The progressive income tax, far from automatically keeping the economy on a stable path as it is designed to do, actually made the 1974-75 recession worse because it pushed people into ever higher tax brackets when their real incomes were falling.
That is the contention of a Congressional Joint Economic Committee staff study released yesterday.
The study argues that the federal personal income tax system must be indexed - or corrected for inflation - so that effective tax rates are not raised by wage increase which merely keep pace with, or even lag somewhat behind inflation.
Under an indexed system, persons with larger incomes would continue to pay a bigger percentage of those incomes to the government than would poorer persons, but wage increase which merely keep pace with higher prices would not raise the average tax rate for any individual.
Thomas F. Dernburg, chairman of the economics department at Americans University and author of the study, contends that not only does the progressive income tax reduce real incomes during inflation periods ("so that erstwhile automatic stabilizers become destabilizers) but that is also provokes labor to seek higher wages, lowering production (and employment) and intensifying inflation.
Traditional economic theory holds that the graduated income tax is an "automatic stabilizer" because when prices and wages are rising during periods of excess demand, progressively higher percentages of the incomes are taxed. This boosts the federal tax take economy. Similarly, when production and wages are falling during a recession, the percentage tax take falls faster than wages decline, thereby propping up real income and production.
The same theories argue that indexing will contribute to inflation and economic instability by failing to reduce excess demand during period of inflation.
But when, as in 1973 and 1974, inflation occurs not because of excess demand but because of supply problems - such as the quadrupling of oil prices by producing countries and thw worldwide grain shortage which boosted food prices - the progressive tax system does not help inflation and can contribute to recession.
"Very few competent analysts would seriously claim that the economy of 1974 was characterized by excessive demand," Dernburg contends. Instead, it was plagued by what economsts call stagflation - rising prices and falling production.
Yet, because prices were rising, the progressive income tax pushed federal spending and taxing policies into a sharply restrictive mode. Between the final three months of 1973 and the third quarter of 1974, real economic output (as measured by the gross national product adjusted for inflation) fell at an annual rate of 3.2 per cent. But nominal GNP, including the effect of inflation, rose at an annual rate of 11.1 per cent. That means that even though fewer goods and services were produced, their total cost was much higher than the prices tag on the bigger output nine months earlier.
Personal income rose 9.4 per cent in dollar terms, but after adjusting for inflation, it fell 2.4 per cent. Because the federal income tax rate rises on additional dollars earned federal tax receipts increased faster than either nominal personal income or GNP.
The federal income tax take rose from 11 to 11.5 per cent of personal income during the period, even though the economy was weakening, as evidenced by the fall in real economic output.
"This is one of the troubles with an unindexed income tax: The aggregate income tax rate rises as long as nominal personal income rises, rather than as long as aggregate demand is excessive," Dernburg notes.Had the tax system been adjusted to account for inflation, the ratio of taxes to personal income would have fallen slightly, to 10.9 per cent.
"There is no doubt, therefore, that indexed taxes would have moderated the collapse of 1974," Dernburg contends.
Even without outside disturbances, however, the progressive tax system contributes to inflation, as workers seeks to compensate for the higher taxes by demanding large wage increases, he argues. The tax increase reduce demand, thereby lowering production, employment and incomes.By itself, this would lower the price level. But the wage increase workers demand raise production costs. Because production costs rise, output falls even further, which lowersincomes. But total consumption never falls as much as total income (consumers either reduce savings or borrow to maintain a higher spending level), so effective demand rises relative to output and may boost the overall price level back up to where it was.
As a result, Dernburg contends, the progressive tax system may decrease employment during an inflation period without much gain against inflation. "This certainly ought not to be permitted to happen automatically, inasmuch as it implies creates a bias towards higher unemployment and rapidly rising wages as well," he says. He concedes that the empirical evidence to support this theory, at least in the case of the United States, is far from conclusive, but says that events in 1964, following the tax cut, and in 1968, following the imposition of the tax surcharge, would be consistent with this theory.
Dernburg, co-author of one of the leading intermediate economic-theory textbooks, notes that Congress regularly has taken action to ensure that inflation does not substantially change the way the tax system redistributes income and to keep the overall share of federal taxes (personal and corporate income and Social Security) at about 20 per cent of GNP.
Discretionary action, however, cannot perform adequately "in the handling of short-run stabilization policy," he says. Without indexing, the progressive tax system today can make matters worse.
He argues that rather than having a tax system which responds to inflation (whatever its cause) by raising the aggregate tax rate, an indexing system would produce a "neutral response that keeps the aggregate tax rate constant and maintains proportionality between taxes and personal incomes when the price level changes."