Optimal Taxation of Inflation

IMF Working Papers, December 8, 2023

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Optimal Taxation of Inflation

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Bibliographic details

• Authors: Damien Capelle, Yang Liu
• Published: December 8, 2023
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9798400261169.001

Main findings

• When inflation originates from distributional conflicts, shifts in inflation expectations, or energy price shocks, monetary policy (MP) is a costly stabilization instrument.
• A tax on inflation policy (TIP), which would require firms to pay a tax proportional to the increase in their prices, would effectively correct externalities in firms’ pricing decisions.
• TIP would tackle excessive inflation and reduce output volatility, without exacerbating price distortions.
• TIP and MP are complements rather than substitutes: TIP addresses markups and inflation expectation shocks, while MP addresses demand shocks.

Analysis and mechanisms

• TIP targets the externality arising from firms’ pricing decisions by imposing a tax proportional to price increases.
• TIP mitigates excessive inflation stemming from:
  • distributional conflicts,
  • shifts in inflation expectations,
  • energy price shocks.
• MP remains the primary instrument for stabilizing demand shocks; reliance on MP alone is costly when inflation has the above origins.

Policy implications

• Implementing TIP can reduce the reliance on costly MP interventions when inflation is driven by markups, expectation shocks, or energy price shocks.
• Policymakers should consider TIP as a complementary tool to monetary policy:
  • Use TIP to address markup-driven inflation and inflation expectation shocks.
  • Use MP to respond to demand-driven fluctuations.

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