Tax indexation is an idea whose times has come - and this year is going to prove it.
Through indexation sounds complicated, it actually is simple. It means that the government automatically corrects the income tax system to prevent inflation from kicking taxpayers into higher and higher brackets. Assume, for example, that inflation raises a family's income 10 percent. It goes into a higher tax bracket, and its tax rate increases even though its "real" income hasn't. Without indexation, Congress must pass a major tax "cut" every few years to prevent this invisible tax increase.
That's precisely what has been happening. Assuming a tax package passes in 1978, Congress will have approved major tax reduction bills in three of the past four years. As long as inflation persists at a 5 percent to 6 percent annual rate, the cycle will continue.
The defects of this system are now becoming increasingly clear.
Most important, it's fundamentally dishonest. It confuses the average citizen and, indeed, possibly the average congressman. It puts the nation's highest officials, starting with the President, in the foolish and ultimately self-defeating position of pushing half-truths on the public. They promise tax reductions, but in the main, all they are doing is repealing automatic tax increases.
Average taxes, as a percentage of personal income, are declining largely against what they would have been, not what they were. Even if President Carter's program passes as proposed the average tax level is estimated to be higher in 1979 than in seven out of the past 10 years, as the following table indicates. It shows federal income taxes as a percentage of personal income since 1969:(TABLE) 1969(COLUMN)11.6% 1970(COLUMN)10.5 1971(COLUMN)9.9 1972(COLUMN)9.9 1973(COLUMN)10.3 1974(COLUMN)10.7 1975(COLUMN)9.9 1976(COLUMN)10.2 1977(COLUMN)10.1 1978(COLUMN)10.3 (est.) 1979(COLUMN)10.5 (est.)(END TABLE)
Bombarded from Washington with propaganda about the beneficence of tax cuts and confronted with a largely static tax bill, the average taxpayer sooner or later is bound to react in anger and disillusionment.
A second flaw of the current system is that it hampers economic policy and increases the likelihood of an economic downturn or recession. In the days when inflation crept along at an annual rate of 1 percent to 3 percent, the dynamics of the income tax system were thought to represent a helpful "automatic stabilizer." If inflation increased, incomes would rise and, consequently, so would the tax bite. That would reduce consumer spending, the economy would slow, and inflationary pressures would abate. This was a comforting notion.
Unfortunately, it does not sit well with reality. As the past few years have demonstrated vividly, inflation has an independent momentum. Through powerful unions, oligopolistic companies, government fiat and social custom - the idea that everybody should stay "even" - inflation gets perpetuated, checked only feebly by weak constraints.
In this climate, the "automatic stabilizer" simply puts the economy on its backside - or threatens to do so - with a mild impact on inflation. There is then a rush to pass a tax cut to revive the economy.
The outlook for 1978 illustrates the risks. Many economists worry that the economy may slow down in the second half of the year in part because the rising tax bite will curb consumer spending. But the administration doesn't think it can possibly get its tax cut passed before Oct. 1. So Carter's economists are forced to bite their nails and hope that the timing turns out right.
A final defect of the existing anarchic approach is that it constitutes a cruel and unusual punishment of congressmen. This, of course, contradicts the conventional wisdom that politicians like nothing better than basking in the ensuing public approval. Many congressmen may have once embraced this simple logic, but, by now, a more complicated reality is forcefully asserting itself.
That reality is that Congress stirs up as much grief as gratitude when it acts on a major tax bill. Every interest group that feels entitled to some new tax break, or simply wants to protect an existing benefit makes a pilgrimage to Capitol Hill. Any congressman is bound to disappoint some of these petitioners. And the more big tax bills there are, the greater the opportunity for offense.
Moreover, on the other side of the political ledger, public gratitude for tax reductions is increasingly tempered by the realization that they largely represent a holding action against inflation. The political arithmetic of this process is not especially favorable. The more the cycle of phantom tax cuts occurs the worse the arithmetic will become. Ultimately, Congress is bound to search for an exit.
Indexation would minimize its problems. Although adjusting corporate and business taxes for inflation is difficult, the necessary alterations for the personal tax present no insuperable technical problems. Tax rates, deductions, exemptions and credits can automatically be changed to reflect inflation.
Indexation wouldn't - and shouldn't - exempt Congress from the necessity of changing the tax laws. There are fundamental political and social problems that will not conveniently vanish. As social security taxes rise (reflecting the program's higher costs), should Congress let the total federal tax bite increase, or should it cut some existing spending? Should the tax system be used more aggressively to promote income redistribution or, on the other hand, investment?
Regardless of what it does, Congress will have a difficult time permanently evading these issues. But, already overburdened by complicated problems that it only dimly understands, it does not need to create added uncertainties by having to fiddle with tax rates every 18 months.