With concern mounting over the size of the federal deficit, much of the discussion in Congress focuses on how to get more tax revenue without heavy political costs. The result is substantial pressure to keep expanding revenue by the hidden increases in tax rates that are caused by inflation. This pressure may result in repealing the permanent tax indexing that is scheduled to begin in 1985. While such a move might mean smaller deficits after 1984, it would also be a serious permanent blow to sensible tax policy and to the attempt to slow the growth of government spending.
Bracket creep: In recent decades, the combination of inflation and our progressive income tax structure has meant that the government has taken a growing share of personal income in tax revenue. When personal incomes have risen to keep pace with rising prices, the increased income has pushed the taxpayer into ever higher tax brackets, and inflation has eroded the value of fixed-dollar personal exemptions and standard deductions. The result has been that the tax burden has risen more in proportion than the rise in income.
The way our tax system currently works, if there is a 10 percent increase in all incomes, total tax revenue will rise by about 16 percent. The relative increase in real tax burdens and the resulting fall in real incomes is most severe for middle-income taxpayers. For a family with $20,000 of income, a 10 percent rise in income means a tax increase of more than 20 percent. In contrast, for a family that earns $200,000, a 10 percent rise in income means a tax increase of less than 12 percent. If the 10 percent income rise is matched by a 10 percent rise in prices, the real after-tax income falls proportionately more for the $20,000 family than for the $200,000 family.
The method of preventing this hidden inflation-generated tax goes by the uninformative name of indexing. Indexing taxes simply means adjusting upward, by the rate of price-level increase, both the tax brackets and the fixed-dollar exemptions and standard deductions. This adjustment for inflation maintains the same tax share for any given real income.
With indexing, if the price level and incomes both rise by 10 percent, the individual's tax liability will also increase by 10 percent. The share of income taken by taxes will rise only if income increases by more than the rise in the price level.
Part of the tax law Congress enacted last summer calls for a permanent automatic indexing of the federal income tax starting in 1985. Although most of the congressional debate and public attention has focused on the three-year sequence of rate reductions in 1981, 1982 and 1983, it is the permanent automatic indexing that can have the greatest long-run importance to taxpayers.
Without the automatic indexing feature, taxpayers have had to wait for the occasional one- shot tax changes to reduce the rising tax burden caused by inflation. Such tax-rate reductions have been too infrequent and too small to offset fully the inflationary bracket creep.
Until last October's 5 percent rate cut, taxes hadn't been adjusted since January 1979, even though the consumer price index had increased more than 35 percent. Even the much ballyhooed 25 percent reduction in tax rates is not enough to offset the inflation-induced increase in tax rates between 1979 and the scheduled start of indexing in 1985. As a result, most households will pay a larger share of their incomes in taxes in 1984 than they did in 1979.
Since indexing just amounts to maintaining the status quo for taxpayers, why is there a significant movement to repeal it even before it has been tried? There are really two different sources of opposition. One group of commentators is genuinely, albeit mistakenly, concerned that indexing will necessarily cause increased budget deficits. In contrast, the second group understands that indexing needn't cause deficits but fears that indexing will prevent the rising level of government spending that they favor.
Mistaken concern: It is easy to understand why some commentators have mistakenly convinced themselves that indexing both taxes and spending will lead to ever growing deficits. They worry that indexing taxes means a reduction in tax revenues just when more revenue is needed to meet the cost-of-living increases in indexed transfer programs. In fact, however, indexing taxes does not cause a decline in tax revenue but only stops inflation from raising taxes faster than the price level. And while indexing Social Security and other forms of spending does raise outlays, it does not cause outlays to rise any faster than inflation.
If taxes are indexed and spending is indexed, inflation has no effect on the real deficit. For example, with indexing, a 10 percent price rise causes a 10 percent increase in taxes and a 10 percent increase in spending. If the budget were in balance before the inflation occurred, it would continue to be in balance. Similarly, any pre-existing deficit would be maintained at the same real level.
Increasing spending: Many of those who argue that indexing would increase deficits actually know better but oppose indexing because they want the rising level of real tax revenue that would result if indexing were eliminated. Even if the 1983 tax cut were eliminated and other recently proposed tax increases were legislated, eliminating the deficit would require slowing the growth of government spending. To avoid this spending slowdown, a substantial number of representatives and senators, as well as outsiders who favor a greater role for the federal government, want a repeal of indexing and the continuation of a tax structure that automatically provides ever-increasing tax revenue in periods of inflation.
Perhaps the most harmful effect of repealing indexing is that doing so would make inflation look more attractive to the members of Congress. Without indexing, inflation provides Congress with greater real tax revenues that can be used to finance politically rewarding increases in government spending and to enact so-called tax cuts that in reality return only part of the tax increases caused by inflation. If indexing is repealed, we would expect changes in congressional policies and attitudes to cause a higher rate of inflation in 1985 and beyond.
A proposal: The right way to eliminate the vast deficits that loom ahead is to slow the growth of government spending. Balancing the budget does not require abandoning tax indexing after 1984. It would be a great pity if a political alliance between the confused and the disingenuous were to cause a repeal of tax indexing.
Nevertheless, Congress' desire for additional tax revenue may prove to be an overwhelming political force for the repeal or "postponement" of indexing. Although we favor no change in the tax indexing rule enacted last year, we offer a compromise solution that maintains the spirit of indexing while providing some additional revenue from bracket creep. Our proposal parallels an approach that many congressional leaders favor for limiting the growth of government spending.
Instead of introducing full tax indexing, under our proposal tax indexing would be limited to the excess of inflation over 3 percent. Thus if inflation is 7 percent, tax brackets and other dollar amounts would all be increased by 4 percent. With 7 percent inflation, full tax indexing would mean that tax revenues would rise by 7 percent as well. Limiting indexing to the excess of inflation over 3 percent would mean that tax revenues would rise by more than 7 percent.
Bracket creep would thus guarantee a certain amount of additional revenue but would no longer cause real tax revenues to increase more at higher inflation rates. Since the extra real tax revenue would be the same with 4 percent inflation as with 10 percent inflation, Congress would have no incentive to tolerate higher inflation in order to guarantee more revenue.
A parallel "inflation minus 3 percent" indexing of benefits would mean that the benefits would rise by 4 percent when inflation in 7 percent. Real spending would thus decrease. The decreased real spending and increased real tax revenue would work together to help shrink the deficit. Advancing the date of our modified form of indexing from 1985 to 1983 instead of the 10 percent tax cut that year would help to reduce the deficit even more rapidly.
And as the deficit shrinks and higher real growth increases the flow of tax revenue, the indexing formulas for both spending and taxes could be adjusted gradually from "inflation minus three" back to complete indexing of both spending and taxes.