The U.S. Senate took a step into the political and economic unknown last week by voting to index, or adjust for inflation, personal income taxes beginning in 1985. More than half the members of the House of Representatives are sponsoring similar bills.
Past efforts at indexing, mostly on the expenditures rather than the recipts side of federal ledgers, have hardly turned out as Congress thought they would shen it enthusiastically adopted them. Social Security, civilian and military retirement, supplemental security income and food stamps all have been indexed in the last decade or so.
No one foresaw any problems when Social Security was indexed in 1972. Liberals voted for it to be sure the real value of benefits would not be eroded by inflation. Conservatives voted for it partly in hopes that benefits would not continue to rise faster than inflation as they did regularly during the 1960s and early 1970s.
Today, Congress and the Reagan administration are struggling to find a way out of a Social Security dilemma in which indexed benefits have been rising much more swiftly than the wages on which the payroll tax supporting them is paid. One suggestion is to reduce the scope of indexing. Similar proposals are about to be adopted for other programs, including civilian and military retirement, for budget reasons.
The Senate bill would widen all tax brackets, increase the zero-bracket amount (formerly the standard deduction), and increase the present $1,000 personal exemption in 1985 and succeeding years according to the percentage increase in the consumer price index during the 12 months ending in September of the preceding year.
How well indexing personal income taxes would turn out is anybody's bet, but one thing is certain: it would greatly reduce political flexibility in dealing with budget questions.
If outlays, whether for the military or for non-defense programs, were increased faster than the inflation rate, offsetting cuts would have to be made elsewhere unless federal tax receipts were rising because of economic growth. The alternatives would be either a larger budget deficit or an explicit tax increase.
Many of the backers of indexing personal taxes like the idea for just that reason. As Sen. Robert J. Dole (R-Kan.), chairman of the Senate Finance Committee said last week during the indexing debate, "With an inflation bonus in tax revenues, Congress need not vote the tax increases appropriate to higher levels of spending. . . . It is time to abandon that cushion and get on with the job of responsible and antiinflationary fiscal management."
Adds economist Rudy Penner of the American Enterprise Institute, "With indexing, the Congress will have to raise tax rates explicitly when they wish to command a higher proportion of national income, and it will no longer be possible to take credit for tax cuts that are not really tax cuts."
Critics respond that over the years Congress has effectively indexed the tax system without putting itself into a fiscal straitjacket. Even during the period from 1967 to 1979, when inflation was much higher than it had been previously and the upward creep of tax brackets thus more severe, periodic tax cuts kept average rates close to what they would have been with an indexed system, according to a Congressional Budget Office study.
The general tax cut now pending in Congress is an example, albeit a larger one than usual, of just such a downward adjustment in taxes that will offset rising burdens due to inflation. Congress also is taking the opportunity to change the tax law in other ways, as it usually has done in these bills. The chance to make such shifts would undoubtedly be reduced by indexing, and whether that is good or bad depends on whether one thinks those other changes have been good or bad.
Opponents also say that if rising inflation is result of an overheated economy, bracket creep can help to restrain economic activity automatically and therefore slow inflation. Indexing would eliminate that so-called automatic stabilizer. On the other hand, today's inflation is not the result of a boom, and a number of economists question whether this stabilizing function is important.
There is disagreement among indexation backers and opponents, too, over whether the change would make the U.S. economy more or less inflation-prone. Those opposing indexing argue it would be just one more accommodation to inflation. As Sen. John H. Chafee (R-R.I.) declared, ". . . . All forms of indexing have led to trouble. If we ever are going to lick inflation in the nation, it is absolutely essential that everyone feel the pain, that the pain be spread around, so that the pressure is constantly on us . . . to defeat inflation . . . ." In reply, other senators said that, on the contrary, the cushion of rising tax receipts enabled Congress to escape hard, necessary choices in fighting inflation.
But deciding to index is one thing. The decision as to how and what to index is another, and there seems to be wide agreement among economists that using the consumer price index to make the adjustments, as the Senate voted to do, is not the best way to do it.
For instance, Richard W. Rahn, chief economist of the U.S. Chamber of Commerce, last week called the CPI "a poor measure of inflation as presently constructed" and said it should not be used to index the tax system.
A Congressional Budget Office study of indexing last year also noted that cost-of-living measures in general and the CPI in particular may not be desirable for this purpose. The CPI measures only changes in the prices of goods and services consumed by households, not the cost of capital goods used by business or by government at all levels. In addition, the CPI is not adjusted very often for changes in consumption patterns.
The most serious CPI defect, however, is that it counts directly price increases for imports, such as for oil, which may be reflected only to a limited extent in domestic incomes, the Congressional Budget Office said. "If indexing is intended only to keep overall tax rates from rising, including these price rises in the inflation index may cause an overadjustment of tax rates," the study said.
As an alternative, a price deflator for the gross national product, personal consumption expenditures or national income could be used, CBO said. Between 1968 and 1979, those measures of inflation, which do not include import prices rose annually by an average of 0.3 percent to 0.7 percent less than the CPI.