When taxes are imposed on goods, consumers will have to pay more and, therefore, it leads to an prices going up. And it should follow that when taxes are reduced, it will reduce inflation as consumers have to now pay less. Therefore, in the broad sense of the word, yes taxation policy could possibly have an impact on reducing inflation.

However, the use of taxation policy to reduce inflation is a short-term or stop-gap measure and should never be thought of as a long-term solution. This is because, taxes on most goods are not particularly high and the lowest you can bring taxes to is zero. Even if taxes are brought down to zero but the prices of goods are still increasing, it may nullify the effect caused by the lowering of taxes. Therefore, to curb inflation, it is much better to focus on the issue that is causing the inflation than using measures such as reducing taxes.

There is, however, a larger issue when taxes are reduced to control inflation. Taxes, both direct and indirect, are the lifeblood for the functioning of any government. When the government reduces taxes on anything, it is in the process cutting down on its own income. While economic research shows that a reduction of direct taxes (income-tax) leads to an increase in consumption, there is no research to show that a reduction in indirect taxes will lead to increased consumption. When a government gets less money, then in the case of India, where the Central Government already runs a deficit, it will have to resort to deficit financing.

Now, deficit financing can be done in two ways: print money and issue bonds. The first method will lead to more inflation, thereby nullifying all effects of the tax reduction. In fact, if money is printed to cover the deficit, the resulting inflation will be far worse than before.

The second method, of issuing bonds to cover the deficit, has a ‘crowding-out’ effect. Imagine there is limited amount of funds in the system and the government issues bonds. These bonds will suck out the money and ‘crowd out’ other kinds of investments that are looking for money. The result of a crowding-out is higher interest rates.

SUNIL RONGALA

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