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The economy needs a new Fed, not a new tax


COOPERS & LYBRAND recently audited Steve Forbes' proposed flat tax. The blue chip accounting firm found that the flat tax would indeed leave the treasury about $200 billion a year short, just as critics allege.

The analysis left Forbes one improbable out. If the economy grew at 5 percent a year, then there would be no revenue shortfall and everything would be rosy.

Well, yes. And if my grandmother had wheels she would be a bicycle. There is no evidence a flat tax would cause the economy to grow at 5 percent a year. On the contrary, there is an iron consensus that the best the economy can do, whatever the tax system, is its current growth rate -- something like 2.5 percent. This is the orthodox view, whatever the rates of savings, investment and productivity.

At that growth rate, workers have little bargaining power. Increases in productivity go to shareholders rather than employees. That's why earnings are flat and the stock market is soaring.

At the very center of this consensus is the Federal Reserve Board, in the role of enforcer. Whenever the economy shows signs of growing faster, the Fed hits the brakes.

And the problem is not just the Fed, but central bankers as a breed. Even though inflation is ice-cold, the world's major central bankers think the risk of reigniting inflation, however remote, justifies their policies of sluggish growth.

In the past decade, the world has moved in the direction of freer markets and presumably greater economic efficiency. But despite all the deregulation, new technology, globalization, the shift from communism to capitalism, and the open trade, the world economy today is growing at only about half the rate of the post-World War II boom -- when everything was more regulated.

Evidently, all these gains to efficiency are impotent to raise growth as long as central bankers keep the economy's potential leashed by keeping money too tight. And that seems to be the real constraint on economic performance, whether the tax system is flat or round.

The flat-taxers reprise the supply-side arguments of the early 1980s: By lowering taxes, especially on investors, we would increase the rewards to capital. That, in turn, would increase rates of savings and investment.

Investment pays for new technology that allows society to enjoy higher standards of living. Hence it isn't so offensive to give the wealthy a tax holiday, since "everyone" ultimately benefits. The dubious part of the flat-taxers' claim is that lower taxes are the key to higher investment.

Goodbye, inflation

But even if the flat-taxers are right about taxes and investment (which is doubtful), the Fed isn't changing its views about how much growth the economy can stand. There have already been momentous structural changes in the economy that allow higher, non-inflationary growth rates -- but the Fed hasn't budged.

For example, globalization makes it hard for producers to impose price hikes on the public. Consumers just shift to imports. Deregulation, likewise, has weakened old monopolies and left industry in a brutal contest to cut costs, not raise prices.

Similarly, weaker unions and higher unemployment leave labor unable to press for wage increases. The old risk of industry passing along wage hikes as price hikes is a dead letter.

The Fed has somehow missed it, but inflation is dead. And if the central bankers are oblivious to all of these epochal changes, a flat tax won't make a difference either.

Besides, investors are reaping plenty of rewards without additional tax favoritism. The stock market continues to set new records, notwithstanding the tax system. And every time the Fed grudgingly eases up a little, as it did last Wednesday, the market sets a new record.

This should tell you what we really need: not a different tax code, but a different Fed. That would be a much more direct route to higher growth, without widening inequalities that are already appalling.

It used to be said that the chairman of the Federal Reserve held the second most powerful job in the country. But perhaps his job is the most powerful.

Consider: Jimmy Carter lost his job when Fed Chairman Paul Volcker slammed on the money brake in 1979-80. Ronald Reagan won a handy re-election when Volcker obligingly eased up in 1983-84. George Bush crashed when Alan Greenspan took too long to allow a recovery in 1992. And in 1996 Bill Clinton, far from criticizing the Fed, is being very, very deferential to Greenspan. Wouldn't you?

If supply-siders want to do something useful to unleash economic growth, they should drop the flat tax and join other critics of austerity in a common project to reform the Federal Reserve.

Robert Kuttner is a syndicated columnist.

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