The liberal soothsayers and politicians whose previous policies created the current inflationary mess are now rushing forward to oppose the tax cut as inflationary. Is this evidence of contrition and a return to old-time virtues? We doubt it.
Our guess is that the liberals who are opposing the tax cut are simply afraid that if tax rates are lowered the government will have a hard time getting that money back again to finance increased spending programs. In the past 40 years, Congress has never raised tax rates except in time of war. The surge of spending in the past 15 years has been supported by the extra revenue that comes in automatically as inflation pushes us all into higher tax brackets. The debate over whether or not to cut taxes is in reality a dispute over the level of government spending.
We also suspect that the liberals who are posing as inflation-fighters don't like the form of the tax cut either in the 1970s, tax cuts were a vehicle for redistributing income from the middle- and upper-income taxpayers to those with lower incomes. But not the Reagan administration wants to cut the taxes of the middle- and upper-income groups in order to strengthen incentives and to give back some of the extra taxes that the government has collected because of inflationary bracket creep.
But even if their motives are suspect, isn't there validity to the argument that the tax cut will swell the deficit and thereby exacerbate inflation?
No. Although a tax cut would increase the deficit, only a textbook Keynesian theory equates changes in the government deficit with changes in aggregate demand. In the current debate, far too much emphasis is being placed on the federal deficit as a measure of excess demand. In considering the president's program, it's important to recognize that a tax cut that increases the deficit does not add an equal amount to consumer spending and that pairing a tax cut with an equal spending cut actually lowers the demand for goods and services and therefore reduces inflationary pressure.
When the government increases its spending by a dollar, the demand for goods and services is also increased by a dollar. And when the government increases transfer payments or food stamps by a dollar, most, if not all, of that increase is spent. In contrast, lowering taxes by a dollar does not raise personal spending by an equal amount because some part of the reduced tax is saved.
The share of the tax cut going into savings is likely to be particularly important for the tax cut proposed by President Reagan. Since taxpayers with adjusted gross incomes over $30,000 pay 60 percent of the total income tax, they would get 60 percent of an across-the-board tax cut. This relatively high-income group -- about the top one-sixth of all taxpayers -- saves a much higher share of income than the average household. Indeed, one-third of an across-the-board tax cut would go to those with incomes over $50,000 while less than one-fifth would go to those with incomes under $20,000.
The tendency to save a large part of the tax cut will be reinforced to the extent that the cut is regarded as providing only temporary relief. While many low-income households spend all of their after-tax income each year, higher-income families use saving and dissaving to avoid large fluctuations in consumption. For such individuals, each year's level of spending reflects not only current income but also what they expect after-tax income to be in future years. Although the president has proposed a permanent cut in tax rates, inflation can rapidly undo this reduction by pushing individuals into higher brackets. Even a 30 percent tax cut would be completely offset at the current rate of inflation in about five years.
Looked at in this way, the administration proposal represents only a temporary tax cut and will therefore result in a proportionally smaller increase in spending. Moreover, some kind of tax cut has been anticipated for many months now. The higher-income taxpayers who base their spending on expected future income will increase their consumption after the tax cut is enacted only to the extent that the final legislation involves a bigger tax cut than they had anticipated. And reducing the maximum tax rate on interest and dividends to 50 percent should be a further stimulus to saving at high-income levels.
Although it seems almost certain that taxpayers will save a substantial part of the personal tax cut, economists cannot say with precision just how much will be saved. It is important to recognize, however, that the saving rate is not fixed but can vary substantially -- it ranged in the past half dozen years from 5.2 percent to 8.6 percent -- and that even a 1 percent increase in the saving rate would cut consumer spending by nearly $20 billion.
But don't get us wrong. In advocating a tax cut, we're certainly not saying that deficits don't matter. When the government borrows to finance a deficit, it absorbs savings that would otherwise be available to private investors. Indeed, over the past decade the high rate of government borrowing has been an important contributor to our nation's low rate of capital formation.
The tax cuts must therefore be coupled with the spending cuts the administration has proposed. The exact timing and balance of the tax and spending cuts are matters on which experts can disagree. But we're hopeful that Congress will not be seduced by the false prophets of fiscal rectitude into continuing the current policy of over-taxing the American people.