Policy Proposal: an Inflation-tackling Productivity Investment Fund
This blog entry is the third in a series where I discuss ,and argue, on behalf of a a unique policy proposal which I have either heavily modified from existing ones or I have come up with largely independently.
Contextual and theoretical background
In May 2022 the United Kingdom reported its highest rate of inflation for 40 years: soaring to 9% and predicted to climb even higher. This is far from a British problem; across much of both the developed (and developing) world, inflation remains far above the standard 2% target which most central banks aim for. Naturally, it has been these central banks, such as the Bank of England and the Federal Reserve, which have been the main centres of attention when it comes to solving the inflationary crisis. In what is probably a bit of a hangover from responses to 1970s stagflation as well as the Great Recession, much of the West is relying on the one-trick-pony of central bank interest rate changes to resolve our current economic ills. Governments have been asked to play by the same usual playbook by limiting spending and doing little to exacerbate the problems after the triple-whammy of pandemic-era government spending, ongoing supply issues in China and the war in Ukraine.
Faced with the most dramatic rise in living costs for decades, many politicians (particularly on the left) aren’t too pleased with only having one major tool to tackle inflation, especially as many firms see record profits on the back of already increasing prices. Many figures, especially in the United States, are terming this “price gouging”. Oftentimes the term is used for sudden price rises during acute shortages and crises rather than steady, general inflationary price rises. For the former case, you can check out my article on what I termed “Ethical Price Gouging” for more details. A general inflationary rise, however is a slightly different beast that requires more examination than situations like a sudden unexpected shortage of a single good (whether that is energy or baby formula).
Although inexorably tied to the only partly-related baby formula shortage in the United States, recent debate on inflation has been linked to short-term price-gouging, spearheaded by legislation advanced by Democrat Senator Elizabeth Warren. Warren is calling for price controls on specific goods which for reasons described in my Ethical Price Gouging article would open a can of worms entirely and may worsen inflationary issues in the medium to long term (Noah Smith has a great article on this which I advise checking out if you’re interested). One other proposal from the American left has found some headway on the other side of the pond; after adopting a policy borrowed from Labour who borrowed from the Lib Dems and ultimately modified from 1997 New Labour, a one off “windfall tax” on the large profits energy companies have made in recent months is being implemented by the Conservative government, with the money raised used as a subsidy to lower household bills. As even the Chancellor of the Exchequer has pointed out, this would do little to target the overall problem of inflation, creating a short term fix with many some unfortunate consequences — particularly the investment allowance when it comes to tackling climate change.
Both Warren’s plan for price controls and the British windfall tax simultaneously do too little and too much to tackle the crisis of a rising cost of living. They both exacerbate the problem by shifting price rises elsewhere, they both enable unintended consequences and both create distortions for the economy at large which will slow and disrupt any recovery, particularly as the economy has already begun to shrink in both the UK and the US.
The role of corporate profits in inflation
Rising interest rates, rising inflation and a shrinking economy can appear to be a completely unconscionable combination while companies make record profits. Within the US debate, the term “greedflation” was coined and has had quite a vitriolic reaction from many economists, much like the consensus around the similar “price-gouging” debate in short term crises. But as economist Paul Krugman points out “talking about [how] gouging is like prescribing ivermectin or injecting bleach — is weirdly over the top, and should provoke some self-reflection”. He points out that there are three positions relating to how “gouging” from big companies contributes to inflation:
- Gouging is the main cause of inflation
- Gouging could be a contributory factor
- Gouging cannot possibly be a cause of inflation, and anyone saying otherwise is ignorant and dangerous
Krugman notes that while position 1 is demonstrably false by all metrics, position 3 is also “dubious economics”. However, it is still incredibly difficult to determine exactly how much of inflation is contributed by firms exploiting their market power. He notes that one aspect of Warren’s bill — forcing firms to deliver an explanation for price-hikes to congress — is still sound and can act as a brake on one contributor of inflation.
Like Krugman, I have no real issue with the crux of the Warren bill, while I share some of the concerns around actual Venezuela-style price controls, I see no harm in ensuring that firms are transparent about their price rises.
However, what I believe may be the underlying concern that has spurred so much vitriol for even daring to ask if companies are padding their profits on the back of an inflationary crisis, is the worry of windfall taxes which will (so the theory goes) harm the profits needed to incentivise the investment into production of a greater volume of goods and services needed to tackle the inflationary imbalance. To say that some firms are not exploiting their market power just a little bit is, I suspect, a white lie from some people to keep profits up and supposedly inflation down in the long run.
Assuming that these individuals are acting in good faith, there remains one central problem with relying on corporate profits to be the bearer of lower inflation: corporate profits are not entirely re-invested in productivity gains and supply, instead they are incentivised to increase shareholder value with high profits instead of providing larger volumes of goods and services.
I am positive however, that the advocates of a high-profit strategy have considered these drawbacks and consider them better than the only other alternative which is for governments to tax those profits and use the revenues how they wish. The story of proposed windfall taxes in Britain and the US demonstrates two large drawbacks which economists fear:
1) In Britain, while the tax can be avoided by increasing energy production, the revenues are being redistributed as a subsidy to households, increasing the money supply almost back to square one.
2) In the United States, proposed windfall taxes won’t have Britain’s loophole, thereby reducing any corporate incentive to reinvest their profits in increased production.
Caught between a rock and a hard place, economists and policymakers are torn to embrace what appears to be the political and economic pros and cons of either large corporate profits or windfall taxes. Spurred by the democratic pressure to act quickly, it is more likely than not that windfall taxes will be the option chosen, but there is an alternative way to manage it.
The Policy Proposal
“Profit” can be a dirty word, but is the ultimate driver of growth in economies. In an textbook capitalistic free market, it is profits that drive investment, profits that fund expansion and profits that increase production leading to lower-cost, higher quality goods and services over the long run. Profits also line the pockets of shareholders and increase inequality, causing some firms to act rationally for themselves but damaging the economy as a whole. The taxation of profits, usually through corporation tax, is usually presented as a moral necessity, but it may in fact be a practical one.
Arguments against taxation of profits have both academic and practical reasoning. Classical liberal economists would be keen to note that firms know best how to invest and divulge their own profits more than any government bureaucrat could. Some politicians would say a low rate of corporate taxation keeps their country competitive and attracts more investment. But in the face of the current crisis, taking a chance on whether those profits end up helping shareholders or help to increase our productivity is not a gamble we ought to be taking.
As economists of all stripes point out, handing a share of those profits to the state is still a risky venture. Governments will be tempted to give their money back to their citizens but this has an even larger risk of exacerbating inflation itself. The massive stimulus spending of the Covid pandemic is one of the large factors that has brought us to this point.
Inflation is a trade off that has to come out of somebody’s end and there are only three ways to do so:
1) It could be “passed on” to consumers, which is the least popular option.
2) It could be absorbed by profits, which although a more popular option, could harm growth
3) It could be offset by increasing productivity.
The debate has so far largely focused on the first two issues without doing much to tackle the third. The ideal policy should focus on the latter as increasing productivity would relieve pressure on both growth and inflation.
Productivity gains are notoriously difficult for markets generate organically, but thankfully the state is in a position to deliver the correct interventions. My policy proposal has three simple steps, each one modified to rectify for the mistakes of some of their real world equivalents.
Step 1: A universal Windfall Tax
The current Windfall Tax on energy only targets one industry but that is far from the only sector where we have seen a surge in profits. In order to avoid the aforementioned distortions and lopsided nature of the policy, a windfall tax should instead be instituted universally, applied as a higher rate corporation tax bracket on firms with suddenly larger than normal profit margins. In many ways this will be a win-win, if companies have large profits it will raise plenty of revenues, if however, they decide to decrease prices so that it eats into their profit margins to avoid the tax, then inflation won’t rise as much. Primarily, the tax will raise enough revenue on a one-off basis that won’t require it to be raised annually, allowing firms to continue to utilise their profits in tandem with public sector investment in the medium to long-term.
Step 2: Creating a Productivity Investment Fund
The revenues from the Windfall Tax would then be spent, not towards the kind of inflationary spending that could bring us back to square one, but to create a sovereign wealth fund, a so-called Productivity Investment Fund, instructed to create the kinds of investments that would safely raise productivity levels — ensuring above-inflation growth. While there are riskier bets such as certain new technologies, these can be addressed by the private sector. The state, however, (in the form of the Productivity Investment Fund) would be well placed to invest in projects that are harder for the private sector to fund autonomously but relatively easy for the state: housing and infrastructure.
While infrastructure projects, such as high speed rail, broadband etc have almost become cliché textbook examples of the productivity benefits brought on by public investment, the economic case for them is robust, particularly now while borrowing is cheap, but especially when it is self-funded as the Productivity Investment Fund would be. For housing, the case for investment is even stronger. As Bowman, Myers and Southwood write in The Housing Theory of Everything (another article I highly recommend in its own right), the productivity gains from new housing in the places that need it could potentially be astronomical with benefits beyond productivity leading to greater innovation, lower inequality, higher birth-rates, lower obesity, decarbonisation and potentially much, much more.
The Productivity Investment Fund’s internal structure and governance would be crucial for its success. For contextualisation, let’s assume that the fund was created in the UK. Firstly, it would be a public sector body accountable to government much like other funds such as the Alaska Permanent Fund or Norway’s Statens pensjonsfond and would be run by investment managers appointed, and working on behalf of, the Bank of England. Like the Bank of England, it would be independent but governed by a charter, in this case that charter would explicitly limit the Fund to housing and infrastructure investment within the UK but retaining ultimate freedom over which projects it aims to pursue, targeted for productivity gains.
Step 3: Giving the Fund legal and financial independence
Ambitiously, to ensure that the Fund is able to act as effectively as possible, it should be a fund with some teeth — having a built-in ability to override ordinary planning processes that have shrunken and slowed projects such as HS2 as well as housing construction in the UK generally. The fund should also have an ability to fund itself beyond the initial one-off Windfall Tax.
Inspired by Radical Xchange’s concept of ‘Plural Property’, legislation should be passed to ensure that asset owners across the UK are obligated to self-assess and declare the value of their properties. Based on the self-assessed value, they pay a fee, or tax, which is funnelled back into the Fund. Should the Fund wish to purchase that property for development, current possessors would be forced to sell it for their self-assessed value. Once the sale has been actioned, this would supersede any subsequent need for approval by central, regional or local government.
The case for a Productivity Investment Fund is a complex one, but can be best surmised in the following points:
- It enables the state to create the kinds of large-scale, ambitious investment that is often too difficult or risky for the private sector to engage in.
- It will ensure rapid development by overriding planning law and create steady, inflation-proof growth in the economy with real productivity gains.
- It will be financially robust with its own funding mechanisms through the initial universalised Windfall Tax and subsequent property self-assessment.
- It maintains independence from meddling by governments, acting in a mission-focused direction.
- It avoids the need for any future Windfall Taxes, preserving strong market-led recoveries in the future.
- It addresses longstanding productivity stagnation in many high-income nations such as the UK.
- It avoids the false binary between increased inflation and slowed or halted growth.
That is not to say that the plan is without fault, as ever, the devil is in the detail:
- The initial one-off Windfall Tax will still face much of the same issues of current ones. What rate should it be set at? How much of a drop in private sector investment is worth the trade off to create the fund? These are difficult and technical questions for which I will admit I do not have the immediate answers to. Assuming that we follow the UK government’s model, an estimated £5billion will be raised annually on a 25% tax (and that is even with loopholes factored in), applying this to every other sector of the economy beyond energy will raise significantly more, even with a similar loophole to the British model: enough to build enough homes or portions of a railway line to at least make a dent in our flatlining productivity.
- Political opposition would be very difficult to overcome, especially to override planning law. Given that the Fund would be separate from government, its independence may help shield governments from the brunt of criticism, but this will be at the expense of a loss of power from elected bodies (such as local councils) to halt development entirely, which while (in my opinion) is for the greater good, would be a controversial shift in power say the least. Some compensatory mechanisms could be put in place to make the loss of this power easier to swallow: for instance, (as I have argued for before) local communities could be given the power to set aesthetics and design codes which will allow for the types of construction that they can tolerate. In addition, much like the Alaska Permanent Fund, some form of compensatory dividend for any profits generated could be given back to members of the public affected by construction, however this could come at the risk of exacerbating inflationary issues. Instead, perhaps bonds or publicly-listed shares in the Fund could be granted instead which won’t have the immediate potentially inflationary effects of a cash dividend.
- There is the risk that Fund managers could end up investing in projects which would constitute wasteful spending. So called ‘bridges to nowhere’ could end up being built which cost more than the productivity benefits derived. To avoid this, the Fund’s remit eliminates most of this risk by avoiding more nebulous productivity boosters in favour of low-risk, tried and tested investment in housing and infrastructure. But with that being said, “infrastructure” is a highly encompassing term, as noted during the passing of President Biden’s landmark infrastructure bill. To avoid risk, the charter which governs the Fund could explicitly define what is and isn’t “infrastructure” as well as require multiple independent analyses of projects available to invest in, with the projects deemed to derive the largest overall productivity gains to have the highest priority over lower-cost but less productive investments. Ultimately, which analyses to make and where revenues are spent will be the final decisions of the fund managers, but like Elizabeth Warren’s inflation proposal, a legislatively required explanation will at least give grounds to justify investments for the public and ensure full transparency for every major decision.
- Investments take time. Construction, particularly for large infrastructure projects, does not happen overnight. It can take years, perhaps even decades, to ensure some projects can finally realise the productivity gains they will provide, meanwhile inflation and other economic woes would rage on. Notwithstanding, the Fund would not be the only tool at our disposal. A targeted uplift of welfare benefits, interest rate rises, increased income taxes (among other policies) could all soften the blow of inflation in an equitable way. The slower growth, unemployment or even recession, that would normally arise when inflation is normally tackled can be directly softened by the Fund. While the economy shrinks, the Fund has the capital needed to create jobs in the key sectors such as construction which will allow for higher employment than you would normally have in a laissez-faire free market scenario. The Fund would not be a panacea by any means, but in the medium to long term it would help to recoup the losses from inflation and any ensuring periods of recession or low-growth, ensuring long-term prosperity that would not have been in place otherwise. Furthermore, as these projects are concluded, particularly housing, some of the biggest components of the cost of living would be addressed structurally, rather than left to fester.
Current discourse would have us believe that we are faced with a choice between a continually increasing cost of living and a harmful economic contraction. This is a fiction created by a lack of imagination of the options we have in front of us. If we are bold enough to create something like the Productivity Investment Fund, we can soften these trade-offs and create tangible long-term benefits, the potential of which is being left unrealised and hasn’t been taken. We could not only help to tackle inflation, growth and productivity in one fell swoop, but guarantee a steady run of jobs and have positive benefits far beyond what I have articulated already. If we are to avoid the sluggish pitfalls of 1970s stagflation and the rollercoaster volatility of the 1980s, then we have no choice but to act boldly and invest in productivity before it’s too late.