Inflation and Taxable Capacity: Some Recent Evidence

Colin Clark\u27s theory of inflation has had a profound effect on present-day economic theory concerning taxation policy. While his belief that inflation occurred when all tax revenues exceeded 25 percent of national income was rejected by his contemporaries in the 1940\u27s, supply-side economists incorporate Clark\u27s theory into their proposals for curing the unemployment and inflation of the 1970\u27s and 1980\u27s. These proposals gained popular support and resulted in the election of President Ronald Reagan who implemented such proposals. The purpose of this study is to determine the veracity of Clark\u27s theory. Clark\u27s theory was tested in this study with the use of regression analysis. The dependent variable, inflation, was measured as the percent change in the consumer price index. The consumer price index was chosen because it is a broad-based index that is representative of commodity and service prices and excludes labor costs. Measurement error was minimized by the use of annual CPI data. The independent variable is the ratio of total tax receipts as a percent of the officially reported national income. The preliminary run of the test was performed on the United States from 1941-1981 using ordinary least squares contained in the Econometric Software Package. Autocorrelation appeared in the regression and attempts to correct this failed. The modified test model used the rate of inflation acceleration (percent change in the inflation rate) as the dependent variable. This dependent variable exaggerates the magnitude of price changes, making the relationship more likely. The independent variable represented the elasticity coefficient of total tax receipts to national income (percent change in taxes divided by percent change in national income, expressed as a percentage). This independent variable is far more descriptive of the interaction between tax revenues and national income. The model was used to test Clark\u27s theory in Canada, Finland, France, Germany, Italy, Switzerland, the United Kingdom, and the United States from 1963-1981. The regression results show that there is no relationship between the rate of inflation acceleration and the elasticity of total tax receipts and national income. On the basis of the regression analysis and the country by country statistical analysis, this study finds little evidence to support Clark\u27s theory of inflation. For this reason, the study recommends a re-examination of all policies that have been implemented on the basis of Clark\u27s theory or other similar theories of inflation