed.org/fred2/series/EXCRESNS. And it seems to me that Sweden had the right idea: tax the banks for holding excess reserves.

Although, I think if policy makers let this go on long enough then eventually consumers will be hoarding money. But I don't think we're their yet.

[Matthew Evans]

Why is a tax on holding money not practical? It's true that some people might try to cheat by not reporting holdings of Money, but people currently cheat by not reporting income. Anyone who has money in a bank has an implicit guarantee from the state which goes beyond the explicit bank insurance guarantees which exist.
It may be politically difficult because of the fact that policies tend to be shaped in the interest of those with money. But it could be done. Surely those who have no wealth have given enough to those who do in the past 3 years without another round. And the subsidy would go to those with most wealth who presumably have a lower propensity to consume than the poor who would suffer from the cuts which would probably be imposed to make the move fiscally neutral. If the state has money to spend to boost demand this is about the worst way to do it.

[Tmmbloguk]

'If people have a choice between consuming apples and bananas, a tax on eating apples or a subsidy on eating bananas would both have the same effect on choices at the margin -- people would substitute away from eating apples towards eating bananas.'

I don't think it's equivalent. You're forgetting preference reversal, where people change their response to a situation based on how it is framed. A tax on money would probably be perceieved as worse (and therefore more likely to stimulate AD) than a subsidy on bonds due to loss aversion.

Furthermore, I think any tax/subsidy would have to be noticeably large and well advertised - inertia is a powerful force, and I'm not sure that people would bother changing their behaviour for the sake of a few quid.

[Nick Rowe]

Adam: One one side of the divide, you have money and government bonds, and on the other side of the divide you have all other assets? Again, what I'm really trying to do with this post is not put forward a policy proposal, but try to elucidate the implicit assumptions underlying different people's macro. Would it be correct to say, in your case, that the key difference is private vs government assets? Because private demand for newly-produced goods and services responds to rates of interest on private assets, but government demand does not respond to rates of interest on government assets? (That's not what you said, but it might be what's at the back of your mind.)

David: good point about the trade off between investment vs current consumption. I'm going to duck your question about why can't central banks credibly affect expected inflation. That's a whole other post. (And it's not an assumption I would really accept, anyway, so I would be trying to explain the position of people I don't really agree with.)

Lee: Thanks. Sure, we would like the increase in AD to result in more real growth and less inflation, but that's more a question of the slope of the SRAS or SR Phillips Curve, rather than "what shifts the AD curve?"

Bill: Now Bill, if I interpret him correctly, and unlike Adam, sees the dividing line as money vs all other assets. Bill would subsidise the return on government bonds?, and Adam wouldn't. That is a key point of disagreement.

I think we can talk about a gross of tax and net of tax natural rate of interest, in exactly the same way we can talk about a gross of tax and net of tax price of apples.

Jacques: in principle yes, if we could distinguish the return to human capital from the return to innate skill and effort. Impossible in practice, of course, but this is more of a thought-experiment.

Lee: almost certainly a typo by Bill. I have edited his comment.

But I think David is right: there would be a change in the composition of spending, away from consumption towards investment, as well as an increase in overall spending.

jesse: you lost me there. The way I look at it, investors aren't putting their money anywhere -- they are just holding it. We want them to spend it. Of course, if they all spend it, it just returns to their pockets, but the velocity of circulation has increased, which is what we want, because that increases aggregate demand.

RSJ: your dividing line seems similar to Adam's. Again, what is the underlying rationale for drawing it between government-issued vs privately-issued assets?

(What's the "Lucas wedge"?

btg: and your dividing line is different again. You have money and *all* bonds on one side, and real goods on the other side. Why?

Leroy: OK, assume it is banks and not people that are hoarding excessive amounts of money. Wouldn't a subsidy on other assets persuade those banks to dishoard money in exactly the same way?

Matthew: because it is hard to measure and tax people's holdings of currency. (I'm not so sure it is impossible, because we could make notes with random serial numbers worthless, but anyway, this is an assumption I'm making for this post.)

Tmmbloguk: OK. Maybe. I'm just using standard economic theory of rational choice here. Behavioural economics may differ slightly. (This is a Canadian blog, so you can't say "quid" here, because people might not understand you. You have to say "buck" instead!)

Everyone:

I should have said this in the post: There is a whole spectrum of different assets. Money at one end, and real capital goods at the other. If we were going to subsidise some of those assets and not others, to increase aggregate demand, where should we draw the line? And why? What is the theoretically important underlying distinction? Why?

[Lee Kelly]

Nick,

Yes, my first comment was off. You mentioned inflation as a way of effectively taxing money. Increases in aggregate demand that produce real growth would fail to that end.

My second comment was only kind of wrong. Eventually your proposal would change the composition of spending between consumption and investment. But I was talking about the short run. In the short run, additional investment spending would be financed by reducing money balances -- total saving would remain unchanged. Only once monetary equilibrium is restored will additional investment spending be financed by reductions in consumption, i.e. increases in savings. Moreover, this would not be any kind of distortion, because the distortion already exists in the double taxation of income used to defer consumption. Indeed, it would be a reduction in presently existing distortions in the tax system that penalise saving.

One last thing. This idea has an added benefit over creating inflation in the traditional way (expansionary monetary policy), because it has automatic breaks once we approach monetary equilibrium. There is no real danger of overshooting inflation and creating all the problems associated with it.

[Buyer]

Nick, where does our Canadian TFSA fit in to your discussion? Anywhere?

[david]

there would be a change in the composition of spending, away from consumption towards investment, as well as an increase in overall spending.

Yeah. Still processing this, but isn't a balanced-budget alteration in national spending toward investment generally contractionary, via the multiplier effect...?

There's an oddity here because we are, again, attempting to validate a 'wrong' price rather than right it. My economic intuition is failing me!

[Adam P]

Nick,

In normal circumstances I wouldn't lump all government debt together like that but right now it's clear that t-bills and reserves are awfully good substitutes for liquidity.

We need to keep in mind that having just "money" and "bonds" in a theoretical model is basically like using a binomial model as a simplified model of what in reality is a continuous distribution.

Clearly in reality there is a continum along which we go from liquid/low yield/low risk to illiquid/high yield/high risk. At one end is actual base money, not quite risk free if there is an uncertain inflation rate but very liquid, very low yield (though not zero anymore in the case of reserves) and very low risk.

In normal times T-bills are not such great substitutes for base money in terms of their yield (though they are in terms of liquidity and risk) so changing their yield via OMOs does something. Now that's not true.

Now we still accomplish something by buying longer bonds (QE clearly works) so it's unclear where to include longer-term treasuries. For long enough maturities you could also subsidise their interest and have a positive effect.

I just made the distinction government debt vs everything else for simplicity and brevity and because it clearly would be effective. It wasn't for any deep theoretical reason.

[RSJ]

Nick,

I'm operating under the assumption that the return demanded of actual (physical) capital is higher than the return demanded of risk-free bonds, which itself is higher than the return demanded of risk-free bills, which is zero.

Possibly because the returns of real capital are positively correlated with consumption. Now you do not know whether a zero rate means a low rate for real capital or a high insurance premium for the government paper. In the case of the latter, the rates on capital can still be too high, even at the zero bound for government bills.

So you would subsidize only the private sector assets, and preferably the longer dated stuff, and that is all you should ever subsidize, as open market operations can take care of the other stuff.

The Lucas wedge is the cumulative gap in flows.

[david s]

Yup. Good idea, Nick. Oh, and since human capital is also a non-money asset, personal income taxes should probably also be reduced.

[Scott Sumner]

Nick, Another brilliant post. I have only one comment. It seems slightly odd to compare a lower tax on bonds with a higher inflation target. Surely a policy that increases AD (like a lower tax on bonds) will also result in higher expected inflation. So think of taxes on bonds and open market operations as two alternative policy instruments, and expected inflation as an intermediate target. In that case I'd say open market purchases and lower taxes on bonds are two alternative policy instruments that can raise expected inflation and thus raise AD.

If the open market purchase option is ineffective for credibility reasons, then the lower tax on bonds might be the superior policy, the more foolproof path to reflation.

But all this is just quibbling about terminology--I love the idea.

[Sergei]

... "all non-money assets" ...

If you subsidize non-money *assets* their prices will increase. But I see little generic reason to claim that price increases of all non-money assets (stock) will automatically lead to the increase of AD (flow of produced goods).

And obviously the question is what will happen when subsidy is removed. We have clearly seen it with car sales and see now with house prices.

[reason]

A tax on holding money would be a good way to increase Aggregate Demand, except it's not very practical.

http://www.arbitragemagazine.com/features/miracle-town-worgl/

(P.S. For some odd reason "Austrian" economists like to claim this for their own - the value of "free currency" - but forget that it was a government - allbeit local - issuing its own script for government services and taking it back for taxes. Talk about selective blindness!)

[P.S. I view Woergl as support for MMT much more than for "Austrian" economics. Yes Woergl was in Austria - but that is about the end of it.

P.P.S.
An important part of the woergl story is that the currency lost value every year by law. (P.S. I thought later that they could do the same thing effectively and more flexibly and simply by giving the currency an expiry date.)

Added by NR, because reason posted these additional PS and PPS comments on the wrong post by mistake.]

[reason]

Thanks Nick. Sorry about that.

[Jacques René Giguère]

reason: Austrians like the idea of money-holding tax. They are also very worried about inflation ...I stopped trying to resolve their internal contradictions.
That's why getting rid of them could be a nice side-effect of a professionnal order. ( nice way of cross-linking thread)

[reason]

"Austrians like the idea of money-holding tax." - how could you possibly reconcile that with a free currency? - A voluntary tax? Huh?