Consumers Can't Spend It If It's Going To The Taxman

With household spending accounting for some 65% of total demand, no decent economic expansion can possibly take hold without a pickup in consumption. Yet consumer spending has been notably weak in the current recovery, and efforts by the Federal Reserve to quicken the pace of economic activity have thus far met with only scant success.

In a recent analysis, economist Lacy H. Hunt of HongkongBank Group underscores a hurdle complicating the Fed's task. "In one of the worst blunders of modern economic policy," Hunt says, "federal taxes were hiked sharply during the 1990-91 recession at a time when both economic common sense and historical precedent argued that they should have been cut." In fact, by June, the latest tax hikes had helped push the federal tax bite to 17.3% of personal income less transfer payments-only slightly below its 17.8% level in September, 1981, just before the much-heralded Reagan tax cuts began to take effect.

Although it was intended to reduce the federal deficit, claims Hunt, "the federal tax increase actually served to crystallize recessionary forces and to make them more severe, thus slowing revenue growth and deepening the deficit." Federal tax revenues in the first 10 months of the current fiscal year, he notes, were up only 2.2%-far below projected levels and only half the gain posted in the first 10 months of fiscal 1990.

In previous recessions, of course, tax rates were often cut to help fuel an economic turnaround. Moreover, the progressivity of the income tax system itself acted as an important automatic stabilizer, since households whose incomes declined because of the recession fell into lower tax brackets. This time around, however, the flattening of tax brackets has muted the countercyclical effect of the tax system during downturns, and the huge federal deficit precludes significant tax relief.

To make matters worse, some 34 states followed the federal government's example and enacted tax increases last year. As a result, the combined federal, state, and local tax rate on individual and family incomes hit 22.3% in June, an all-time high. And with other rises in state and local levies either pending or now taking effect, plus a hike in medicare taxes imposed on upper-income individuals, the tax burden will grow even more onerous in the months ahead.

"Historically, recessions have been brought to an end by a partnership between monetary and tax policy," says Hunt. "Never in the past has the U.S. economy staged a successful recovery with the average tax rate on households so high-and rising." If monetary policy is to offset the impact of rising taxes, he argues, "the Fed will have to ease a lot more aggressively than it has so far."