Pensions, Taxes and the Budgetary Process

By Diamond, Peter | American Economist, Fall 2012 | Go to article overview

Pensions, Taxes and the Budgetary Process


Diamond, Peter, American Economist


I. Introduction

I appreciate the high honor of receiving the John R. Commons award, and take great pleasure in joining the list of very distinguished past winners.

1978 saw the publication of The Structure and Reform of Direct Taxation, the report of a committee headed by James Meade. (1) To consider the design of a tax system for the UK, the Meade Report, as it came to be called, analyzed the elements that should be considered when designing a tax system. Chapter 2 of the Meade Report, "The Characteristics of a Good Tax Structure," is divided into six sections: Incentives and economic efficiency, Distributional effects, International aspects, Simplicity and costs of administration and compliance, Flexibility and stability, and Transitional problems. To consider direct taxation in the UK, the Meade Committee examined each of these issues separately and then combined the insights into a policy recommendation. It seems to me, as it seemed to Alfred Marshall, that this is an appropriate way to proceed. (2) While the capacity of computers to find equilibrium in complex models has grown greatly since the Meade Report, the models available for analysis, like much of the underlying theory, are still quite limited in the ability to address the allocation issues that they incorporate and are still too far from reality to proceed in any other fashion than that followed by the Meade committee, by addressing multiple issues separately.

The part of Chapter 2 in the Meade Report on which I focus is Flexibility and stability. Although tax legislation can have an open-ended horizon, it is expected that taxes will change as circumstances develop and governments change. Moreover, governments do not articulate, much less commit to, a complete (contingent) set of future policies. Individuals making decisions that affect their future tax liabilities (such as investments and education) are faced with uncertainty about future circumstances, future governments and their possible tax reforms, and any transition rules the government may include in tax legislation. Recognizing the ongoing process of the adaptation of tax policies to economic and demographic developments as well as to changes in normative perceptions and in political balance, the Meade Report expressed its concern for both flexibility and stability:

   A good tax structure must be flexible for
   two rather distinct purposes, the first being
   primarily economic and the second primarily
   political.

   In the former category there must be recognition
   of the need to be able to adjust total tax
   burdens reasonably rapidly and frequently in
   the interests of demand management.

Until the recent crisis, discretionary fiscal policy was not in high favor among academic economists (Auerbach, 2002). The length and depth of the slow recovery from the financial crisis has been a very different environment than the short recessions experienced in the US previously since the Great Depression and, together with the zero bound on nominal interest rates, has put discretionary fiscal policy back in a central place of policy discussion. In today's economic environment of high unemployment in many countries and high vulnerability to the risk of significant further shocks, shocks that have sizable probabilities, fiscal policy has a far more important role to fill than in the earlier post-war US recessions. Indeed, the failure to take further fiscal steps to help the recovery is viewed as a major political shortcoming in the eyes of many analysts, including me.

Built-in stabilizers, while not getting much active attention in recent years, still have been viewed positively (Auerbach and Feenberg, 2000). (3) It seems appropriate to incorporate their role along with the usual arguments about income tax rates in the design of the tax schedule. Social insurance institutions also play a built-in stabilization role, along with that of the income tax. …

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