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Build Back Better would have ‘pretty small impact’ on inflation: Penn Wharton Budget Model director

Kent Smetters, Penn Wharton Budget Model faculty director, joins Yahoo Finance Live to break down what effects President Biden’s Build Back Better bill would have on inflation and the U.S. economy.

Video Transcript

- Welcome back to Yahoo Finance. Senator Joe Manchin blindsided Democrats just now, turning his back on the Build Back Better plan in its current form. He says the nearly $2 trillion tax and spend package is not fiscally responsible. Our next guest isn't so sure finding the plan would have the fairly negligible impact on inflation. Joining us to discuss is Kent Smetters, Penn Wharton Budget Model faculty director. Ken, thank you so much for coming on the show today. We appreciate it. Your Penn model data suggests that the plan as it is would add just 0.2% to inflation over the next two years.

And you also say if temporary spending measures in the bill were made permanent, it would also have not much more of an inflationary impact. Walk us through that, if you would.

KENT SMETTERS: Sure. So we already are, of course, starting at a pretty high level of inflation for this year, a little under 7%. For next year, probably 3%, 3.5%, depending where the Federal Reserve comes in. It's just that most of the inflation is caused by supply restrictions. The Build Back better itself is going to have a pretty small impact, simply because the first year it's mainly child tax credit. That goes away after the first year. And then subsequent years things like pre-K education, those take a couple of years to phase in. Because of the building that is required to support that. So we're talking about something that's fairly smooth over time, especially with that particular piece of legislation.

If as written on a temporary spending basis.

- And also help me understand part of the process here. So what you're saying is some of the portions not going to be deployed for a year, two years, three years. Totally get that. But also in the CBO scoring process, there is a negotiation process in Congress among the Senate and the House, whittling certain programs down to fewer than 10 years. To three years, to one year. That kind of games the process with the expectation that maybe Congress will be able to renew that in the future. So if you were incorporate that into a model, I'm just wondering what that yields.

KENT SMETTERS: Yeah. Absolutely. So the legislation as written, it's about a $2 trillion package. But as you pointed out, a lot of the pieces of the legislation, including a child tax credit and lots of other pieces, are temporary spending programs. And so they don't last for very long. And keeping those spending programs with temporary also allows them to therefore satisfy what's called the Byrd rule that's associated with these reconciliation-driven type spending programs. When you allow for these programs, however, to be permanent-- and that's not what the law actually is-- but if in fact you recognize these programs as permanent, then the cost more than doubles. We estimate is to be about $4.6 trillion over 10 years.

And so that certainly has been a large part of the discussion right now in Washington DC.

- And then, sir, how does it impact consumption expenditures?

KENT SMETTERS: Yes. So the type of spending matters a lot. Certain types of spending, like child tax credit, tends to focus more on what we call-- households are more likely to spend the money. High marginal propensity to consume households, kind of non richer households. On the other hand, some of the other parts of the Build Back Better plan, such as the increase in the state and local tax deduction level-- those who would benefit from that tend to be higher income. And so most of that money would actually be saved. Partly because they pay for that salt increase, deduction increase, by lowering it later in the 10 year window.

And so you're going to have very different effects, depending on exactly who gets that spending relief. Either in terms of a direct federal program, or in terms of a tax reduction. So we actually go through 500 different elements of the Build Back Better plan and break it down into basically who it's targeting, who it's impacting. Building from data to actually see what the consumption impact will be. And then also recognizing that some of these programs such as pre-K education do require a couple of years to phase in.

- And just thinking about the impacts on inflation. In theory, the Fed could dial back some of its monetary policy, stimulus to counteract. But how effective is that really?

KENT SMETTERS: Yeah. I mean, that's the whole issue about inflation. It's not really just Congress. Congress has a dance partner. It's called the Federal Reserve when it comes to inflation. So the question always is, how much will the Fed neutralize through its open market operations any type of demand side inflation that's caused by Congress? During recessions, during times when GDP is below its potential, the Fed typically doesn't focus so hard on the 2% rule.

We know they've been pretty relaxed about that the last few years anyway. But then over time, we certainly do think that inflation is not a longer term issue. It's a shorter term, the Federal Reserve will tend to neutralize a lot of that. So the wild card in this-- whenever we talk about inflation-- the wild card is always going to be the other dance partner, the Federal Reserve. How much they're going to neutralize. And we think, over the next couple of years, we're talking about 0.2%, 2/10 of 1%.

That's, of course, on top of a base that's already-- this year we're talking about the average family is going to have to spend about $3,500 more just to get the same consumption that they were getting last year. So we're certainly talking about off of a bigger base, this year and even going forward. But nonetheless the Build Back Better, because of the way it phases in and the way it's structured, is not going to have more than, say 2/10 of 1% impact on inflation.

- All right, well, we will leave it there. Ken Smetters, Penn Morton Budget Model faculty director. Thank you so much for coming in and joining us today.