And the greatest pain falls, as often happens, to the poor and the unemployed. Higher interest rates can change the spending decisions that wealthier people make. If it’s a bad time to buy a home, even a millionaire may wait a few years. But higher interest rates won’t change how much childcare they buy or whether they upgrade their phones or how much they spend on clothes. And it is the spending of the wealthy that drives the economy: in 2021, the top fifth of incomes were responsible for nearly 40 percent of total spending. One-fifth of the lowest income was less than 10 percent.
It would be nice to have policies that can work in tandem with interest rates so the adjustments are less severe. It would be especially nice to have a policy that targets the rich rather than the poor and done so in a way that does not harm long-term investments. Such a policy exists.
For years, Cornell University economist Robert Frank argued for a progressive consumption tax on the ground that would discourage the rich from spending on luxuries and give them more reasons to save and invest. The way it works is simple: Instead of reporting your income to the IRS and having it taxed, you report your income minus your savings, and it gets taxed. This is a consumption tax: Your taxable income is what you spend, not what you save. Congress can make it progressive by adding a huge standard deduction and applying a much higher tax rate to people who make a lot more money, just as we do now.
Frank wasn’t writing in a time of high inflation, so his argument centered elsewhere: he considers too much spending among the rich to be harmful, not just wasteful. Take the wedding spending: the wealthy are competing with each other for more lavish weddings. This competition is carried over to those closest to the rich, who want to appear rich and thus increase their spending as well. The pressure then moves to the next group down the income ladder, the next group, and so on, until everyone spends more on weddings because the frame of reference about how much they “should” spend on the wedding has changed. You can find similar dynamics in spending on everything from homes to schools to cars and jewelry.
I’ve always liked Frank’s argument, but I’m now more interested in another feature of a progressive consumption tax: the ability to call it up and down to respond to different economic conditions. In times of recession, we can lower taxes on new spending, giving rich and poor alike an extra reason to spend. In times of inflation, we can raise taxes on new spending, especially among the wealthy, giving them a concrete reason to cut spending immediately and to save and invest more at the same time.
Even better, we can make it automatic, as Lee Posen suggested. Perhaps for every percentage point increase in the unemployment rate above 5 percent, the tax rate would fall by three points, and for every percentage point increase in inflation above 3 percent, it would rise by four points. Other rules may apply to periods when unemployment and inflation move together. Tax law will become responsive to the economy by default, and not just through new laws of Congress.
Are we likely to put a progressive consumption tax in place now? of course not. Congress isn’t likely to do much of anything right now. But over the past two decades, we’ve had a massive recession in which Congress passed very little stimulus and now it’s an inflationary crisis that Congress and the Federal Reserve have been too slow to address. Perhaps it is time to think about policies that move at the speed of economics and psychology rather than the pace of institutions.
Additional research by Rollin Ho.
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