Taxes, Inflation, and the Dismal Arithmetic of Deficit Finance

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The real federal budget is always balanced. There can be no deficit in an actuarial sense. What the government spends is a measure of the real tax burden.

The fact that explicit tax revenues in any fiscal year are less than outlays does not mean that actual taxation is less than spending. That's impossible. The implicit plan behind any current excess spending is to cut future spending increase future tax revenue.

In a political context, deficits imply a decision to leave to one's successors the problem of which spending to cut or which taxes to raise. The current tax structure will generate greater absolute tax revenue in the future, but revenue will rise relative to national income only very slowly as a result of rising real incomes. Whether realistic or not, there are only two alternatives to raising the tax rate structure: (1) reduce future expenditures sufficiently below future revenue so that Federal budget surpluses in one period match deficits in an earlier period; or, (2) inflate.

Historically, the favorite tax of politicians has been the implicit tax of inflation-debasing the national currency and eroding the real value of existing debts. As long as this "tax that nobody votes for" is available, politicians will be predisposed to resort to it.

The pressures on politicians from special interest constituencies for more spending is by now well recognized. In addition, that politicians will readily vote to reduce explicit tax rates has been demonstrated over and over -- most recently in 1981. But reducing tax rates to reduce current explicit tax revenue does not reduce real tax burdens if spending is not also reduced. If government (noninterest) spending as a share of national income remains the same or continues to rise, and the executive and legislative branches of government do not agree to raise explicit taxes, political pressure on the central bank will raise the very effective tax of inflation.

In the environment in which we currently find ourselves, doing nothing is not an available option. We have finally "rigged the system" such that the politicians will hve to take some action. While they deliberate, the rest of us watch and wait. If Mondale had been elected, my bet would have been that Congess would have enthusiastically "postponed" indefinitely the beginning of tax indexation, then joined the White House in trying to pressure the Fed into reinflating. Assuming the total outlays in the federal budget rose for the remainder of the decade at the rate projected by the Congressional Budget Office last year, the "bracket creep" resulting from an inflation rate in the range of only 8% to 10% would have produced a projected balanced budget by 1990. That's the way it has been done for the past two decades. Interest Rates Are the Problem

Uncertainty about what is going to happen imposes costs on society. There might be some reduction of future spending, but which, when, and by how much is not known. There could be some tax increases, but which, when, and by how much is not known. There might be some "package" of deficit reduction measures, and it might implicitly include more inflation. Everyone knows something is going to change, but all we can do is guess about what, when, and the likely effects.

Uncertainty -- especially about future taxes and inflation -- adversely affects business decisions. Lenders seek compensation for their uncertainty by incorporating a premium into lending rates. Investors prefer opportunities that will return their investment over shorter time intervals. In other words, heightened uncertainty about the future translates into higher interest rates and less long-term investment. It does not really matter whether some people believe that inflation will go up while other people believe tax rates will be increased. Either implies higher nominal interest rates.

The reason large current and projected deficits have been accompanied by relatively high interest rates is that the deficits don't automatically go away like they used to. …