A New Tax Proposal

Wince and Nod has a suggestion for a new tax

I want a new tax controlled by the Fed. It could even be several taxes: like a small property mill levy, a 0 to 5% progressive income tax, a 0 to 5% capital gains tax and a 0 to 1% sales tax. When the economy heats up, instead of raising rates and making our deficit worse by paying more interest on the debt, which I’m very tired of, the Fed temporarily raises taxes a little. And it doesn’t give my former party an excuse to raise taxes, increase spending and then never cut taxes. When the economy cools off, instead of it being an excuse for my fellow Republicans to cut taxes but not spending and then never raise taxes, the Fed cuts them temporarily.

The basic idea sounds quite a bit with what many might consider Keynesian macroeconomic policy. Basically smooth out the business cycle a bit, keep the government from running a deficit (or reduce it at least) and help keep interest rates from being the primary tool for macro policy.

There are a number of possible criticisms. The first is that this is a discrtionary policy. Discretionary policies are time inconsistent.1 Another is that what do you do with the money? As soon as you do something with the money, it will create an incentive on the part of those benefitting from that spending to try and control how that money is spent. Granted, the Fed chairmen is not beholding to voters, but he does have to be confirmed by the Senate and Senators are beholden to voters. Finally, suppose this tax actually does do what it is supposed to do and it raises $x revenue that is applied to the deficit. What is to stop the politicians from increasing spending by $x dollars? This last one is what I see as the biggest drawback to this proposal. Politicians sometimes talk a good game about the deficit but neither side is really serious about the rhetoric.
1Well technically optimal discretionary policies are time inconsistent, and by time inconsistent I mean the following. An optimal policy if believed, will result in the situation where deviations from that policy (if people believe the policy will be adhered too) will result in greater social benefits. This in turns means that forward looking agents wont believe the policy will be adhered too and the resulting outcome is sub-optimal. While this sounds like so much gibberish, one could make a pretty strong case that the stagflation of the 1970’s was due to time inconsistency.

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Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.


  1. jwbrown1969 says:

    Any suggestion like that must be protected with a constitutional amendment or sure as shoot congress will find away to keep the higher rate active.

  2. I agree that an amendment is the only way to get spending permanently under control.

  3. Well, Congress can screw it up, for sure, but I was thinking that raising taxes is better for the deficit than raising interest rates. I don’t understand your point about optimal discretionary policies, probably because I need a step-by-step example to follow it. But, even if it is so, doesn’t Fed interest policy suffer from the same problem? I know that the Fed raises and lowers rates at its own discretion, and that it tries for optimal rates.


  4. Steve Verdon says:

    But, even if it is so, doesn’t Fed interest policy suffer from the same problem?

    Yep. The typical “solution” is to find a Fed Chairman who has a reputation for being an inflation hawk–i.e. willing to tank the economy to short stop inflation.

    As for an example of time inconsistency a common example is the following:

    You have a Pass/No Pass college course. The instructor tells the students that at the end of the course there is an exam. If the students believe the instructor they study for the exam. Once the students have studied, then the optimal strategy at that point is to not give the exam. The students have studied and learned, they don’t have to suffer from an exam, and the professor doesn’t have to grade the exams. Now, realzing this welfare enhancing switch once they have studied, the students don’t study. Realizing this, the time consistent outcome is for the professor to announce the exam, give the exam, and you get a sup-optimal outcome.

    Now, the two previous commenters and their idea of a Constitutional amendment is pretty good, but comes with its own difficulty; amendments are hard to pass. One possibility is to put in a super-majority requirement to keep the tax from being abused. Not exactly how it would work though. Also, some sort of “auto-destruct” language; such as if another law is passed trying to tamper with the super-majority the entire tax becomes null and void. Don’t know if that would work though.

  5. Steve,

    I’m having a hard time generalizing that example to something like a tax increase, which has a continuous rather than a one time effect. It could be a lack of sleep though.