The 1981 Economic Recovery Tax Act is a historic bill. For better or worse, it is a major driving force in shaping our economy. The magnitude of individual tax relief through cuts in marginal tax rates and the reordering of priorities to encourage greater business productivity will be key stimulants in the economic recovery finally under way. As important as these provisions are, though, I'm convinced that in the long run, indexing inflation out of the federal income system will be seen as the bill's most significant achievement.
Indexing is the key that locks other accomplishments into place. Without indexing, the American taxpayer would have no guarantees beyond the three years of the individual tax rate cuts. Without indexing, we'd have a tax system that would be no more predictable than it was before the 1981 Economic Recovery Tax Act. Indexing makes our tax system more fair and our government more accountable.
An unindexed progressive income tax is a boon only to government. Interacting with inflation, such a system increases government revenues faster than the rate at which inflation increases taxpayers' incomes. In other words, government gets an automatic tax increase, while taxpayers get less real after-tax income as inflated incomes are taxed at higher average rates. The result: government continually extracts a greater proportion of taxpayers' real incomes for its coffers.
My own state of Minnesota illustrates the point. Like the federal government, Minnesota has a steeply progressive income tax, steeper than most other states'. In 1972, a typical taxpayer with a gross income of $20,000 paid 7.9 percent of his gross income to the state in income taxes. By 1978, assuming that his income increased at exactly the rate of inflation to $31,855, the interaction of inflation and the unindexed progressive Minnesota income tax had increased his average tax rate to 8.7 percent, even though his real income remained constant.
Let the record be clear: Minnesota's severe fiscal problems are not a result of indexing. It is true that for the 1980-81 biennium, indexing cost Minnesota approximately $317 million in lost revenues; in the current 1982-83 budget cycle, the estimated cost is about $543 million. But over the four years, this $860 million has been fully taken into account by budget restraint--cutting programs, containing their growth or looking for better, more cost-efficient ways to meet the needs of people.
Something else happened independently of indexing to create fiscal stress on the state after 1979. Both the national and state economies fell far short of their expected performance, and so the drop in state revenues was over and above the expected and planned-for decreases due to indexing. This additional fall-off in revenues is what spawns Minnesota's continuing fiscal troubles. It has absolutely nothing to do with indexing. It has everything to do with a weak economy.
Another curious argument is that indexing is somehow a sneaky way to shift reliance away from the progressive income tax and onto the regressive sales tax. Again, the Minnesota experience, when fully understood, shows exactly the opposite. When state legislators in Minnesota had to raise additional revenues last year, competing proposals to raise the sales tax or raise the income tax were openly debated in the state legislature. The governor recommended increasing the income tax--already the highest in the nation in several brackets. But thousands of Minnesotans contacted their state legislators, and, in the end, an increse in the income tax was soundly rejected, while a 1 percent increase in the sales tax was approved.
This was certainly a more open way to increase taxes than under the previous unindexed system, when tax rates were automatically increased by inflation, and revenue rolled into the state treasury without a single public official's being accountable for a single public decision. Indexing restored rather than destroyed, honesty in Minnesota fiscal policy. It will do the same at the federal level.
To see the fiscal irresponsibility bred by an unindexed progressive income tax, one need only look to Minnesota over the 10 years prior to indexing. The state income tax served as a great money machine for the state government. To make matters worse, the legislature also put in place a well-known mechanism to dispense the money as fast as it came in: entitlement programs that do not have to be voted on each year but automatically send out the money. The state of Minnesota was on full automatic pilot, and on a collision course.
The entitlement with the largest appetite in Minnesota is the real property tax circuit-breaker, the Homestead Tax Credit. While the income tax levied hidden tax increases annually, the circuit-breaker bestowed highly visible--and politically valuable--so-called "tax relief" to homeowners and renters. This tax credit was continually increased until now Minnesota property taxpayers pay only about 42 percent of their levied property tax; the state of Minnesota pays the rest. Of course, this grew far beyond true tax relief, into a targeted political payoff.
Finally, Minnesota's experience with indexing explodes the myth that it hurts the low- to moderate-income taxpayers while giving a break to the rich. At lower income levels, tax brackets are much narrower, meaning that inflation propels these taxpayers into a higher bracket much more readily than those already in a higher and wider bracket.
Indexing is designed to correct this "bracket creep." But since high-income individuals are already in the highest tax bracket, they do not suffer from bracket creep in the first place, so indexing gives them no special aid. Furthermore,,taking into account the erosion of fixed- dollar deductions and credits as well, there is no doubt that indexing the Minnesota income tax granted greater relief to lower income levels.
For those who support ever-increasing spending through the public sector as a basic philosophy of government, indexing no doubt causes great concern. Indexing eliminates the part of the system that most facilitates and encourages the growth of government.
On the other hand, if one supports the notion that taxing and spending decisions should be made explicitly through the legislative process on a periodic basis, then indexing in Minnesota is having exactly the effect one would hope. Indexing will bring fiscal responsibility and accountability back to the federal government as well.