How Will Build Back Better Impact Inflation?

November 17, 2021

Last week, the Bureau of Labor Statistics (BLS) announced that prices had risen 6.2 percent in the year up to October 2021, the fastest rate since 1990. The persistently high inflation in recent months has made some lawmakers question the need for additional deficit spending. In the short term, the Build Back Better Act (BBBA) would likely contribute to inflation, but the magnitude of that contribution is unclear.    

The idea that productivity-improving investments will ultimately reduce inflation in the long term, as argued by Treasury Secretary Janet Yellen, has some validity—as investments that increase productivity and growth can reduce the price level. However, those effects take time to show up—for instance, improvements to physical infrastructure take time to get built. In the context of the next year, the immediate impact on the deficit is more relevant for inflation concerns. While the plan would increase the deficit in 2022, pushing inflation directionally upwards, the effect likely will not be large compared to the many factors driving price increases.

The American Rescue Plan Act (ARPA), enacted in March of this year, provides a useful comparison. This $1.9 trillion plan focused on further alleviating the burdens of the pandemic-induced recession. In other words, the plan’s spending was heavily concentrated in 2021. According to the Congressional Budget Office (CBO), of the nearly $1.9 trillion in deficit impact over the next decade, about $1.16 trillion would come in 2021.

And the spending was mostly transfer payments, rather than long-term investments. This included a second round of stimulus checks, a vastly expanded Child Tax Credit, and an extension of more generous pandemic-era unemployment insurance, among other policies, meaning money went into the economy fast.

A report from the Federal Reserve Bank of San Francisco last month estimated that the additional social spending in the ARPA raised annual inflation in 2021 by 0.3 percentage points, and will raise inflation in 2022 by another 0.2 percentage points.

Now, that’s not nothing, but it is a small fraction of this year’s 6.2 percent increase in prices that the BLS measures. Other factors like rapid shifts in consumer demand between goods and services, related supply chain bottlenecks, and other pandemic-driven disruptions, help explain the rest of the gap. We would also expect the BBBA to have a smaller effect than the ARPA due to differences in the timing and magnitude of the spending.

The BBBA is often reported as a $1.75 trillion package, but that is not the net deficit impact of the bill. It combines around $1 trillion in revenue increases (roughly $1.5 trillion in tax increases partly offset by $500 billion in tax credits) with roughly $1.3 trillion in direct government spending, for a total deficit impact of about $300 billion over 10 years.

That is a much smaller total deficit impact than the ARPA, but the impact is front-loaded into 2022. We estimate the BBBA would reduce tax revenue by about $200 billion in 2022—largely due to extending the generous Child Tax Credit provisions from the ARPA by one year, as well as raising the cap on the state and local tax (SALT) deduction to $80,000. Based on our understanding of the spending pattern (very rough until the CBO produces a complete score), the bill would result in approximately $100 billion in direct spending in 2022. That would indicate about a $300 billion deficit impact in 2022, amounting to a substantial fiscal stimulus next year that would likely contribute to higher inflation.  

The magnitude of the inflation impact of the BBBA may be quite small, perhaps a small fraction of the impact of the ARPA. However, to the extent it increases the deficit next year at all, there is reason to think this bill would make the inflation problem worse, not better.   

Tax Proposals by the Biden Administration

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The state and local tax (SALT) deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. The Tax Cuts and Jobs Act (TCJA) capped it at $10,000 per year, consisting of property taxes plus state income or sales taxes, but not both.

A tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly.