A proven method to prevent both deep recessions and rapid inflation

Progressive taxes help stabilize the economy and budget

by Richard Schiming
Published in the Mankato Free Press, Sunday, March 20

The author teaches economics at Minnesota State University Mankato.

What if a macroeconomic tool existed that could protect an economy from both deep recessions and rapid inflation? What if, as a bonus, this tool could help balance the federal budget?

We already have such a fiscal tool: a progressive tax system.

A progressive tax structure has numerous tax brackets with increasing marginal tax rates.

When the economy and income expand, people move into higher tax brackets. This movement reduces aggregate demand and inflationary pressure while increasing tax revenue. When the economy and income are slowing, a progressive tax structure automatically moves taxpayers into lower tax brackets, reducing their taxes without the necessity of waiting for Congress to act. Aggregate demand doesn’t fall as far and as fast, moderating any recession.

Since World War II, a more progressive federal tax system correlates with good federal budget outcomes.

If we count federal budget surpluses and small federal budget deficits (defined as less than 2 percent of U.S. gross domestic product) as fiscal successes, there is a clear difference between the budgetary impacts of a more progressive or a less progressive tax structure.

With a more progressive tax structure (the 27 fiscal years from 1946 to 1963 and from 1994 to 2002), we had 11 federal budget surpluses and 13 small federal budget deficits, a 90 percent success rate.

With a less progressive tax structure, (the 39 fiscal years from 1964 to 1993 and from 2002 to the present), we ran 1 surplus and had 12 small deficits, only a 33 percent success rate.

Since 1981, we have had a schizophrenic federal tax policy: We use the correct Keynesian pol icy of cutting taxes during bad times to help the economy recover but use supply-side tax policy to cut taxes during good times. Our federal tax structure is becoming progressively less progressive, and our deficits over the last 30 years reflect the consequences of that trend.

From 1946 to 1981, our federal budget deficit averaged 0.88 per cent of GDP. Since 1982, the aver age deficit has been 3.1 percent of GDP.

Some believe that, by cutting taxes during good times, we are only giving the public’s money back to them. Yet if that foregone federal budget revenue was used to reduce the national debt, the nation and the public would benefit in the long run by lower inter est payments on the debt and lower interest rates.

The missing piece of fiscal sanity is running a surplus in good years. If you want a balanced budget over the course of the business cycle, you must accumulate surpluses in the fat years to prepare for deficits in the lean years.

There is a lesson here for Minnesota as well. A more progressive tax system, by providing surpluses in good times, would help avoid the need for drastic fiscal medicine of budget cuts and tax increases during bad times.

Real fiscal discipline recognizes that good times do not last forever and government should tax accordingly. Even a modest increase in the marginal tax rate for the highest income individuals would add some needed progressivity to our federal tax structure and reinvigorate the usefulness of this key fiscal tool.