Income, sales and payroll taxes and the problem of inflation

I. INTRODUCTION

Considerable disagreement exists an to the advisability, from the point of view of inflation, of introducing a general tax on sales. It is argued with equal vigor (1) that sales taxes are deflationary because they take purchasing power from those who spend virtually the whole of their incomes, and (2) that the effect of the tax in to set in motion a spiral of wage increases and increases in agricultural parity payments which results in serious price inflation.

Before discussing the relative effects of sales, payroll, and income taxation on prices, a few remarks must be made on the general question of prices during wartime. In theory the problem of inflation in easily dealt with if agreement is obtained that a war finance program should adhere to a single objective. This objectively to use the tax system, the instruments of monetary control, and Government borrowing to assist in bringing about the transfer of commodities and factors of production from private to public use. Wherever any of these instruments is applicable it would operate to immobilize all potentially inflationary reservoirs of purchasing power. The task is difficult in a democracy even when conditions are relatively static; it is much more so when wartime changes in the volume and nature of production constantly release new streams of purchasing power.

Under an ideal financial and productive system in time of war, once provision for private consumption has been made by the introduction of a subsistence ration. these instruments ought to be employed to siphon all released purchasing power into the hands of the Government. The goods and factors of production devoted to substance must, of course, be subtracted from real national income before the volume of commodities and factors available to the war effort is known. If the Government attempts to divert mare than this residual, taking account of all possibilities of increasing supply, the magnitude of real national income must fall because of the decreased physical efficiency of the working population. Even under an ideal financial system an above defined, however, this is only the first step. A further decision must be taken as to the desired ratio between taxation and borrowing of the sums no longer unable by individuals when there is complete rationing and allocation of factors.

This decision cannot rest on either economic or social grounds along. In the main, it does not make much difference for war production whether factors diverted to the armed forces are lent to the Government, or whether they are taken once for all through taxation. In marginal cases, however, taxation may prove inferior to borrowing because the latter, in allowing the firm or individual to save for the post-war period, offers more stimulus to a high rate of production. These marginal cases may constitute a significant element of the production needed for a successful prosecution of the war. On the other hand, wartime direct controls are likely to reduce the importance of the reaction of the individual, so that the decision as to the ratio of taxation to borrowing does not significantly affect production. If this is so the tax -- borrowing rations assumes importance mainly with respect to tax burdens on the several income groups during and after the war.

Even before the structure of the tax system is established, then, decisions as to social policy have been implicitly made in the determination of the tax-borrowing ratio. If the whole of the financial mains for the conduct of the war is borrowed, those whose incomes permit of saving are left in command of those savings, and inequality in the distribution of nonconsumable income and wealth is preserved during the war period. In fact, owing to the destruction of real capital, the inequality is greatly increased. To the usual increase of wealth of those whose incomes permit saying is added the wartime paper saying which, owing partly to destruction of capital through enemy action, and partly to the fact that a large proportion of capital takes the form of military goods, has no counterpart in real terms.

If, on the other hand, the entire cost of the war were to be met through taxation the consumable income of higher income groups would not only be sharply reduced for the war period, but these groups/would lose permanently their claims to the goods.

The decision respecting the tax borrowing ratio must be made in the light of realities. That amount will be taxed which it is politically possible to reach by taxation; the rest will be borrowed. But both taxation and borrowing can be made to have various effects on income disposable during wartime. The tax system can be more or less regressive; but borrowing, too, can come from different groups, and if it is coerced from middle and low income groups, not only economic but social decisions are thereby made with respect to the war period. Although properly speaking there is no point in discussing taxation without at the same time defining the nature of Government borrowing, it to necessary as a mode of procedure to restrict the discussion to taxation.

II. INCOME, SALES AND PAYROLL TAXES

The relative inflationary effects of income, payroll and sales taxes cannot be considered independently of their indirect effects on the saving spending and investment decisions of individuals out of income net of tax. First, however, the direct effects of these taxes must be considered.

It has been estimated that in fiscal 1943 the excess of purchasing power of consumers over the supply of goods will reach $25 billion at current price levels. Once it to decided how much of this excess purchasing power is to be reached through that part of Government borrowing which is known to fall on spending, the problem remains of imposing taxes designed to tap off the remainder. The problem is made difficult by the fact that a very great part of the additional income arising out of expanded production accrues to workers in the very low income groups ($1,000-$2,000). Their purchasing power is greatly enhanced at a time when available commodities are in reduced supply. Unless the whole of this additional purchasing power is taken away from consumers (either through taxation or borrowing price inflation will result. But abstracting from differences in demand patterns of income groups the situation would be satisfactorily dealt with from the point of view of inflation if the additional purchasing power accruing to the low income groups were taken from the consumption of higher income groups, say $2,000 to $5,000 or $6,000. If it is not possible politically to do all this. that amount of the burden which cannot be so shifted must be borne by the lower groups: by some out of their increased income, and by others out of incomes which have not risen. (Insofar as the latter already stood at subsistence, Government subsidies are called for.) On the other hand, it seems politically unlikely that the tax system alone or any combination of taxation and borrowing, will tap off the whole of the additional income. This statement to made despite the fact that increased tax rates impinge not merely on increased income, but on all income.

A. THE SALES TAX

If a sales tax is employed with the object of directing to the Government the entire addition to purchasing power of those newly employed or earning higher incomes under the war effort, the bulk of the tax will be paid by those who receive most of the new income, namely, the low income receivers. But at rates likely to be applied, the sales tax cannot take a very large part of the increased income of low income groups. Consequently, as we have seen, those in higher income groups must release commodities to those in the lower groups whose incomes cannot be reached in a sufficient degree by the sales tax. It must be noted, moreover, that much of the increased income will go to the higher income groups, and to this extent a sales tax is no very effective. Furthermore, borrowing and the income tax, which impinge largely on savings, are not very efficient instruments for curtailing consumption out of the increased income of these groups.

We conclude that aside from repercussions on incomes the sales tax used alone is only slightly deflationary relative to the total amount of purchasing power that needs to be diverted because (1) those in the higher income brackets are not greatly affected by a tax on spending, and (2) the sales tax takes only a percentage of the increased incomes of those whose incomes do not permit saving. This leaves what is called an "inflationary gap" of purchasing power which cannot find goods; but it should be noted that it is not the sales tax which in thus inflationary, but rather the limited scope for its operation. Properly combined with income and other taxation, and borrowing, it would be one factor working to reduce this gap provided indirect effects of the tax are ignored.

In the present political situation the indirect effects of sales taxation cannot be ignored. Labor has shown a marked disposition to use any rise in cost of living as an excuse to demand higher wage rates. There is no reason to think that a sales tax, even imposed At the retail stage, will not be regarded as an addition to cost of living; and when the tax is imposed at the manufacturing or wholesale stage, becoming indistinguishable from other elements in the cost of commodities, this tendency in even stronger. How successful labor will be in establishing a connection between a sales tax and wage rises remains to be seen. It should be remembered that the power of labor to do this is not unlimited, and the sales tax should not too easily be dismissed as one of the means of immobilizing consumer purchasing power in view of the certainty that we shall have inflation unless private spending to sharply reduced.

In another respect the sales tax can prove inflationary in the present political atmosphere. Farm parity prices are based on the ratio of farm prices received to farm prices paid. If the latter are increased through the imposition of a sales tax. it would appear that certain farm prices automatically increase in step. In the generally inflationary circumstances of total war this provision, coupled with the wages aspect described above, could easily bring about a cycle of rising prices and coots which might precipitate not merely a marked degree of inflation, but an uncontrollable inflationary spiral.

The conclusion seems reasonable that a sales tax ought to be avoided unless simultaneously Congress takes steps to fix wages and to exclude sales taxes from the calculation of parity prices.

B. COMPULSORY LENDING, INCOME TAXES AND PAYROLL TAXES

If a sales tax is not imposed, additional consumption in those groups whose incomes have increased must be reduced by some other means. For the lower groups this means one or more of the following: (1) payroll taxes, (2) a withholding tax which includes low incomes, (3) compulsory lending.

Payroll taxes, insofar as they are levied upon the employee, are not usually regarded by workmen as current income. Therefore the incentive exists to compensate for the reduction in current income by increased wage rates. If labor, leaders have girded themselves to attack a sales tax, however, they may find it difficult to shift their ground quickly and prepare public sentiment to accept the idea of raising wages to rest an increase in rural taxes. But in general there is little reason to think that if they will strive to neutralize the effects of a sales tax, they will not act in the same way with respect to a payroll tax.

A withholding tax applicable to low incomes is in many respects similar to the payroll tax. The main difference is that it is really a tax and not a compulsory loan; it is consequently more difficult for labor leaders to argue that something to being taken from the worker to which he is really entitled now. This point assumes importance when all brackets experience sharp rises in tax rates, because it cannot be argued that low incomes are discriminated against. On the other hand, if labor leaders are concerned with maintaining real labor income, they may, be counted upon to fight any tax or forced loan which affects real wages; in this ease there is little to choose from the standpoint of inflation among, the various methods of taxing or borrowing from low income groups. Finally, the difficulty of making any form of income tax applicable to all lower incomes must be emphasized. A withholding tax only operates for employed persons, while a sales tax, on the other hand, at once affects all who spend. An income tax for the lower groups appears to be somewhat more difficult and, expensive to administer, and may be slower in operation.

Although compulsory lending to the Government would probably stimulate workers to demand higher wages, the fact that this device is likely to be used only as a last resort indicates that the Government will already have decided to institute thorough-going controls throughout the economy by the time it is introduced. Therefore in actual practice compulsory lending in not likely to result in rises in wage rates.

The income tax has not in the past qualified as a tax which in a significant degree diverts purchasing power from commodities, although in a period of heavy private investment it would be anti- inflationary to the extent that it succeeded in curtailing the demand for factors of production. During a war the income tax is anti- inflationary on two important counts. (1) the supply of private savings is diminished at a time when (before the application of rigid priorities and allocations) business men would like to extend production and investment, (2) the need for tremendous amounts of revenue not only extends the income tax into lower brackets, but also greatly increases the rates in the brackets already subject to tax, thereby exercising a sharply restrictive effect on consumption. Ideally, the income tax is the perfect anti-inflationary tax because it can be made to strike at both savings (the basis of the demand for factors of production by private individuals) and consumption. In practice, however, the difficulty exists of extending the income tax to low income groups, as well as to certain types of enterprise in which self-employment assumes importance.

A discussion of the relative inflationary or deflationary effects of various types of taxes is not complete without at least a reference to the indirect effects exerted by them on the disposition of income not subject to tax. For individuals, the spending-saving ratio is likely to change when large-scale taxes are placed on either their incomes or on their expenditures. Furthermore, the change in this ratio will vary depending on whether taxes are increased step by step during the war, in which case individuals do not know precisely what to expect in the future, or whether there is a single definitive increase. With respect to business firms, production policies must be rearranged in the light of changed demand resulting from the effect of the several taxes on consumer budgets.

Nothing quantitative can be said of the changes in the spending- saving ratio resulting from the imposition of higher income, sales, or payroll taxes, or of forced loans to the Government. This is because the reactions of individuals and firms are largely subjective, while to the extent that they are objective they involve difficult predictions as to the future course of Government controls and tax policy. An extension of the income tax in a given bracket will cause some income receivers to reduce consumption and others to reduce savings. Although under contemplated rates most individuals will do both, in some budgets consumption will be a relatively fixed element (private schools, an, expensive house), while in others savings will be more rigid (insurance). Furthermore, the reactions of individuals will be different depending on their income levels and on the spending-saving psychology and other special circumstances in different households. For example, cases may exist in which high taxes cause the head of the family to give up trying to create an estate; here the effect may be to increase the spending-savings ratio. In other cases the tax may have opposite effects.

A sales tax imposed at a high rate may also operate for certain groups in a manner somewhat different from that usually assumed. In those income groups and in those families in which maintenance of a standard of living already set is considered more important than maintenance of the previous rate of savings, increased living cost is allowed to impinge on savings. It must be admitted, on the other hand, that in the presence of rationing, it is more likely that on balance it will be consumption which is curtailed; but the curtailment will be less where families are willing to revise their savings schedules sharply downward.

The above comments are submitted as a basis for further discussion of problems of taxation and inflation.

Treasury Department, Division of Tax Research

March 21, 1942