Taxes and Inflation

WHILE the economy has moved rapidly from recession to boom, our political leaders have created a policy straitjacket that has made it virtually impossible to debate a tax increase on its economic merits. Some politicians foolishly cling to the same position they held on taxes during the '81-82 recession, even though the economy is threatening to overheat. But unless we open up our options on taxes, America will be stuck with a fiscal policy most likely to lead us into a deep recession or rampant inflation. Unemployment is now at a 15-year low, and robust economic growth will likely push the unemployment rate below 5 percent within a few months. Inflationary pressures are already building. There's no better time for a tax increase to slow things down. Unfortunately, the Bush administration has adopted an inflexible political stance on this issue (``Read my lips'').

Without the flexibility to adjust taxes as needed to respond to our economic cycles, and with public expenditure programs already cut to the bone during the Reagan years, the only remaining instrument for combating inflation is monetary policy. But using high interest rates to slow down the economy will not work.

First, they add to the cost of borrowing, raising production costs that are passed on in inflationary price increases. Moreover, they add to government interest outlays, and therefore to the deficit. High interest rates also attract foreign capital, produce an overvalued dollar, and exacerbate the trade deficit and our international indebtedness. Finally, high rates reduce incentives for domestic investment, the basis for productivity growth and long-term price stability.

The congressional budget debate should not begin with rigid attitudes from either side on the tax issue. Rather, the focus should be on national priorities: public investments in human capital (education, health) and physical infrastructure (roads, bridges, environmental improvements), social programs, and a strong defense.

If more taxes are needed to finance these programs, so be it. While deficit financing is appropriate when economic stimulus is required, this is not the case today. While both taxation and debt financing remove purchasing power from the private sector, debt financing returns assets in the form of government bonds to private hands. Because such bonds make those who hold them richer, they increase demand, while a tax increase would have the opposite effect. Thus, a tax increase is the best way to ensure that any new public spending will be offset by reductions in private demand, maintaining a prudent growth path without excessive reliance on tight monetary policy and high interest rates.

That a president could commit himself to a policy of no tax increase for a four-year future, regardless of inflationary pressure in the economy, reflects terribly on our collective will to undertake sensible macroeconomic management. President Johnson's similar failure to raise taxes early in the Vietnam buildup left us with an inflationary legacy that required more than a decade to undo.

The only way to avoid a similar stalemate over taxes now is to move the fiscal-policy debate away from the Gramm-Rudman deficit targets to one that emphasizes national priorities for government spending, even if that means raising taxes to pay for the society we all want.

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