Entrepreneurship

The Problem with Tax Cuts as a Tool to Promote Economic Growth

By Johnny Fuery ⋅ October 30, 2008 ⋅  Print This Post ⋅ Post a comment

There’s been a lot of political rhetoric being broadcast both on CNN and around the water cooler about basic economics. Everyone seems to have an opinion about tax cuts and about the steps we should take as a nation to improve our economic vitality.

The thing that irks me is that it seems to be a foregone conclusion that tax cuts — especially the Republican version of it — are empirically good.

The Obama folks don’t want to get into this discussion, even though, as I’ll show in about eight paragraphs, they’re right. A tax cut on the middle class, even one financed by the top 5% of income earners, is a significant step in the right direction.

Now, before you conservatives close your entire browser window in disgust, I’ll give you a nod. Categorically, tax cuts should have a stimulating effect on the economy. Go ahead, gloat. Yes, you’re right. When McCain says “a tax increase right now would be bad for our economy”, he’s right. Across the board, if nothing else changes, raising taxes — even if only on the top 5% of wage earners — should have a negative aggregate effect on consumption and saving with an appropriate echo in production.

But the Obama plan doesn’t just raise taxes on “the rich”. It reduces taxes on the other 95% of the population. You can use all the incorrect negative allusions you want, e.g., “socialist”, “redistribution of wealth”, heck, even “unfair”, but it doesn’t change the fact that this is actually a good thing for both (a) more people more of the time, and (b) the economy as a whole.

Why (b), you might be wondering? Because rich people don’t buy more stuff (and therefore spawn more production) when they make more money. That’s the definition of wealth — having everything you need! If someone who takes home $50 million a year suddenly takes home $51 million, will he (sorry ladies, statistically speaking, it’s a dude — that’s another blog post for another day. Don’t kill the messenger!) go out and by 30 new Ford Taurus Sedans? No, he’ll hoard it. He’ll put it in the stock market. He’ll buy some oil futures. Now, yes, if you took Econ 101, you know that this wealth should in theory being put to work in the economy in the form of capital investment — which banks would then loan out to build more factories. But we have a credit crunch, banks aren’t making loans, and it’s a time of historically high inflation (no, it’s not 1979, but it has been over 5% for most of the year — meaning T-Bills are effectively returning a negative rate, but again — sigh — that is another blog post). So, even if those wheels can start turning again, and that extra million dollars gets invested and then spawns some new factories, it will take a while to “trickle-down”.

On the other hand, we have some real problems. In aggregate terms, banks aren’t making loans, and even if you think that this particular problem will subside in a relatively short period of time (and I agree with you — heck, I just purchased some stock in the few banks I think will weather the storm and hold deposits more than our annual GDP in 24 months), trickle-down economics does nothing for the short term. This is aside from the utilitarian aspect that most of us believe government should be about, at least in rhetorical terms. (For those of you that missed that day in philosophy or political science, utilitarianism is the idea that policies should be set up to make the most people the most happy. There are certainly problems with this idea — at some point the pain of the few still isn’t worth it — but I think the generalized version is what public policy should be about. My impression is that most of the population would agree.)

So, instead, we should give money — in the form of a permanent tax break, which will immediately pad their paychecks — to the working poor and the middle class. Rich people hoard extra money, which takes quite awhile to echo into the system. Poor people go out and buy more toilet paper and better food. Middle class folks go out and buy newer cars and replace those nasty incandescent bulbs with Compact Fluorescents (don’t you?!). Both groups buy more Coca-cola and pay off a little credit card debt (another form of saving just as powerful as the rich guy investing that money, I might add — probably more, in fact, because American Express immediately uses that new capital to loan to the Small Biz right down the street and our aforementioned rich guy took his million bucks and bought a position in a hedge fund that holds a crapload of AIG paper). This has an immediate positive effect on job creation, wages, and aggregate prosperity. Oh yeah, and it makes more of the populace happy.

What’s my point? Well, if it’s an equal sum game — if the total tax revenue collected stays the same — then it is absolutely better in the short term (say, 24 months) for a little bit of belt tightening (that’s maxes out at 4.6% — you know, roughly a third of what the average American pays in regressive payroll taxes… again, another blog post) for the folks that make more money than you, your Mom, and your brother. Put together.

Still awake? Ok, here’s the whammy. Taxes change behavior. What, that’s it?

Well, yeah. Want that as a sound bite? Ok, here’s the kicker: Higher taxes on the rich encourage more capital investment.

In other words, if you raise taxes on the top tier of wage earners, you don’t need to trickle that shizzle down. You get new factories right now.

What? What’s that you say? You say today is election day…?

Ok, here ya go:

Given that our aforementioned Richie Rich makes $50 million a year, he is almost certainly in a position of some power at his company. setting aside state taxes for the sake of simplicity, at a 35% tax rate, Rich takes home $32.5 million. Let’s say this is all in salary because he owns the company. Now, what does he do with that hoard of cash? He spends a couple million, he drops $10 million into a hedge fund, he drops another $10 million on his favorite college so his drunk, mostly lazy son named George can get in to school, and he buys a yacht or two.

Now, let’s say the tax rate is 80%. Yeah, that’s jacked up, I know. I’m not suggesting we do that, I’m just making a point here. The typical conservative response to this is “why would anyone ever work?” Well, do you happen to think that Bill Gates and Warren Buffet give two shits about their net worth? I mean, sure, it matters, but do you really think that either of them planned on being the richest guys in the world? No, they just wanted to get laid. Ok, they wanted to get laid by some gorgeous gal way out of their league several times a week while eating caviar, but you get my point. That higher taxes on the rich discourage innovation is a tenuous argument. You don’t need to be a billionaire to pull a gorgeous girl out of the crowd. A million or two will do just fine, thank you.

Back to my 80% world (which, incidentally, has happened in US history — and during a period of great economic growth, I might add. One might even call it a [baby] “boom”). In this world, Richie Rich gets his corporation to buy that yacht he wants, and the company holds sales meetings on it. The company also uses it to reward employees, which makes them work with more enthusiasm, creativity, and tenacity (all great, with no real loss to Rich’s happiness). He gets the corporation to donate a bunch of money to the school of Georgie’s choice. Of course, the board of directors cuts the endowment a bit, so George has to wait-list and go to junior college for a couple of years, but heck, when he runs for president in another 30 years, that will help him understand his constituents better (again, no real loss to Rich).

In short, Rich takes home less money. He still wants (and will) avoid paying taxes any way possible, so he funnels what he can out of the company, lives a little less high on the hog, pays more taxes in sheer dollars, but pays far, far less than the $40 million implied because he changes his behavior. He lowers his own salary. This leave more money in company coffers, which leads to all kinds of social goodness — the company has more money for salaries and dividends (which Rich gets some of as a shareholder). The CEO as egomaniac factor is reduced (c’mon, high salaries make men more proud. Higher salaries still make them arrogant!). Rich even pushes the company for more social activism, even if it is based mostly on the plight of poor Georgie stuck in junior college.

Oh, and then there’s the core point that I haven’t cycled back to, yet — more money in company coffers means they invest in more production. They build factories, hire more smart people, buy technology, and put money into basic research. All good stuff that yields direct economic growth. Directly, not via some sort of “packaged asset” issued by Lehman Brothers to the hedge fund Rich started back when he took home more than the GDP of most African countries.

Taxes change behavior. Rich guys have control over their own salary. The behavior — how much they pay themselves in the form of wages — will change if taxes rise.

Couple this idea with lower taxes for the average consumer (who, again, immediately consumes with those dollars), a pay down of the national debt (gotta fight that inflation at some point, somehow!), and government investment in infrastructure that private industry won’t readily subsidize (this means everything from national defense to bridges that go nowhere — and all of the completely reasonable things in between, like basic research, high speed rail, and renewable energy), and the Dow might never drop below 10,000 again. Imagine that.

Now, I’m not telling you who to vote for (although I’ll happily do so if you ask), but I am suggesting this: McCain’s rhetoric on what will help the economy is dead wrong. Trickle-down economics via maintaining fiscally imprudent tax breaks for the rich will not improve the economic situation. That is not a sound policy towards maintaining a healthy economy. It will lead to a weaker dollar, higher inflation, and more unemployment.

Oh, and just in case you want to point out that the 1980s under Reagan rocked, let me remind you that the top income tax rate through most of the 80s was 50%. If we let the Bush tax cut expire, the top rate rises from 35% to 39.6%.

Tags: Economics, Election, Inflation, Public Policy, Tax Cuts, Trickle Down Economics