BUILT-IN TAX FLEXIBILITY AND THE EXPERIENCE OF THE FIFTIES

Kenyon E. Poole

The purpose of this paper is to call attention to certain interactions between built-in tax flexibility and the kinds of economic instability (and stability) that we have had in the present decade; and to point up some issues with respect to formula flexibility. Recent studies of the response of the personal income tax to changes in the level of aggregate income during the early fifties indicate that the built-in flexibility of this tax is less than many had supposed. These studies are naturally concerned with the direct responses of tax revenues to changes in gross national product or national income, and their inferences for the strength of built-in flexibility are restricted to these direct responses in particular episodes. It is also useful to speculate, however, on the relation between built-in tax flexibility and other automatic stabilizers and destabilizers as they operate in varying economic circumstances. The period 1952-59 is an interesting one in this connection because of the rather novel mixture of inflationary and deflationary forces combined with cyclical downturns and recovery in 1953-54 and 1957-58.

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By way of introduction, it is worth while to locate the criterion of built-in flexibility of the tax system in the broader framework of tax objectives as a whole. How far should the contribution of the personal and corporate income taxes to built-in stability be given weight when changes in the structure of tax rates are up for consideration? If the contribution is believed to be reasonably large, we may be tempted to pay some attention to this criterion of tax policy when dealing with the traditional task of distributing tax burdens among economic groups. Perhaps a better way to put it is this: We find that if we are indifferent as between two tax structures, we will prefer that alternative which promises the greater stabilizing response to unwanted movements in national income and spending. If, on the other hand, built-in tax stabilizing effects are found to be quantitatively not highly significant, there is not much point in wasting time in figuring out minor ways in which they can be increased.

There is general agreement that the built-in flexibility which at present exists in the Federal tax system (and a fortiori in State and

1 Leo Cohen states (American Economic Association, "Proceedings," May 1959, p. 540) that in the period 1949-53, "The average rate of taxation [of income] remained rather constant at 25 to 26 percent, regardless of the continuous increases in taxable income. This evidence seems to negate the generally accepted notion that the United States has a high degree of effective progression in the individual income tax structure." The small magnitude of the overall measurement of the built-in flexibility of the individual income tax (at 1953 rates), which for 1949-53 was about 0.138, indicates that "there are definite limitations to built-in tax flexibility as a device for promoting economic stability." Cohen's paper extends the findings of Joseph Pechman, "Yield of the Individual Income Tax During a Recession," National Bureau of Economic Research, "Policies To Combat Recession," pp. 123-145.

local taxes) is much too small to eliminate major fluctuations in output and prices. At the same time, this is no reason to lose all interest in built-in tax flexibility. The countercyclical factors automatically called into action in response to economic disturbances of a cyclical nature are complex. We must not suppose that any one of them can do the whole job. Therefore, the mere fact that built-in flexibility of the tax system, or of the entire fiscal system, is insufficient to eliminate fluctuations does not mean that the objective of increasing the built-in flexibility of the tax system should be ignored. Our conclusion would be different, to repeat, if built-in flexibility were inconsequential. I am going on the assumption, therefore, that unless other tax objectives are of overwhelming importance, recommendations for revisions of the tax law can reasonably include the criterion of increased built-in flexibility.

One more point should be made by way of introduction. The strength of built-in flexibility, both fiscal and nonfiscal, is likely to vary significantly from one inflationary or deflationary episode to another. This fact has significance for the usefulness of an index of built-in flexibility as a predictive device. A measure of built-in flexibility calculated from a prior episode may not have much relevance to the one which we are experiencing at a given moment. One of the major reasons for expressing doubts on the predictive value of the measure is that episodes differ in their impact on the distribution of income and spending, and consequently in the development of the tax base.

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A first policy recommendation for maximizing the stabilizing power of any given combination of Federal, State, and local tax structures is that an effort should be made, at least during a period of inflationary pressure, to avoid introducing such new taxes (and raising rates of old taxes) as affect the Consumer Price Index. If we accept the common definition of inflation as a rise in a general price index, additional indirect taxes have immediate inflationary effects whatever their ultimate anti-inflationary effects may be in siphoning off purchasing power from consumers. All sales and business taxes imposed prior to the retail stage are automatically covered into the index, and in addition, the schedule used by BLS field representatives specifically provides for adding the city and States sales taxes imposed at the consumer level. But besides this immediate impact on the index, there is an income effect by virtue of the fact that wage rates are geared to the Consumer Price Index, either formally through escalator clauses, informally through the cost-of-living criterion of wage determination, or (less immediately) through the pattern formation of wage rates characteristic of the overall wage structure.

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2 This point is of interest in developing measures of the strength of various countercyclical forces at similar stages of different recession episodes. (Cf., the suggestion by G. H. Moore, "Measuring Recessions," National Bureau of Economic Research, Occasional Paper 61, reprinted from the Journal of the American Statistical Association, June 1958, p. 264.) Two possible measures of the strength of countercyclical factors, easier credit terms and lower taxes, may have different values at the same stage of different cycles. That is, they have the properties of induced variables only to a limited extent; their reaction is likely to be different, within limits, from episode to episode in accordance with political and institutional reactions to economic events.

3 If sales taxes are intended to help to transfer resources to public use, it is hard to see the reason for including retail sales taxes in the CPI if the latter is to be used in escalator contracts.

At present writing (July 1959) there is the possibility that a considerable exodus from escalator clauses might be initiated by steel and meat-packing.

At this point I want to protect myself against the accusation that I am an adherent of any crude cost-push view of the inflationary process. Obviously no decisive inflationary pressure is established through rising sales and business tax rates if the transactions demand for money associated with the rise in the cost-price structure drives up the interest rate sufficiently to reduce investment and employment. In that case there is an offsetting downward pressure on the price level which can override the cost push originating in the higher rates of sales taxes, business taxes, and other indirect taxes. But experience in this country and abroad during the period 1955-57 indicates that even with a restrictive monetary policy there is likely to be enough liquidity in the system so that for several years, at least, aggregate spending can rise even though it is associated with a rising interest rate. The explanation seems to be that the rise in interest rate produces enough of a rise in velocity through a more economical use of money so that the transactions demand for money does not rise proportionately as much as aggregate spending. Finally, even if monetary policy did ultimately become effective in reducing investment demand, the associated decline in employment would (with a lag, to be sure) impel the Federal Government to increase spending or reduce tax rates in order to restore the minimum politically acceptable level of employment. This implies either an injection of money, or an increase in the rate of spending out of hoards. I conclude from this that if unit cost (in this case unit tax cost) is allowed to rise, we cannot count on any immediate brake from monetary policy.

The objective of maximizing the stabilizing power of the tax system lends support, therefore, to the argument that the Federal and State Governments ought to give the preference, where possible, to the individual income tax over taxes which enter into cost of production. (This leaves us in a somewhat ambiguous position with respect to the corporate income tax, since a lively debate is still going on among economists over the extent to which the corporate income tax rests on profits, increases unit cost, or increases unit cost and also the price level of final goods.) No policy issue arises so long as current rate structures, applied to a growth-induced rise in money and real national income, and thus in the tax base, are adequate to provide the desired rise in Federal, State, and local tax revenues. But this may prove difficult to achieve at all levels of government. Therefore, we have to reckon on the need for higher tax rates, certainly at the State and local levels, and possibly also at the Federal level. The nominal rate structure of the Federal individual income tax, in the middle and upper brackets at least, is believed to be about as progressive as it can get in terms of political acceptance, although the width of the

The United Nations noted this phenomenon for Canada, the United States, the Scandinavian countries, and Britain from 1955 to 1957. World Economic Survey, 1957, p. 53. In the United States GNP rose from $397.5 to $440.3, while demand deposits adjusted and currency outside banks remained virtually stable at $110 and $28 billion respectively. The rate on AAA corporate bonds rose from 3.06 to 3.89 percent.

It may be that corporations' price policy is in part a function of the strength of demand for product. To the extent that this is so, the burden of the corporation income tax is affected by cyclical factors, and the impact of the tax on the Consumer Price Index would be greater during a period of prosperity and rising prices. The incidence of sales and excise taxes likewise probably responds to the strength of demand for goods.

This gets us into the benchmark problem: we cannot tell accurately from the proceeds of the tax what its built-in stabilizing effect is. Built-in flexibility of taxes and the stabilizing effect of tax changes in response to changes in the level of income are not the same thing.

brackets could be narrowed, and the marital deduction eliminated. And at the State level the fact that only two-thirds of the States have a personal income tax is an indication of the widespread preference for indirect taxes.

At the Federal level, large amounts of revenue are lost through the so-called mitigating exemptions and deductions which have excited fears for the debilitating effect of "erosion" of the income tax. Both equity and built-in flexibility would be served by the elimination of some (though by no means all) of these mitigating provisions. The point is that if they were removed, it would be possible to effect a reduction in the nominal rate structure. This would be desirable from a number of points of view; but in the present context the advantage would be that room would be provided for some increase in income tax rates in the event that there was a need for a rise in tax revenues great enough to call for additional taxes or higher tax rates.

The problem is more difficult at the State and local levels, if only because the States and their municipalities are fiscally independent of the Federal Government, and therefore difficult to integrate into a fiscal program which includes economic stability among its objectives. At the same time their relative importance in the economic system increases inexorably as their spending programs rise,' and they are continually forced (as a group) to raise the rates of taxes entering into unit cost. It should be noted that changes in Federal tax rates in response to the adoption of a policy of "formula flexibility" would have to take account, in terms of estimating the probable stabilizing effects, of simultaneous changes in tax rates dictated by the fiscal needs of the States and localities. Each year the increment of rises in State and local tax rates, which should serve the purpose of preventing the lower levels of government and their citizens from bidding up prices against each other, contributes to a rise in the price level, and thus in wage rates and other factor returns geared to a cost-of-living or other price index.8

A second policy recommendation, to keep prices as stable as possible in the light of the competing objectives of full employment and optimum growth rates, may appear at first sight to be somewhat banal. But it seems to me that there is a real, though at present admittedly

State and local revenues (excluding Federal grants) rose by $21,970 million between 1946 and 1957. The rise in income tax receipts was more than fourfold (as contrasted with a threefold rise in total tax receipts). But income tax receipts were relatively small in 1946; consequently despite their large percentage rise they accounted for only 6.1 percent of the increase in total State and local tax revenues ($1,345 million). Total tax revenues at the State and local levels were 6 percent of GNP in 1946 but had risen to 7.8 percent by 1957, or a rise in the ratio by 30 percent. It follows that if this trend continues, as it is expected to do, the States and municipalities will not only need more revenues, but will have to raise tax rates significantly. It is likely that more and more States (and possibly cities) will be forced to turn to the individual income tax in the future. Nevertheless, sales, business, and property tax rates seem certain to continue to rise. The BLS sometimes makes estimates of the effect of State and local taxes on the index for a particular city. An estimate of the effect of State sales taxes for 1954 showed that for Detroit they accounted for about 21⁄2 percent of the total CPI.

8 It would be useful, for purposes of dramatizing the impact of indirect taxes on the price level, to publish the Consumer Price Index with and without taxes. The precedent has already been set in several countries, for example, Denmark. In addition, there is need for an index of tax cost, among other nonlabor cost indexes. It may be mentioned also in passing that with respect to State and local expenditures, much light could be thrown on the inflationary impact of expanding factor-purchase programs if an index were prepared of the cost of labor, materials, etc., incurred by these levels of government. The same index could probably be used as that proposed for Federal Government expenditures (cf. Bureau of the Budget, Office of Statistical Standards, Report on Statistics for Prices, Costs, and Productivity Analysis, Apr. 8, 1959). The index would be built up out of the major cost elements of construction: labor, materials, contractors' overhead, engineering fees, etc.

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rather remote, possibility that an accelerating rate of inflation could, once some critical point was reached, set up a reaction that would work against the stabilizing effect of the tax system. This would come about if more and more economic groups got themselves under the escalator umbrella. The inclusion of indirect taxes in the CPI would then assume greater importance as a source of autonomous cost inflation than is the case at present. Each rise in the index attributable to a rise in the rate of an indirect tax would automatically raise the incomes of a much segment of the population than is the case at present. Moreover, while it can be argued that the formal wage escalator does not cause wage rates to rise substantially more rapidly than they would do in response to a rise in the price level under collective bargaining or under the market determination of wage rates (some argue that the escalator retards wage increases), this is far from the case with those groups whose incomes (and wealth in the form of dollars) notoriously lag behind price level changes.

Much of the potential detraction of the stabilizing force of the tax system would be eliminated, both under wage escalation and under a system of extensive valorization of incomes and money wealth, if firms, unions, and the public at large could be brought to recognize the destabilizing effect of escalation (all types) in response to very small rises in the index. Immediate and full compensation for every small (and often temporary or nonrepeated) rise in the index insures the propagation of inflationary shocks that might otherwise be absorbed into a flexible economic system.10

II

Built-in flexibility is defined by Pechman as the product of the flexibility of the tax base (i.e., the change in taxable income divided by the change in adjusted gross income) and the marginal rate of taxation (the change in tax liability associated with the change in taxable income). Built-in income tax flexibility thus partly depends on the redistribution of income associated with changes in the level of aggregate income. The role of before-tax shifts in income distribution is stressed as one important element in accounting for the low marginal rate of income taxation in response to income changes

It is not necessary to belabor the fact that there has been considerable rise in public interest in variable annuities and other defenses against inflation in recent years.

10 It is unrealistic, of course, to expect sentiment in this country to accept a device that is frequently used abroad to reduce the impact of inflation from the cost side, namely, a feedback from rising prices to the terms of the escalator contract. A striking feature of escalator practice in a number of countries since World War I has been the disposition of governments, and even the representatives of the workers, to permit loosening of the 'bond between cost of living and wage rates (and other escalated incomes) when it has 'been feared that a critical rate of inflation was being reached. The most common methods have been an increase in the escalator lag (between the rise in the price level and the induced rise in wage rates, etc.) and a reduction in the permitted response of wages and other incomes to a given rise in the price level.

We should perhaps be aware of another contribution that the tax system can make to price stability. If we are to believe those who have stressed the wage-price spiral as a major factor in rising prices in the fifties, inflationary pressure could have been reduced if the CPI could have been made less responsive to temporary pressures from the cost side. 'One way to accomplish this is to give the executive the power to raise or lower excise tax rates, within limits, in order to offset minor and temporary rises in non-tax-unit costs. The revenues could be made up through increases in income tax rates (this constitutes an argument in favor of sharply reducing the number of provisions which permit income to escape the tax base, so that it would be possible to start off with a lower income tax rate -structure) or through additional borrowing from savers. This method has been used particularly in France, and is perhaps no more novel than the frequently made suggestion that the executive be empowered to vary income tax rates to offset short-term fluctuations in income and employment.