Saturday, May 14, 2011

Growth at a measured GAIT

My fellow Americans, I believe I have solved our budget problems.  In the shower, no less.

Mulling therein the consensus that 'you don't raise taxes in a recession' (or frail recovery), and the reality-based community's corollary that you do raise taxes when faced with a structural deficit, I thought, why not index tax rates to GDP growth?  The government has no trouble indexing the yield on TIPS to inflation. Why not set a baseline tax rate that's operative at, say, 3% GDP growth, adjustable down in a set ratio all the way to, say, a 3% contraction, and adjustable up all the way to, say 6% annual growth? Economic velocity will determine our GAIT (Growth Adjusted Income Tax).

Republicans will screech, as they did when Clinton raised taxes in 1993, that the American economic race horse has been hamstrung forever. Fine. Make the whole package contingent on performance over one multi-year cycle. If GDP growth doesn't hit an agreed annual target once in, say, six years, sunset the system.  If it does hit the target, reassess after ten years.

Some will protest that taxpayers need 'certainty.' Good -- let's grant ourselves the certainty that tax rates will be commensurate with the demands of the economic cycle.

 Go forth, economists and budget wonks, and work out the details. You're welcome!
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  1. Tax receipts already vary directly with economic output. Indexing tax rates to economic growth will add significant additional volatility to aggregate tax revenue. Not sure that would be a good thing. However, since recent policy actions have amounted to cutting taxes during economic contractions AND expansions, having automatic increases during good times would be better for deficit reduction than the current insanity.

  2. Hamstringing the "economic race horse" isn't necessarily a bad thing if the economy is experiencing a mania. Booms and busts are bad and they go hand in hand. Dampening booms could lessen the severity of a boom-bust cycle. Monetary policy already does this (in theory) by raising interest rates when an economy becomes over-heated. One criticism commonly leveled at the Greenspan Fed is that they let interest rates stay too low for too long. That is, they didn't dampen the boom. So why not set up an automatic boom-dampening mechanism on the fiscal side?

    I also like the incentives aspect. The standard conservative tax argument is that raising marginal rates will induce people to work less since those extra dollars earned will be taxed more anyway. This gets to the fact that one's income, and thus one's effective tax rate, is endogenous. I can stop working before I hit the higher bracket. In the plan above, its not the individual's income that affects the tax rate, its aggregate income, and thus, something outside of any single individual's control. If it is outside of any one person's control, no single person has an incentive to work less. We go from, "If I earn too much, I go into a higher bracket," to "if I earn too much, I may push the country's income up to a higher level." The first makes some sense, but the second is a bit preposterous. An individual would have to think that they are the straw that will break the camel's back. Even some hedge fund manager that makes over a billion in a year would be right to think their income is too small to matter in a $14+ trillion economy.

    In other words, the argument as to how higher taxes lesson the incentives of the individual no longer applies when the tax trigger is on the aggregate level. The argument that this tax system would decrease incentives only apply if every tax-payer coordinated their actions and committed to making less money to keep aggregate growth low enough to avoid the tax trigger. This is unlikely, if not outright impossible, and even if it were, every individual would have an incentive to deviate from the agreement and make more, while everyone else agrees to make less and keeps the tax rate low. That is, coordination is impossible, but even if it weren't, its still an unsustainable equilibrium.

    In other words, whereas saying, "if you do really well, we'll tax you a lot" may result in people saying, "Fine, then I won't do well!" (not that I believe this Galtian argument). If it was instead, "If the country does well, we'll tax you a lot," no one will say, "Fine, then I'll purposely not do well," since their individual effort is too small to affect the aggregate anyway.

  3. Doesn't reported GDP rates take multiple months to become final? Don't tax rates need to be adjusted only with the calendar?

    E.g., last year's growth of 3% wasn't known until about February 2011. Tax rates for 2011 needed to be set before January. Granted, you could have a period of uncertainty but for all you know 2011 will end with 6% growth but a tax rate based on a completely different number from another year.

  4. I like the overall concept of automatic indexing. The idea could be extended to determine tax brackets. Calculate the poverty level each year. No taxes for income up to the poverty level. Subsequent tax brackets are multiples of the poverty level.

  5. Instead of GDP growth, use wage growth, but, like beeshma suggests, use the average income growth within each bracket to adjust the marginal tax rates. This way, the poor and middle class wouldn't have tax hikes in years in which the rich are the only ones who see significant wage growth.