What's Up With Taxes

by Robert Lekchman

IT SEEMS only yesterday that President John F. Kennedy was assuring an audience of conservative businessmen assembled to disbelieve him at the Economic Club of New York that “an economy hampered by restrictive tax rates will never produce enough revenues to balance our budget, just as it will never produce enough jobs or enough profits.” This was in January, 1963. And as recently as January, 1965, another President, Lyndon B. Johnson, was asserting his firm confidence that “1964 will go down in our economic and political history as the ‘year of the tax cut.'” Mr. Kennedy was starting his long campaign to enact the tax reduction measure which became the legislative centerpiece of his last months of office. For his part Mr. Johnson was celebrating the happy impact of the February, 1964, enactment of Mr. Kennedy’s proposals.

Even allowing for the necessities of political hyperbole, President Johnson had a legitimate point. First the expectation and then the reality of reduced taxes made businessmen more cheerful, enlarged private investment, and encouraged consumer spending. Among economists there is little dispute over the conclusion that the $10 billion tax cut prolonged the economic expansion which began early in 1961 and made possible early in this year the belated attainment of the Council of Economic Advisers’ interim unemployment target of 4 percent. Equally there should be no doubt about how the tax reduction worked its benign consequences. It achieved its stimulus by deliberately creating a large federal deficit, the inevitable consequence of slightly increasing federal spending and reducing tax levies on personal and corporate incomes. What President Eisenhower’s Secretary of the Treasury George Humphrey had believed impossible was actually occurring — we were indeed “spending ourselves rich.” This is only to say that in a sluggish economy, individual consumers and business investors used the bulk of the increased incomes which tax reduction gave them to buy either consumer goods or the machines, tools, and factory structures which represent real investment. Since the unemployed were so numerous and the amount of unused factory capacity so substantial, the effect of increased demand was an enlargement of output, not, save in very small measure, higher prices.

How could an economic policy have worked better? How could the outcome have been happier? Men long out of work found jobs. Business profits swelled. Overtime supplanted short work weeks. Gross national product, the handiest measure of the money value of the goods and services an economy produces, rose more and more rapidly. The American rate of economic growth, such a warmly contested issue in the 1960 presidential campaign, surpassed the Russian growth rate and caught up with the various countries in Western Europe which had been passing assorted economic miracles — France, West Germany, and Italy. Even automation, a bogey which threatened imminent mass unemployment for some, suddenly receded in scale to the status of a medium-sized menace. Incontestably, fiscal policy worked, and as a nation Americans have always cherished the workable.

What makes the economic conversation suddenly so puzzling to ordinary citizens who have just barely learned to live comfortably with ideas so contrary to common sense as the benignity of unbalanced budgets, the wholesomeness of tax cuts even when deficits already exist, and the harmlessness of a bigger national debt is the abrupt reversal of the prescriptions offered by the very wise men who only a moment ago had induced them to sip the soothing syrup of tax reduction. Thus Walter Heller, President Kennedy’s economic tutor and the successful promoter of the tax cut, spoke out as early as last February in favor of suspending the investment tax credit — the 1962 tax boon to business investors, which has the effect of reducing machine and equipment prices by 7 percent. By May of this year he had expanded his program to include as well a temporary $5 billion tax increase as “good insurance against inflation.”

Early in March, James Tobin of Yale, another original member of the Kennedy Council of Economic Advisers, testified in favor of a tax increase “without further delay.” Even though Professor Tobin began with a glowing testimonial to the success of past tax cuts, he now warned his congressional auditors that the moment for change had come: “The government quite properly kept its foot on the accelerator. It would be a shame to endanger the achievement by failing to use the brakes.” Thus runs the voice of the pundits in 1966.

Why do they speak so dourly when only a year or so ago they sang sweet songs of tax reductions for everybody?

THERE is a short and only momentarily paradoxical explanation of the changeability of the economic seers: the very success of the tax cuts has created the need for tax increases. Consider more closely the condition of the American economy in early 1963 at the time that President Kennedy introduced his tax proposals. For the whole of 1962 average unemployment exceeded 4 million persons, a rate for the year of 5.6 percent. Factories were idling along at only 86 percent of their capacity to produce useful goods. In sum, the economy’s slack was both wasteful of material resources and damaging to the income, pride, and morale of the unemployed.

The partisans of tax reduction had a basically simple, Keynesian interpretation of the economy’s troubles. These troubles were related to low national spending, or, in the technical tongue of the economists, a shortage of aggregate demand. After all, what sets factory wheels spinning and increases employer recruitment of additional workers is simply an enlargement of new orders. Orders rise when one or more of the economy’s three major spenders — consumers, investors, or government —is inclined to spend more money. Accordingly, if unemployment is high and factory utilization rates are low, then one or more of these groups is failing to do its part. Either consumers are saving too much out of incomes that are too small, or business investment plans are lagging because businessmen take a dim view of the prospects for profitable sales, or government is Spending too little or taxing too much. Such a statement of the condition implies the answer of modern fiscal theory to the symptoms of the malady. It is all a matter of raising the spending of one or more of the three groups.

As far as the means of achieving this end are concerned, Keynesian economics, despite an early and inappropriate reputation for radicalism, is perfectly neutral. A stimulus to aggregate demand will evoke larger output and employment whether it is administered to private investment, private consumption, or government spending. It the first route is followed, business profits will soon rise. If the second path is chosen, consumer incomes rise. And if government spending is pushed upward, either social welfare or military programs may be the beneficiary. Fiscal stimulus is perfectly capable of enlarging the relative role of the private economy if the tax reduction method is preferred. It is equally usable in the Galbraithian sense, as a deliberate attempt to expand the influence of public contributions to the economy — education, housing, and social welfare. All routes lead to higher aggregate demand, gross national product, and total employment.

After experimenting with the investment tax credit as an investment stimulant, President Kennedy settled an internal argument within his Administration between the proponents of larger social spending and the friends of tax reduction by choosing the latter, in part at least out of an estimate of the uncertain temper of a balky Congress. How effective the tax cut has been can be glimpsed in a very few comparisons. Gross national product in 1963 totaled $589.2 billion. During the first quarter of 1966 GNP was running at an annual rate of $714.1 billion. Business profits in 1963 amounted to $58.1 billion. They were running during the fourth quarter of 1965 at an annual rate of $75.2 billion, and they are substantially higher in 1966. Unemployment averaged 5.2 percent in 1964. In March, 1966, this rate had dropped to 3.8 percent.

As a result, in mid-1966 there is very little slack left in the economy. A few more of the unemployed can still be put to work, but not a great many, at least in the context of the likely demand for labor. With only a few exceptions, of which autos are the most important, factories are operating at above 90 percent rates, and in some industries perilously close to 100 percent. Business investors contemplate substantially larger expenditures in 1966 than in 1965. As force levels in Vietnam edge upward toward 400,000, military spending seems fated to continue to rise. In an election year Congress has taken to enlarging instead of curtailing the President’s $112.8 billion budget request. All the omens point to a more rapid increase in the community’s demand for goods and services than in the community’s capacity to produce these goods and services at current prices.

Of course nothing in economic affairs is absolutely certain. Sinking spells in the stock market and pauses in automobile sales are straws in a wind blowing from another economic quarter. As Business Week conceded early in June, the moderation in the boom’s acceleration “may be the start of a genuine decline.” All the same, the stock market has been a poor forecaster in the past, and if autos after several boom years are leveling off, other spending continues to increase — notably, plant investment and military outlays — labor markets continue to tighten, and the money supply continues to expand.

Inflation may not be galloping, but the odds still favor continued price rises caused by growing total demand, private, business, and public, for most varieties of goods and services. When labor, particularly skilled workers, is in short supply, employers bid eagerly against one another. When merchandise is gobbled up by voracious customers more rapidly than retailers can replenish their depleted inventories, sellers tend to mark up their prices and ration their merchandise by price among the most eager of their buyers. What alarms good Keynesians like Paul Samuelson, James Tobin, and Walter Heller is the fear that the United States in 1966 is at the beginning of a classic inflationary spiral — a dramatic chase of prices after wages and wages after prices, a competitive jostling after scarce labor, raw materials, and finished goods which cannot fail to accelerate the rate of price increase far beyond the modest trend of recent years.

Fortunately the diagnosis implies the medication. Inflation is a disease of excessive spending. Then the thing to do is to diminish spending. Whose spending? One candidate is the federal government, in our day a greedy consumer of raw materials, specialized equipment, and technical talent. As far as the reasoning of current theory goes, a reduction in federal spending would be just as efficacious as a reduction in other varieties of expenditure. But, what is to be reduced? Unless our Asian policy is dramatically revised, the more than 50 percent of the budget devoted to military purposes can scarcely be reduced. Much of the remainder of the budget is devoted to agricultural subsidies, veterans’ benefits, international aid programs, and interest on the public debt — sums protected either by entrenched special interests, national policy, or the good faith of the Treasury. About the only substantial programs at all susceptible to curtailment are the Great Society measures so recently enacted, such as aid to education, the War on Poverty, medical research, and housing experiments. Indeed, these are the very items which congressional conservatives of both parties are exceedingly eager to slash in all economic seasons.

If these programs are to be preserved, then it is essential to reduce other varieties of spending. A second candidate is business investment, which may rise as much as 17 percent this year over last year’s boom level. Although it is true that in the long run, business investment expands plant capacity and the output of consumer goods, in the short run, investment simply results in larger income payments to the people engaged in constructing the factories and building the machines, without increasing today’s output of consumer goods at all. In a boom, higher investment simply generates inflationary pressure. This meaning of investment today has stimulated Walter Heller among others to advocate immediate suspension of the investment tax credit. Such a suspension, particularly if it is supplemented by a rise in corporate income tax rates, might moderate an investment boom which may in any case be too exuberant long to be sustained.

Finally, there are the consumers, the largest spenders of all. When the Tax Act of 1964 was finally enacted, consumers were presented with a multibillion-dollar addition to their incomes. As expected, they responded by spending over 90 percent and saving less than 10 percent of their tax benefits. Presumably if this year they are asked to pay $5 billion of additional personal income taxes, they will reduce their spending by $4.5 billion or so and their saving by the remaining halfbillion dollars. When consumer spending rises, the incomes of the people who sell them goods and services also rise. Out of these larger incomes emerges a second stream of increased spending. Similarly, decreases in consumer spending depress the incomes of the sellers of goods and services and lead to decreases of spending on their part. Thus the effect of tax increase, like the impact of tax reduction, soon spreads through the economy.

IN PRACTICE then the policy choices which confront President Johnson and his Congress are in 1966 only three: unchanged tax rates and federal spending, decreased spending, or increased taxes. What would be the consequences of each of these three courses of action?

If the President and Congress opt for the first choice (in an election year much the easiest), the national Administration is not quite helpless in the fight against inflation. Something may yet be achieved by still more forcible application of the wage guidepost to labor union demands and the price guidepost to corporate efforts to raise their quotations. Most economists have extremely small faith in the capacity of voluntary restraints to prevent the exercise of market opportunities to get higher wages or higher prices. All the same, it is possible that they are underrating the ingenuity and persuasiveness of a masterful President. No doubt something can also be achieved by further increases in interest rates, a policy which accords with the persistent preferences of Mr. William McChesney Martin, chairman of the Federal Reserve Board. It cannot be said that rises in interest rates are especially equitable. They bear heaviest upon small borrowers and home buyers. But their efficacy is substantial.

Nevertheless, it is likely that a national economic policy which depends only upon interest rates and guideposts will be unable to prevent an acceleration of price increases. How much acceleration? On this ticklish issue opinion is divided. There are some, including myself, who believe that mild inflation is preferable, for example, to unnecessary unemployment. If prices rise 3 to 3.5 percent this year instead of last year’s 1.7 percent, the heavens will not fall, the dollar need not be devalued, and De Gaulle need not acquire all the gold in Fort Knox. If the reward is a decline of unemployment to 2.5 percent instead of 3 percent, is the additional inflation really too high a price? The trouble is that prices may rise more than 3.5 percent, that more rapid inflation will cause genuinely dangerous gold losses, that inflation will produce serious inequities, and that one of the crashes such as inflation brought in the past will be the consequence of present events. Hence there is very serious risk in adopting the first economic course.

Then what about a reduction in federal spending? The argument against such a policy is simple and strong. If Lyndon Johnson is the instrument of a popular consensus on the need to diminish poverty, improve national support of education, enlarge medical services, and rehabilitate the cities in which most Americans live, then it makes exceedingly poor sense, politically or otherwise, to extinguish these programs at the very beginning of their lives. Since the President has already reduced allocations for these programs to perilously low levels out of consideration for Vietnam exigencies, further reductions mean the deathblow to the first substantial revival of general interest in social welfare since the early years of the New Deal. This is an exceedingly heavy price to pay for the restraint of inflation, and it is doubtful that either Mr. Johnson or the majority of his constituents care to pay it.

And why should they pay such a price when there is a third alternative available which combines restraint of inflation and preservation of Great Society innovations, namely tax increases? Who should pay the increased taxes? As usual in tax matters, expediency and equity are in conflict. Political considerations suggest that the easiest kind of tax rise to get through Congress soon enough to have some therapeutic effects this year, when they are needed, rather than next year, when they may not be, is a flat rate surcharge on current personal income tax payments, combined with an increase of two or three percentage points in corporate rates and a suspension of the investment tax credit. In the interests of flexibility the increases might be defined as temporary, expiring in six or twelve months unless expressly renewed by congressional action.

A program so shaped would avoid some bitter arguments. However, the price in equity is high. As Gardner Ackley, of the President’s Council of Economic Advisers, has noted, profits after taxes by the end of 1965 were running at a rate 88 percent higher than they were in early 1961, an improvement far in excess of gains in wages and salaries. Mr. Ackley has gravely warned: “It is time to ask whether a further rise in the share of profits in the national income is in the interest either of the health of the nation’s economy or in the interest of business itself.” What Ackley said highlights one of the changes which the last few years have brought. The 1964 Tax Act scaled down the progression of the personal income tax and reduced corporate income tax rates. At the same time the states and the localities have been raising larger and larger sums from sales taxes and real estate taxes which place a disproportionate burden upon low-income groups. In all probability the result of these changes is to increase the inequality of income distribution in the United States. No doubt the prosperity of recent years has benefited most Americans, but it appears to have benefited the affluent rather more than the rest of the population.

An equitable tax program for 1966 would raise corporate tax rates very sharply indeed, suspend the investment tax credit, and impose a larger share of the personal income tax burden on those who have benefited most from recent tax revisions. A tax surcharge on small incomes should be very low. On large incomes it might well be substantial.

Like every other economic policy, tax increases contain certain risks — above all, of the sort of overcorrection which initiates a recession instead ol checking an inflation. What the uncertain art of business forecasting implies, however, is not inaction (which is itself a policy) but flexibility. In the summer of 1966 flexibility implies raising taxes, because on balance this is the soundest policy, but also a willingness to reverse the increase if events prove the policy mistaken. Still more desirable would be congressional delegation to the President of some discretionary authority over tax rates.

We are passing through a second stage of public education in modern economics. The first lesson has been absorbed. Most people who follow public issues at all are probably by now convinced that tax cuts are capable of shortening recession and stimulating economic growth. It may even be that once a person gets over his puritanical fears of debt (in their private lives most Americans seem to have made the transition to the post-Puritan era), there is something very pleasant about patriotically stimulating the national economy by gritting one’s teeth and accepting a tax cut.

The second lesson is harder and all the more difficult because the Presidents who preached the virtues of tax reduction seldom if ever accompanied their panegyrics with the reminder that fiscal policy is symmetrical — that there will be times when tax increases not tax decreases are in order. It is so much easier to be patriotic in the face of a tax cut than in the presence of a tax increase.

Nevertheless, a considerable effort of popular education will be wasted if the President and his Administration do not persuade the people that the very same reasoning which produced successful tax reduction in 1964 and 1965 now urges tax increases. Since flexibility is at the heart of modern public finance, unless the realization becomes general that neither tax increases nor tax decreases are to be regarded as permanent, the noble experiment in modern economic enlightenment initiated by President Kennedy in his Yale commencement speech of June, 1962, continued in his fight for the tax bill, and carried on by Lyndon Johnson to the enactment of the bill will be a failure. What is at stake is the enlargement of the American government s capacity to cope with both inflation and deflation.