TIPs: Further Explanation

When I was reading Blinder’s chapter on ‘Striking a Balance between Unemployment and Inflation,’ I was fascinated by his description of tax-based incomes policy, and how it could possibly be a better way to combat inflation than wage-price controls enforced by the state. I decided to dedicate my blog post to exploring the argument behind TIPs more than Blinder did.

In a nutshell, tax-based income policies are policies that control the rate of increases in wages and the associated increase in prices through tax penalties and incentives (sticks and carrots). Specifically, a TIP is an incentive to the employer or employees at a firm to reduce the firm’s own wage increase.  Laurence Seidman composed a paper released by Brookings Institution that explained the concept of TIPs by comparing them to levying a tax on an externality like pollution. In order to see the externality that necessitates TIPs, we have to assume that the nature of the labor market lead a firm to raise its wage rate increase relative to that of the last period at an unemployment rate in which the marginal unemployed worker prefers work to leisure. Externalities result from the firm’s action of increasing wages in two different ways depending on the economy’s reaction. First, if monetary and fiscal policy maintain this unemployment rate, accelerating inflation is generated, harming the public. Second, if monetary and fiscal policy allow for a higher unemployment rate so as to reduce inflation, there is lost output and optimal unemployment, both of which have a value that exceeds the value of the aforementioned ‘leisure’ to the marginal unemployed worker. By prescribing a tax to internalize this externality, each firm must weigh the social cost of raising the rate of unemployment when it increase its wage rate. In his paper, Seidman concludes that a permanent TIP would permanently reduce the unemployment rate while keeping inflation constant.  Although few economists advocate for tax incentives because they assume individuals act in their own self-interest, Seidman believes that the most effective TIP would not be solely a penalty or a reward, but rather a combination of the two.

Another Brookings Institution paper written by Larry Dildine and Emil Sunley further explores the idea of implementing a combination of penalty and reward TIPs. First, if tax penalties were imposed on employers of employees to restrain price or wage increases, small and/or unincorporated businesses would be excluded from the program because of their generally rudimentary accounting. This exclusion would greatly reduce administrative problems without having a serious impact on the effectiveness of the whole program. However, if a tax incentive were levied, there would be mounting pressure to allow all business taxpayers and their employees to participate and take advantage of these rewards (assuming all are driven by self-interest). In order to fix these administrative problems, Dildine and Sunely suggest a ‘stick’ approach to implementing TIPS, which would impose penalties on firms that increase wages above a certain threshold while also giving a tax reduction for workers if wages have not exceeded this threshold.