As the Federal Reserve announces its latest interest rate decision this afternoon, one economic fact will doubtlessly be forgotten: Interest rates are terrible. They can tank markets. They can throw people out of work. They can even cause recessions. They're just not a very good way to manage business cycles.
But there's a better tool, one that we should take out of the hands of government's most dysfunctional institution, Congress, and put into the hands of one of its most functional, the Fed. I'm speaking, of course, of taxes.
To understand why, you first have to understand why interest rates are awful.
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National economies seem to suffer from a cycle where demand first outpaces supply, causing inflation, and then falls well below supply, causing a recession. Wash, rinse, repeat. It's fallen to the Fed to make those ups and downs as painless as possible.
How do interest rates do this? Well, demand comes in two flavors: consumer spending and investment. When the Fed lowers interest rates, it makes credit more affordable. That directly encourages more business investment and indirectly makes it easier for people to get home and auto loans and to use their credit cards. When it hikes interest rates, it discourages investment.
This is where the problems start.
At the moment, consumer spending has grown to nearly 70 percent of GDP. By contrast, private investment is less than 17 percent, and has never gotten above 22 percent in over half a century. As mentioned, investment and credit affect jobs and wages and ultimately bleed into consumer spending. But the fact is, the Fed's effect on consumer spending is mixed and incomplete while it clearly and directly influences investment.
Yet its focus on investment is profoundly unjust. Businesses don't respond to tighter credit by cutting CEO bonuses and upper management salaries. They respond by laying off workers. And they usually start with workers they've employed for the shortest time, and for the least amount of money. Taming inflation with interest rate hikes inevitably sacrifices the most vulnerable: poorer Americans, less educated Americans, and Americans of color.
We may think of taxes and interest rates as two totally different things. But when it comes to managing the business cycle, they're flip sides of the same coin: Tax hikes suck demand out of the economy, just like interest rate hikes do. Meanwhile, tax cuts increase demand, just like interest rate reductions.
It's just that, in almost every way, tax changes do this better.
First off, tax hikes and reductions take money right out of our paychecks, or leave more in. That's why so many Americans find taxes vexing. But it also gives taxes a far more direct impact on the 70 percent of GDP that's consumer spending. We already have a tax withholding system for our paychecks. So if the Fed adjusted tax rates over the course of the year, those changes would affect consumer spending regularly and quickly.
Taxes can also be designed progressively, to hit the richest consumers first and hardest. Indeed, the federal income tax already does this. When inflation needs to be cooled off, tax increases can slow the economy from the top down instead of from the bottom up. Progressive taxation is also a natural corrective to inequality.
But just because taxes are clearly a better macroeconomic policy tool than interest rates doesn't mean we should just hand them over to the Fed wholesale.
Rather, Congress should create one overall framework for taxes, then allow Fed officials to adjust specific dials within it. The federal income tax provides a good starting point. It has multiple income brackets with different income level cutoffs, and higher tax rates for the higher brackets. Congress could allow the Fed to simply adjust the rates for each bracket up and down as it sees fit, but not income thresholds for the brackets.
Congress could also lay down other ground rules, like telling the Fed that it has to increase rates in the highest brackets first or decrease rates in the lower brackets. That would help keep the system progressive and just, and keep national tax policy accountable to democratic governance.
Of course, this setup wouldn't be perfect. It would create a bigger paperwork headache for employers and government agencies and everyone else who helps operate the tax withholding system. Freelancers would also have a tougher time under it.
There's also the question of spending, of course. Wouldn't our spendthrift Congress just become completely profligate if it didn't have to make tax decisions? Maybe — but half the Fed's job, given to it by Congress, is to keep inflation under control. Congress would know the Fed would increase taxes however much was needed to prevent its spending from overheating the economy.
Yes, this sounds like a crazy idea. But it just might be crazy enough to work.
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