Manage economy with national sales tax

March 12, 2002|By David H. Feldman

WILLIAMSBURG, Va. - President Bush has signed into law an economic stimulus bill that's too small to be a real stimulus and too late to be of much use.

Congress could have enacted legislation of this sort in the fall but for an unseemly political quarrel. Republicans fought for fiscally irresponsible retroactive tax cuts of dubious value in stimulating current spending. Democratic plans, while more balanced toward people of lesser means and the unemployed, weren't (and aren't) well targeted to raise consumption broadly across the economy.

Welcome to dM-ijM-` vu all over again.

Each recession opens an intense partisan debate over the entire American tax system. Fashioning a coalition to pass a stimulus takes so much time that any policy enacted usually is too late to be of use. If we're lucky, the process grinds to a halt before accomplishing anything. The president and the Congress effectively abdicate responsibility, and the Federal Reserve Board becomes the sole source of stabilization policy.

What does it take to have an effective counter-cyclical fiscal policy, one that uses the government's taxing and spending powers to stimulate demand in a weak economy and curb it in an overheated inflationary climate? The key words are quick, consumption spending and reversible.

Because any stimulus package takes months before showing significant economic results, the political side of the process must give us a policy as soon as a downturn can be identified. Most downturns are based on self-fulfilling changes in consumer expectations; we are less confident so we spend less, our reduced spending generates layoffs and this confirms our fears. So a good policy breaks this cycle by shifting consumer spending from the future to the present.

Lastly, the policy ought to be reversible so it doesn't affect the long-run balance sheet of the federal government. Permanent cuts in some tax rates, such as income taxes, do have a stronger effect on consumption than temporary ones. But because they increase long-run government debt, permanent tax cuts are likely to cause offsetting rises in long-run interest rates that crimp business investment. And permanent changes to the tax code involve political wrangling that makes them awful for short-run stabilization.

The problem in constructing an American fiscal policy is that we don't have a tax instrument that both parties agree would be a good device to use for counter-cyclical policy. Unlike the rest of the civilized world, the United States has no federal tax on consumption spending that can be adjusted up or down in response to bumps in the business cycle. Changes in consumption taxes work directly on consumer spending. Income tax changes, especially those targeted toward the wealthy, often do not.

A small national sales tax or value added tax would give us the right instrument. If we wanted a genuine fiscal policy, we could use the next economic expansion to institute such a tax, and do it in a revenue-neutral way by lowering income tax rates just enough to offset the new source of funds.

Since sales taxes are somewhat regressive, we could even maintain the existing progressivity of the tax code by increasing the earned income tax credit. The next time a recession looms, all Congress has to decide is how big a cut to make and, once the recovery is gathering steam, when to reverse it.

However wonderful the Federal Reserve is as an institution, it controls only one economic lever - short-run interest rates. Many situations require more than one economic tool, but for now the executive and legislative branches aren't in the game.

David H. Feldman is a professor in the Department of Economics at the College of William & Mary.

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