Warning! Bracket Creep Ahead!

With a guarantee that only those making more than $250,000 a year will see a tax increase it is probably a good time to talk about something that has not been a problem for decades: Bracket Creep.

Bracket creep is the result of a progressive tax system in an inflationary environment. In a progressive tax system the rate at which income (or whatever the basis for taxation is, but for this discussion it is income) is taxed at a greater rate as income goes up. The increases are incremental in a discreet number of brackets, of which there are currently six. The net effect is that the last dollar earned is taxed at a greater rate than the first dollar earned as long as enough is earned to advance out of the lowest bracket.

In a relatively inflation-free environment earners move up the brackets as a result of gaining earning power and so greater income. Progressive tax policies can be accused of having the effect of diminishing motivation to improve one's earning power since rewards are effectively less as income, and so the marginal tax rate, increases.

In an inflationary environment income levels rise more or less in time with rising prices: more for those with valued skills, less for those without. As one's income rises, so too does his or her marginal tax rate. However, due to inflation, buying power does not increase with increasing income. This is why bracket creep is a problem and why a $250,000 income will not mean "rich" for long.

Inflation and Finance

Inflation, the decline of purchasing power, is caused by a number of factors. Most relevant now is massive increases in government spending. Technically this is demand-pull inflation. Inflation has not been zero for a very long time, and arguably some inflation is better than disinflation because the latter causes inventories to decay value over time. When inflation is tame, as it has been for over twenty years, the gradual decline in purchasing power is not noticed. Fluctuations in food and fuel prices mask the effect in the short term, and annual merit raises preserves buying power in the long term.

The impending flood of government spending can be financed in one or a combination of three ways. The three are: Increase Tax Revenue, Borrow, and Print Money. Increasing taxes on those making over $250,000 will not pay the bill. Confiscating the entire income of the top 10% of earners in the United States would not pay half of the proposed deficit, and that would work only once as top earners lose all motivation to earn anything. Increasing tax revenues would help but, contrary to what would make sense at first glance, that generally only happens when tax rates are lowered. This policy is not currently under consideration.

Borrowing money, which the government accomplishes by selling bonds, has been an ongoing government activity for generations. There is no point in putting a number here for the total debt as of now, it changes constantly, so just visit the Debt Clock. Perspective is important when looking at numbers that, in a perfect world, would be presented in scientific notation. Remember that debt, when managed responsibly, is a good thing for both borrower and lender. The borrower uses the capital to improve operations in some way, and the lender earns interest income on funds for which there is no better use.

There are few lenders with adequate resources to provide the incredible pile of cash needed to fund the proposed government programs. Recent losses in the equity markets has drained the private sector of capital, so it comes to China. But China has only about $2 trillion on hand at the moment, and the best possible use is probably not to lend it all to the United States. The Chinese economy is slowing too and they have their own stimulus packages to finance. Secretary of State Clinton may have some favors to call in from the Chinese, but they may not be able to provide financing even if they want to.

In principle the Chinese may be interested in seeing this process through:

The principle governing our economic policy is to proceed with all the essential work of economic construction within our power and concentrate our economic resources on the war effort, and at the same time to improve the life of the people as much as possible, consolidate the worker-peasant alliance in the economic field, ensure proletarian leadership of the peasantry, and strive to secure leadership by the state sector of the economy over the private sector, thus creating the prerequisites for our future advance to socialism.
  -- Our Economic Policy, Mao Tse-tung (Mao Zedung)

So, if the Chinese care to help finance our advance to socialism, perhaps they will put economic considerations aside and approve the loan. The priorities seem remarkably similar now in the U.S. as in China in 1934. Twenty-four years after writing this Mao launched the Great Leap Forward, and perhaps as many as 20 million Chinese died from starvation and related diseases. Mao resigned his position as head-of-state, but remained popular and powerful as party chairman (they only have one party, greatly simplifying the decision of whether to report a politicians party affiliation in the press), kicking off the somewhat less disastrous Cultural Revolution a few years later. If the Chinese, given their recent history, believe that this proposed loan is beneficial to both lender and borrower, considering political implications as well as economic ones, then they will approve the application. Time will tell.

Another observation by Mao from Our Economic Policy:

As regards the private sector of the economy, we shall not hamper it, indeed we shall promote and encourage it, so long as it does not transgress the legal limits set by our government. For the development of private enterprise is essential to the interests of the state and the people at the present stage. Needless to say, private enterprise is now preponderant and will inevitably continue to occupy a dominant position for a considerable time.

Mao was arguably more supportive of the private sector in 1934 than the President of the United States is in 2009. Now that's progress! Perhaps it would help if the current administration adopted this policy of promoting and encouraging the private sector, like Mao?

Print Money

Since the rich do not have enough money to confiscate, and the Chinese may not be inclined to provide debt financing, it is likely that it will be necessary to print money. Of course in the digital age the money does not need to be literally "printed;" actual currency is only one part of the money supply. The informal definition of inflation is "too much money chasing too few goods." Providing a job in the bike path industry pays the bills and provides more self-esteem than public assistance, but it produces no good or service with economic value so money chasing goods goes up, supply of goods stays the same - which way does inflation go?

Of the trillions of dollars in stimulus and other spending, which started in the previous administration and is accelerating in the current one, only a fraction will stimulate the economy without introducing inflationary pressure. For example, if a new bridge or improvements to an existing one cuts transport time and fuel consumption it provides real economic value, albeit indirectly. Projects in this category are being considered. This does not suggest that bike paths and Salt Marsh Harvest Mouse conservation efforts are not necessary or that they are bad ideas, only that government spending in some areas will tend to have better economic results than spending in other areas.

There is a perverse side to this strategy. Whatever bonds can be sold will be repaid with considerably shrunken dollars, and we get to keep the bike paths. So if inflation exceeds the interest rate paid on the debt, the bonds are a bargain in the long run for the government, not so much for the lender. The lender knows this and will act accordingly.

Those who live in the shadow of a macroeconomic game of chicken should expect to become familiar with terms like bracket creep, stagflation, and another measure of economic performance of little interest for the last couple of decades: the Misery Index. And do not be surprised if you find yourself among the rich taxpayer class sooner than expected.

Tom Bruner holds an MBA from an ivy-free institution somewhere in darkest America.