People can afford to pay the government more money in good times but need more money to spend when times are tough

One of the worst things that the government can do is to raise taxes when the economy is struggling. That results in even less money for the private sector to spend and weaker economic activity. So you often see the opposite: legislatures sometimes temporarily cut taxes during a recession to encourage spending and investment. But why not take this idea and mechanize it? Tax rates could be set to move up and down as the economy expands and contracts.

This idea expands upon one offered by former Obama White House budget chief Peter Orszag. In his Bloomberg View column this week, he wrote:

To mitigate the harm to the labor market from this fiscal drag, policy makers should provide additional macroeconomic support in 2012 by extending the existing payroll tax holiday. But more than that, Congress should link the payroll tax to the unemployment rate. This would allow the tax holiday to automatically calibrate itself to existing conditions, providing support only when the economy is weak. If necessary, the underlying payroll tax rate could be raised to make this mechanism budget-neutral.

This is a pretty slick idea. By allowing tax rates to automatically adjust as the economy changes, you do two things. First, you ensure that taxes remain low when the economy needs extra spending and investment. Second, you ensure that the government doesn't become too enamored with ultra-low taxes and keeps them too low for too long after the economy recovers, creating budget deficits.

But why stop at the payroll tax? Why not apply this to other taxes as well? If taxes were countercyclical, then workers would pay more money when times are good and less when times are bad. This would allow the government to accumulate a surplus when the economy is humming that could be relied upon when the economy sputters and tax receipts decline below revenue projections.

We can anticipate a couple objections to the practical implementation of such a tax structure, however. For one, it would encourage managers to lay people off: the higher the unemployment rate, the lower the tax rate they'll pay. You certainly don't want to see firms err on the side of firing more workers instead of fewer when a recession hits. But presumably, managers would realize that having too small a workforce could cause a firm serious problems. So firing more people to try to derive a tax benefit would ultimately be a pretty foolish strategy.

The other problem would be finding a way to force the government to keep its hands off of any surplus that accumulates to use during future recessions. If recent history tells us anything, then we know that politicians can't even resist spending money that they don't have. So the hope that they will ignore the money than they do have might be too much to ask.

But if there is a way to protect the surplus that accumulates, a countercyclical tax system might be a pretty good way to cushion the impact of economic cycles. It should also help to combat bubbles, since higher tax rates would make it harder for people to mindlessly plow more money into overpriced assets as the economy overheats.

Image Credit: REUTERS/Jim Young