THE GENERAL iNSTITUTIONAL FRAMEWORK FOR POLiCYFORMATIONinflation. Taxation, and IndexationGeoffrey BrennanAustralian National UniversityVirginia Poiytechnic Institute and State UniversityINTRODUCTION. It is a familiar complaint that the inter-action of inflation with the progressive income tax scaleforces people into higher tax brackets. Under a fixedprogressive rate structure, a purely nominal increase inincome (an increase in income matched by an equi-proportion-ate increase in prices) will always leave the taxpayer withless real take-home pay. Indeed, even a real income in-crease Twhere the proportionate increase in money incomeexceeds the rate of price increase) can leave the taxpayerwith a smaller net-of-tax real income. And when the rate ofinflation is at all high, the reduction in real disposableincome can be quite sizable.

If the taxpayer is at all interested in these things,he can calculate just how much real take-home pay he hasnow compared with what he would have had if he had earnedthe same real income last year, or the year before, or morestrikingly in some long-forgotten time when the current ratescale was settled on through explicit legislation.!

All these reflections tend to make the taxpayer ratherirritated. He cannot see why he should be moved into ahigher tax bracket when his real income has not gone up.Still less can he see why his taxes should go up when hisreal income has gone down (as occurs for example when theincrease in money income is less than the rate of inflation).It is all quite unfair]

Such taxpayer indignation represents the electoralspringboard for a policy which has received quite a bit ofattention recently, and has actually been implemented in anumber of countries. This is the policy of indexing theprogressive income tax rate structure, so that tax bracketsare specified in real, rather than nominal, terms. Onceimplemented, such indexing insures (or is supposed toinsure) that purely nominal increases in income levelsgenerate ££ increase in tax rates; real tax rates remainunaffected by the inflationary process.

The attributes claimed for this policy are nothingshort of breathtaking. It is supposed to make the taxsystem "fairer." It will make politicians "responsible.".It will transform the electorate (currently, the mostscandalously ignorant mass) into a set of intelligent, wellinformed decision-makers. It will make the job of stabi-lizing the economy much easier. It may even cure inflationitself.

In the face of such claims, it is ironic to reflectthat much of the popular enthusiasm for indexation of incometax rates arises from precisely the sort of fiscal illusionthat indexation itself is supposed to dispel. Taxpayers arealways complaining that taxes are too high, or are going uptoo much, irrespective of how the tax increases come aboutor what taxes happen to be involved. The same taxpayerswill often be enthusiastic about new expenditure programs,or at least singularly unenthusiastic about specific

expenditure reductions. In fact, the "taxes are bad,expenditures are good" view of things informs electoralperceptions in much the same way as the "imports are bad,exports are good" adage informs the perceptions of modem-day mercantilists.

Once the crucial nexus between taxes and expendituresis acknowledged, however, it becomes clear that it is notinflation which is forcing people into higher tax brackets,but rather the government's decision to increase publicspending. To be sure, allowing inflation to interact witha fixed progressive income tax rate structure is the meanswhereby revenue is raised—but governments have a choicewhether to use the real revenue increment obtained therebyfor new expenditure programs or for explicit tax reductions.The reason for the net increase in tax liabilities is that,by and large, the former course seems to have been chosen.The policy of indexation of income tax rates, by contrast,involves an explicit legislative commitment to use therevenue in question for the latter purpose, and more specif-ically, for a very particular set of reductions in incometax liabilities.

Seen in this light, what are the pros and cons ofindexation as a fiscal device? If it is the government'sdecision to increase public expenditures that increases realtax rates, what might people reasonably mean, when theycomplain about the interaction of inflation with an essen-tially unchanged progressive income tax rate scale?

There seem to be five main possibilities.

Firstly, they may believe that this particular means offinancing incremental expenditures is distinctly inferior--according to standard criteria of tax policy--to othermeans available.

Secondly, they may believe that, in the absence ofautomatic increases in revenue due to inflation, the expen-diture increases would not have occurred—and that expendi-ture increases are undesirable.

Thirdly, they may feel that, although they have noantipathy to expenditure increases in principle, expenditureincreases financed in this particular way are less subjectto electoral scrutiny than otherwise, and hence that indexa-tion would "improve" political processes even if theexpenditures were ultimately undertaken.

Fourthly, they might argue that absence of indexationgives governments a distinct preference for higher rates ofinflation.

Finally, they might argue that automatic increases intax revenues under inflation poses problems for the fiscalmanagement of the economy.

It is not possible in this brief discussion to coverall these possibilities. Here, I shall focus on the firstthree, and my treatment of the first is necessarily fairlycursory. This is undertaken in Section II. In Section III,I look at the second and third arguments, which seem to mepotentially the most interesting and important. Section IVoffers some tentative conclusions.

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THE FAIRNESS DIMENSION. In this section we focus on the"fairness" dimension of indexation—the aspect that seemsto predominate in most popular and professional discussion.

There are three ways in which this issue might beexamined, all of them generally viewed as legitimate bypublic finance specialists.

One is to take the expenditure levels of government asgiven and independent of the revenue raising source, and toask whether the automatic increase in personal income taxliabilities spreads the cost of the incremental expenditurein a way that is fairer than the relevant alternatives.This is the so-called "differential tax incidence"perspective.

A logical alternative would be to assume that the incre-mental expenditure would not otherwise have occurred, and toexamine the total distributional impact of the expenditureincrease together with the automatic tax increase—a so-called balanced budget incidence perspective.

A third would be to take the revenue raised as given,and ask whether the particular set of personal income taxreductions which indexation represents is "fairer" thanalternative "expenditures" (including alternative tax cuts)that might be undertaken—a "differential expenditure inci-dence" methodology.

Interestingly enough, most of the available discus-sions 2 adopt none of these methodologies. Rather, they tendto compare relative tax burdens at different points in time—and particularly changes in the degree of progression,variously measured, over time--when expenditure levels arequite different. What they succeed in showing, focussingon the tax side alone, is that over time the progressivenessof the income tax has declined. The implication, presumably,is that with indexation the income tax would be moreprogressive (and therefore fairer).

This particular sort of comparison is, however, notonly methodologically suspect but also extremely misleading.It is misleading because it overlooks the crucial fact thatthe degree of progression exhibited by a particular tax, ortax system, is necessarily negatively related to the levelof revenue raised. The point seems to be worth spelling outin some detail.

A standard measure of progression is given by the"liability progression" of the rate structure, or

A£ ,AY _ AT /T _ mT'' Y " AY^Y t

where T is tax, Y is taxable income, m is the marginal taxrate and t is the average tax rate. Clearly, m is boundedfrom above by disincentive considerations. It must certainlylie below 100 percent, and in most tax systems is set muchlower. Now, as revenue demands rise, average tax rates mustrise. But if there is an upper limit on m, then the averagemarginal rate for all taxpayers taken together cannot riseby as much. Liability progression declines.

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A simple example may elucidate. If the maximum marginaltax rate is set at 60 percent, then when government raises30 percent of GNP the tax system can exhibit reasonable"liability progression." But as the proportion of govern-ment revenue rises towards 60 percent of GNP, the tax systemmust necessarily become more and more proportional: progres-sion must decline, simply as a result of the arithmetic.

If the empirical investigations were conducted witzhin a"differential tax incidence" framework, this fact would nodoubt be all too apparent. To maintain the degree of lia-bility progression implied by a tax rate structure legis-lated when revenue demands were more modest than currently,would require maximum marginal tax rates that might wellcreate doubts for even the most inveterate "progressivist."In any case, in the practical policy context, the questionis not whether more progressive ways of financing incre-mental expenditures can be imagined, but rather whether theyare actually likely to be used. The relevant alternativeto automatic income tax increases, in most countries atleast, has probably been not explicit increases in incometax rates, but rather a sordid mess of much more dubiouspossibilities, such as excise tax increases, new money crea-tion, company income tax hikes and so on. And as a purematter of fact, the absence of indexation has in most casesprobably increased the overall progressivity of the taxsystem as a whole, because it has greatly increased theweight placed on the one genuinely progressive instrument inthe tax armory.

Of course, this discussion is not sufficient to suggesta judgment on the distributional impact of indexation (orits absence). What it does show is the need for some clearthinking about the assumptions concerning counter-factualsthat are necessary if any such judgment is to be made.

Would expenditure rise as fast (if at all) in thepresence of indexation? If we have indexation, how willincremental expenditures be financed? If expenditures dorise more quickly under indexation, what is the likelydistributional impact of the extra expenditures undertaken?

In all discussions I have seen on the "fairness"aspects of the indexation issue, these questions are sweptaway by the simple expedient of pretending that they do notexist. Given the magnitude of the revenues at stake (andunder current rates of inflation they are considerable), itseems to me that they are questions which should not beignored any longer.

The ensuing section is concerned (largely) with thefirst of them.

INDEXATION AND EXPENDITURE LEVELS. The reasoning underlyingthe view that indexation will slow down the rate of growthin expenditures is obvious enough. The argument is quitesimply that taxpayers are less conscious of automatic in-creases in tax rates due to inflation than they would be ifthose revenue increases had been the result of explicitlegislation. Thus, the perceived cost of incremental expen-ditures to the taxpayer is lower in the absence of indexationthan in its presence, and hence incremental expenditures

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will be implemented which would not have been if they hadhad to run the gauntlet of explicit electoral approval.

The validity of this line of reasoning seems unas-sailable. Yet it tells, I believe, only part of the story,and some of what I wish to say here involves sketching outsome of the untold chapters. Specifically, I am concernedwith the question—what is the likely direction and magni-tude of the effect which indexation of personal income taxwill have on public sector size and rate of growth?

One point we should note at the outset is that automaticincreases in income tax revenue are not the only source of"fiscal illusion." Similar sorts of electoral mispercep-tions about the tax costs of public expenditures arise underexcise taxes (the rates of which are often significantlyunderestimated by taxpayers), company income taxes (whichmany of those who might be alleged to pay the tax believe tobe paid by someone else), and with a whole range of tax/subsidy instruments whose incidence is unknown.

In fact, within the sort of institutional democracy weare typically dealing with, the process of inter-partycompetition will generally tend to lead to a tax system inwhich the perceived cost of public expenditures will be mini-mized (i.e., "fiscal illusion" of this sort will be maxi-mized) . A party can always gain votes by substituting for aconspicuous tax one which collects the same revenue withless perceived sacrifice by the taxpayer, other things beingequal. There may of course be limits on the extent of suchsubstitutions: taxpayers may also value "fairness," "sim-plicity" and "efficiency" in the tax system, and there mayof course be other dimensions to a tax system via which aparty might be able to increase its chance of being electedunder majority rule (e.g., redistribution away from a minor-ity). Nevertheless, "fiscal illusion" will tend to becultivated naturally under democracy, just as in less"cooperative" models of political processes.3

Clearly, the greater the extent to which these "subtle"taxes are used in the tax systems the larger the public sec-tor will be ceteris paribus. The rational voter willalways want to push public spending to the point where theperceived benefits from the marginal expenditure equal theperceived costs, and the lower these perceived costs arethe larger will be public spending. It should be emphasized,however, that this is a purely incidental outcome: it de-pends on the nature of politically viable tax substitutions,not on any assumption that politicians benefit more than thetypical taxpayer-voter from public spending.'^

Given a political preference for unobtrusive taxes, itseems difficult to explain significance of personal incometax in most tax systems apart from the absence of indexation.For of all taxes, personal income tax, even per dollar oftax paid, tends to be the one of which taxpayers are mostconscious. Indeed, there is very substantial "fiscal illu-sion" of precisely the opposite sort to that which we havebeen discussing. Taxpayers often mistake marginal foraverage rates. Fear of "moving into a higher tax bracket"often indicates that individuals believe that marginal taxrates exceed 100 percent over some ranges. And the practiceof withholding tax (often at rates far above those which the

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taxpayer ultimately pays on his taxable income, net ofdeductions) may encourage individuals to believe that theirtax rates are higher than they really are. These fiscalillusions tend, ceteris paribus, to make personal incometax an electorally unpopular tax, and to the extent thatthe automatic revenue increase makes the income tax politi-cally palatable, the absence of indexation may be an impor-tant ingredient in maintaining it as a significant part ofthe total tax system. If so, then absence of indexationmay actually be a limiting factor on the size of the publicsector, because it implies continued heavy reliance on thepersonal income tax.

We should note that one of the likely tax "substitu-tions" that would emerge in this democratic model is theuse of the (dimly perceived) increase in income tax ratesdue to inflation to finance cuts in the (all too conspicu-ous) nominal rates of income tax. In fact, in the absenceof any preference for higher levels of expenditure per seon the part of political parties, it seems unreasonable tosuppose that all of any inflation-induced revenue increasewould be spent in increased expenditures: at least some,and perhaps most, would be returned to the taxpayer in theform of explicit tax cuts, because it is electorally advan-tageous for parties to behave in this way.

Consider a simple example. Suppose we live initiallyin a world without inflation, and that the tax system andthe level of spending are in political equilibrium. Anexogenous inflationary shock occurs, and real revenue in-creases by $10 billion, although the electorate perceivesthis as a reduction in real disposable income of only $5billion. This latter $5 billion must be returned to theelectorate given that the level of spending was initiallyin equilibrium. The remaining $5 billion is equivalent intaxpayer perceptions to "manna from heaven," and will besplit between public and private uses according to theincome elasticity of demand for public spending. Assumingthat private uses are not "inferior," this implies that onlypart of the $5 billion will finally emerge as increasedpublic spending, say $2 billion. Then of the original $10billion revenue increase, 20 percent is spent in public use;80 percent is returned to the tax payer as explicit taxcuts.^ (An ideological commitment on the part of the partyin office may mean that somewhat more of the $5 billionapparent gain is spent in public use—but the influence ofthis in a model in which political outcomes are constrainedby party competition seems unlikely to be marked.)

The magnitude of the problem is more substantial ifpolitical parties themselves suffer from "illusion." If theparty in office treats the entire $10 billion as "manna fromheaven," the public expenditure increment will be perhapstwice as large ($4 billion or more), and electoral defeat isnot necessarily threatened by this because the alternativeparty does not discern its competitor's mistake. Thus,"fiscal illusion" by those in office is, in this contextat least, potentially a more significant source of rapidpublic sector growth, than taxpayer illusion.

Of course, even accepting that indexation is likely toslow the rate of growth of public spending (albeit somewhatless than is often implied), no necessary policy

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implications follow. There is, to be sure, an impressivearray of arguments to the effect that the public sector islikely to be too large in a democracy. But this is an issueon which not surprisingly, professional opinion is divided.In fact, it seems to me to be perfectly possible to arguethat fiscal illusion on the tax side might be a "good" thing,both on the grounds that it offsets corresponding illusionson the expenditure side and more provocatively because itmay leave taxpayers feeling better off than they would underan alternative, more overt, tax system. I do not intend toargue these propositions here, but it does seem important toacknowledge them as crucial issues in this context.

CONCLUSION. My aim in this paper has not been so much toargue a case for or against indexation as to indicate thatthere is the need for a case to be made.

Many discussions seem to regard the desirability ofindexation as self-evident, and scarcely requiring scrutiny.This is not my view. And although I personally remainlargely agnostic on the whole issue, I believe profoundlythat it requires serious thought and detailed analysis.This brief paper is designed to provoke a little of both.

NOTES

If he has any difficulty in remembering that far back, he can get alittle assistance from the professional literature. See, for example,C. Goetz and W. Weber, "Intertemporal Changes in Real Federal Income TaxRates 1954-70," National Tax Journal (March 1971), or J. Bossons andJ. Wilson, "Adjusting Tax Rates for Inflation," Canadian Tax Journal(1-Iay-June 1973).

2Including those cited in Footnote 1.

o

See, for example, Buchanan's summary of Puviani's arguments in the con-text of a "ruling class" theory of political processes in J. M. Buchanan,Public Finance in Democratic Process, Chapter 10.

In this respect, there is a marked contrast with "ruling class" theoriesof government.

The effect of indexation in this context is then to reduce public spend-ing by approximately 20 percent of the real automatic revenue increase.

The Discount Rate for Public Investments: Should the GovernmentReally Be Different?*Kenneth A. ShepsleWashington University, St. Louis

Individual investment involves the deferment of somecurrent consumption in order to obtain a future, possiblyuncertain, return. An individual ordinarily discounts thereturn of a prospective investment in accord with the dura-tion over which his consumption must be deferred and

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