December 3, 1991
Are Taxes Poisoning Economy?
Rising Levies in Weak Period Thwart Recovery
by Laurie Marmor
Recent sharp hikes in federal, state and local levies are creating a phantom “inflation” problem that may be obstructing monetary policy, hurting consumers and businesses and threatening the recovery’s fragile stamina.
In the past, a coordinated effort between the government and the Federal Reserve to lower taxes and interest rates helped break the self-feeding recession cycle.
But during the most recent recession, which officially began July 1990, legislators at all levels of government broke with tradition by imposing higher taxes.
With the Budget Reconciliation Act of 1991, the federal government raised the gasoline tax to 14 cents, up from 9 cents. The cigarette tax rose to 20 cents a pack from 16 cents; the beer tax increased to 32 cents a six-pack from 16 cents; and the wine tax jumped to 21 cents a bottle from 3 cents.
Similarly, thirty states enacted tax increases intended to raise a total of roughly $17 billion in new revenue for fiscal year 1992.
Creative tax-raising techniques varied among states.
Some, such as Alabama, Delaware and Florida, tapped new tax sources. Alabama imposed a tax on prescriptions, hospitals and nursing homes from Medicaid. Among other taxes, Delaware imposed an insurance privilege tax and Florida placed sales taxes on recreational facilities’ fees and coin-operated games.
Overall, 23 states raised taxes on gasoline, 14 increased their cigarette excises, six states raised corporate income tax rates and six increased their sales taxes.
The increase in tax burdens made fiscal year 1991 the biggest revenue-raising year in history at the state level, according to a special report released by the Tax Foundation in Washington.
Rising taxes and the rising “costs of government…are putting the economy…in a dangerous position,” said Martin Armstrong, chief economist at the Princeton Economics Institute in New Jersey.
Lawmakers contended the national recession seriously drained government coffers, particularly at the state and local levels, where sales taxes account for roughly one-third of revenues.
Thus, taxpayers were told additional levies and the elimination of some health and education programs were necessary to satisfy balanced budget obligations and maintain a minimum level of services. But no state actually cut spending.
Turning the argument on its head, however, a growing number of investors, analysts and consumers blame the economy’s current malaise on rising taxes.
In particular, the increases “tied the hands” of the Fed at a time when other indicators suggested more accommodating monetary policies were necessary to stimulate business activity.
According to Armstrong, state and local taxes accounted for more than 50% of the increase in inflation this year. His calculations are based on a complex analysis that compares increases in basic product prices at the state level.Gasoline and tobacco bore the brunt of the tax additions and seven states—Arkansas, California, Maine, Minnesota, Missouri, North Carolina and Utah—permanently or temporarily raised their sales tax rates.
These fed directly into the consumer price index (CPI), Armstrong noted recently—creating an impression of growing inflation.
The unusual rise in inflation at a time when the economy was contracting, contributed to the Fed’s “slow response” to the weak economy, said Lacy Hunt, chief US economist at the Hong Kong Bank Group in New York.
To the extent that inflation appeared to be high—as a result of rising taxes—the Fed was not as responsive to declining economic activity as they “otherwise might have been,” Hunt added.
Rising state and local taxes also drained consumer’s pocketbooks and contributed to a “big decline in consumer confidence,” Hunt said. At the same time the national recession slowed income growth and weakened job growth, higher taxes forced consumers to reduce spending despite lower interest rates.
“Instead of a partnership” with local governments to spur economy, the Fed has been shouldering a much more difficult job in trying to stabilize economic activity and offset the negative impact of higher taxes, Hunt said.
“This may be one reason why monetary policy appears to be having a limited effect,” he added.
Past experience suggested consumers and businesses could be encouraged to borrow for big ticket purchases if interest rates dropped sufficiently. Until recently, how low interest rates would have to go to spark this recovery was the primary debate among analysts.
However, the process appears to have worked better in theory than in practice. The Fed responded to weak economic conditions by lowering its benchmark discount rate—the rate it charges commercial banks for short-term loans—five times in the last 11 months. The economy, mostly driven by manufacturing activity, seemed to pick up steam in the early summer months. But recent reports on industrial production, unemployment, factory orders and retail sales suggest the recovery stalled in early autumn.
Adding a new perspective to the monetary versus fiscal stimulus debate, Hunt and other analysts suggest state and local government excesses in the 1980s—not just recession—accounted for a significant part of state and local governments’ current financial woes.
During the expansion phase of the 1980s when government revenues expanded, no revenues were set aside and no tax relief was offered, Hunt said.
“Instead, (taxes) went into new programs which bolstered political power bases, and are now virtually impossible to dismantle,” he noted.
According to the Tax Foundation’s special report, state tax collection grew at an average rate of 8.6% in the 1980s, outpacing inflation by more than 3 percentage points and personal income by 0.6 percentage points.
Gregory Leong, directory of special studies at the Tax Foundation, noted recently that five states—California, Pennsylvania, New York, Connecticut and Texas—accounted for more than 75% of this year’s net $17 billion tax increase. The heaviest additional per capita tax burden fell on residents in Connecticut, Pennsylvania, California, Maine, Vermont, Delaware, Rhode Island, Nevada and Arkansas.
Overall state and local personal taxes, as a percentage of individual and family incomes, reached 5.1% in June. That’s up 1.1 percentage points from total tax levels in September 1981, a month before the first installment of the Reagan-administration’s tax reductions, pushing the combined rate with Federal taxes to 22.3%, according to Hunt. He expects the combined rate will continue to move higher, reaching nearly 23% by early next year.
Hunt said job and business growth has been slower than the national average in those states that imposed significant tax increases. And, an independent nationwide survey of households corroborated the worsening conditions in many states.
In October, 15 states were within Sindlinger & Company’s definition of depression. Anther 17 states and the District of Columbia met recession status and nine states were borderline between recession and depression. The Pennsylvania-based economic research company conducts daily interviews of nearly 5,000 households and published its results monthly.
According to the company’s founder, Albert Sindlinger, a state is in a recession if over 50% of the surveyed households report negative household liquidity—a measure measures consumers’ attitudes about current and future income levels and expectations about business activity. A state is deemed to be in a depression if 74% or more of the respondents report negative household liquidity.
As the economy stands on the precipice of another possible decline, most analysts say that anything the government can do to spur economic activity would be welcome.
Lower interest rates could help by increasing the supply of capital and money in the markets, said Duane Parde, director of legislative and policy studies at the American Legislative Exchange Council in Washington.
With credit demand “basically flat,” the Fed does not have to worry about creating any “demand pull inflationary pressures,” said Cynthia Latta, senior financial economist at DRI/McGraw Hill Inc., in Lexington, Mass.
Since there is “not much the Fed can do about the cost pressures created by state and local taxes,” Latta said she would not be concerned about an inflationary environment “until money supply growth was up to 7% or 8%.”
Businesses are unlikely to put pressure on the inflation rate for the balance of 1991 and for all of 1992, according to the latest quarterly study released by the National Federation of Independent Business. Survey results reveal just 17% of the respondents intend to raise prices in the next six months. That’s a record low for the survey’s 19-year history.
Still, the “threat of structural inflation” associated with the increased cost of complying with government regulations, remains strong, according to NFIB chief economist William Dunkelberg. “Only congress can (reduce this kind of inflation) with some responsible legislation and some common sense,” he wrote in the October report.
Additionally, governments “need to cut back and give people a tax break,” Parde said. “The more money the government takes out of the economy, the more money the government takes out from working in the private sector,” he added.
He shares the view of many that the economy receives a much greater boost from private spending than government spending.
Any economic revival depends on consumers who account for nearly two-thirds of gross national product. In the first quarter of this year and in the final quarter of 1990, the economy was dragged down by a surprising back-to-back decline in personal consumption expenditures. GNP fell by a seasonally adjusted annual rate of 2.8% and 1.6% in the first and fourth quarters, respectively.
With federal and local spending rising, the biggest threat to sustaining economic growth is the government deficit and the interest costs to carry the debt, Armstrong said. An increase in the national deficit “in excess of money supply growth results in a capital drain in the system precisely in the same manner as when the Fed tightens credit,” he explained.
Bringing down long term interest rates—which are outside of the Fed’s control—would help the government reduce the deficit, Armstrong said. He contends the yield curve has widened because investors are currently afraid of investing for the long term, raising demand for short term holdings.
He also believes taxes on profits and capital gains should be indexed to inflation, placing the investment community on equal footing with laborers and social security recipients.
The administration has suggested only a few fiscal reforms. These include lowering the capital gains tax, creating tax breaks for research and development and adopting a transportation bill that President Bush says will create thousands of jobs.
But the proposals still have to be formally drafted and presented for Congressional approval. Even if they are enacted, they are unlikely to impact near-term economic activity.