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Give the “Fair Tax a Fair Chance”

September 4, 2007

Holding down the tax chair at NCPA is somewhat different from what I'm used to.  During my 36 years at the Fed, and especially my 14 years as a policymaker on the FOMC, I thought of taxes primarily as half of fiscal policy, which has more to do with how tax receipts stack up against government spending than with the efficiency of the tax regime. During most of my tenure, government spending exceeded tax receipts and produced a deficit.  The perennial question was what the deficit would do to the economy. Would it spark inflation? Would it pull us out of recession?  Did it really matter?

My early training and subsequent reading led me to conclude that the economic impact of a federal budget deficit depends mostly on how it is financedwith existing money, new money, or new money plus new bank reserves, which means further monetary expansion. In other words, the impact of fiscal policy depends primarily on how it is financed, and on monetary policy. The other relevant factor is the state of the economyhow close we are to full employment of labor and other productive resources, or how much slack we have.  The financing and the condition of the economy determine the impact of a deficit, which really means that monetary policy is more important than fiscal policy.

In general, I shared the profession's preference for a balanced budget over time, with helpful deficits during economic weakness matched by helpful surpluses during more exuberant times.  This ideal almost never happened, of course, so a lower bar led us to measure the deficit as a percentage of total GDP and forgive those that didn't break through historical benchmarks.
When I came to the Dallas Fed in early 1991 and was briefed by its excellent economists, I asked our public finance specialist whether there was a good rule of thumb for good tax policy.  I don't remember her exact words, but the answer was that taxes should have broad coverage and low rates. They should distort economic activity as little as possible.  Balanced budgets over time and cycles were preferable to chronic deficits. The main evil of deficits was that they represented negative saving, which had to be offset elsewhere to finance adequate investment.

While I considered deficits to be important, I was persuaded by Milton Friedman's argument that the magnitude of government spending relative to the size of the economy was more important than how it was financed, whether by taxes or debt. In other words, the size of government was more important to economic performance, and especially to individual liberty, than the size or percentage of the deficit. I also accepted the Friedman proposition that deficits were not necessarily a bad thing if they caused the politicians to curb spending.  The problem with higher tax revenues to balance the budget was that, in practice, they would just be spent to make government bigger. They would just feed the alligator.

Some, but not much, attention was paid to whether the existing tax system was a good system and whether it should be scrapped in favor of something radically new and different.  The most common reform proposals, which sounded good to me, were versions of the flat income tax.  I recall Dick Armey coming to the bank to explain his flat tax proposal and emphasizing that taxes could be reported on a post card.  I remember thinking that it sounded like a good idea, but in the back of my mind I couldn't help thinking about the old line that, if something sounded too good to be true, it probably was.  I must now reevaluate that thought in view of the successful adoption of flat-tax systems by several eastern European governments. Who would have thunk it?

The most radical tax reform proposal during my time was conceived by two friends of mine-the national sales or national consumption tax, more recently called the Fair Tax.  In many respects, it made the most sense of all the reform proposals, but it was so radically different that I had a hard time imagining it as a practical alternative to the flat income tax. I participated in a discussion of the national sales tax with Milton Friedman, who pronounced it a good idea-the ideal solution, perhaps-but he too worried about its practicality.

That was several years ago, and I've been surprised by the growing national support for the Fair Tax.  It's still a long- shot reform, but not as long a shot as it once seemed.  In thinking about that, it occurred to me that Friedman's qualification was not very Friedman-like. He was a well-known advocate of economists limiting themselves to "positive" economics and leaving the normative aspects to practitioners, i.e., politicians. Economists should not concern themselves with practicality or the political appeal of sound economic proposals. They should give the politicians their best possible proposals and let them worry about implementation.

So, here's where I am now.  Both the flat tax and the fair tax are big improvements over the current mess. The fair tax is probably superior to the flat tax if it could be implemented. Fortunately, the world is not holding its breath waiting for me to decide.  But if you are interested in the topic, as you should be, I recommend that you learn more about the fair tax and decide for yourself.  Start with their excellent web site, I recommend it to you and ask that you notas they use to say in my church"harden your hearts" against it.  Please, give the fair tax a fair chance!

This entry was posted on Tuesday, July 24th, 2007 at 9:45 am. Click here to go to Bob McTeer's blog.

Bob McTeer is a Distinguished Fellow at the National Center for Policy Analysis (NCPA), covering macro-economic issues, including monetary policy, fiscal policy, tax and education policy. Before joining the NCPA in January 2007, Mr. McTeer was Chancellor of the Texas A&M University System, and prior to that had a 36-year career with the Federal Reserve System, including 14 years as President of the Federal Reserve Bank of Dallas and member of the Federal Open Market Committee (FOMC).


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