Tax Cuts for the Rich Hurt the Middle Class

One of the rationalizations often given for reducing taxes on upper incomes is to promote investment. That investment would then “stimulate economic growth and create jobs.” This, however, is arguing in a vacuum. Two points immediately come to mind:

1. Lack of capital for investment (until the last few weeks) has not been a problem for quite awhile. Many companies (such as MS, GE, Google, and until a couple of years ago even GM!) have been sitting on billions of dollars in cash (equivalents). Venture Capitalists were also sitting on hundreds of millions of dollars that they needed to invest. In 2005-2007 many companies began returning money to shareholders through large dividends and stock buybacks (I’m sure that the effect this had on the executive’s stock options was merely coincidental). The problem all these firms faced was that there was little in the way of promising investments. There were, and are, many promising ideas waiting for funding, but investors did not believe there to be sufficient demand for the potential product or service. This brings we to my second point.
   
2. Cutting tax rates on high incomes places moderate and low income groups at a disadvantage that reduces overall consumption. The rich, by definition, have more than enough to meet all their needs, and also more than enough to meet most (or all, depending on how voracious their appetites) of their wants. Cutting taxes on the rich has little effect on their consumption, so does little to affect aggregate demand or boost the overall economy. For the rich, tax cuts end up as investments (possibly after a trip to Europe or some other treat); this is a point on which the Right is actually... correct. But this is where the problem creeps in. People make investment decisions based on where they expect the largest (and surest) return. To a large extent, this turns out to be real estate. Both the Reagan and Bush terms were times with large run-ups in real estate investing*. The rich bought larger houses, and second houses. The increased demand for housing drove up both housing and construction costs. This squeezed the moderate and low income demographics by raising their housing costs, and as a result, low and moderate income groups had less disposable income, which the nation observed as a weakening in aggregate demand. A cascading effect was to make investments in goods and service producing industries less attractive and real estate more attractive, creating a vicious feedback loop.
   

*Rising real estate values during the Bush years were further fueled by Greenspan’s free money policies at the Fed.

The point is that investments are productive only if there is a market for the product in which the investment is made. The problem with supply-side tax cuts is not that the investment incentive is wrong, it is that the tax cuts (on the top marginal rates) weaken demand and destroy the rationale for investing.

Tax Policy and Personal Income

My friend Deanna’s supply-side economics tribute had it’s share of whoppers. But she did set an interesting metric: “The real test of an economic policy is whether or not it can produce a rising tide that lifts all boats.” This is a a great way to judge recent history and shed some light on what a McCain or Obama tax policy might mean for our futures.

Let’s look at annual changes in average personal income (constant dollars) by quintile -- plus the top 1, 5, and 10 percent of incomes -- for the Reagan, Clinton, and G.W. Bush terms.

Average annual percent change in average income

Percentile	Reagan (1981-1988)	Clinton (1993-2000)	GW Bush (2001-2005*)
1st Quintile (0-20)	-0.4%	1.2%	-0.8%
2nd Quintile (20-40)	0.04%	1.9%	-0.4%
3rd Quintile (40-60)	0.8%	1.6%	0.3%
4th Quintile (60-80)	1.2%	2.2%	0.6%
5th Quintile (80-100)	4.3%	5.6%	3.7%
Top 10 percent	5.5%	7.0%	4.7%
Top 5 percent	7.0%	8.8%	6.1%
Top 1 percent	11.3%	13.1%	8.7%

*The latest year with available data.

Personal earnings grew faster during the Clinton presidency than during either the Reagan or George W. years. But more importantly, that increased prosperity was shared by all income groups. The Clinton tax policy, which raised the top marginal rates, created both higher growth and a more even income distribution.

Source Congressional Budget Office (http://www.cbo.gov/ftpdocs/88xx/doc8885/Appendix_tables_toc.xls)

Tax Rates and Tax Revenue

Supply-side economics is a dead, rotting corpse of a theory; yet despite the odoriferous off-gassing, the right refuses to give it a proper burial. Even Greg Mankiw, former Chairman of Bush’s Council of Economic Advisors, described it as the work of "charlatans and cranks" (in his textbook Principles of Economics).

My friend Deanna recently raised this stinking corpse in a post arguing against Barak Obama’s tax proposals. The Right’s justification for lower tax rates on high incomes, is basically the supply-side rationalization that lower marginal tax rates spur investment which then creates growth that pays for the tax cuts. Deanna adds an additional argument that raising tax rates on the wealthy will also reduce investment. The implication being that rich people will only invest if bribed. I disagree.

Deanna mixes up tax effect changes to overall revenue with income distributions and then spiced things up with revisionist history. In our recent history, tax cuts have reduced both the amount of tax revenue collected and the subsequent growth in tax revenue that followed. Here are a few statistics.

• Reagan’s “Economic Recovery Tax Act of 1981”
• Reduced Federal revenues by more than $575B (constant 1992 $) during the next four years.
• Resulted in Federal revenue growth (constant dollars) of 2.1% per year for the remainder of the Reagan term (1.7% for the combined Reagan-Bush terms). For comparison, the growth rate during Carter’s term averaged 5.9% per year.
• G.W. Bush’s “Economic Growth and Tax Relief Reconciliation Act of 2001”
• Reduced Federal revenues by nearly $170B (constant 1992 $ - around $350 in current dollars) during the next four years.
• G.W. Bush’s “Jobs and Growth Tax Relief Reconciliation Act of 2003”
• Reduced Federal revenues by more than $390B (constant 1992 $ - around $490 in current dollars) during the next four years.
• Federal revenues grew at a rate of 0.9% per year (so far) for the Bush years. Even if we ignore the troubled year 2001 and instead start with 2002, the growth rate still averaged only 1.8% per year

Compare that with the Clinton years, which started with a tax rate hike: 

• Revenues increased almost $170B (constant 1992 $) higher during the next four years.
• Federal revenue growth averaged 5.9% per year during the Clinton Presidency.
  

The Right's faith in supply-side tax cuts is wrong and misplaced. Tax cuts do not pay for themselves; nor do they generate faster growth in Federal revenue streams.

Source: The Tax Policy Center (http://www.taxpolicycenter.org/taxfacts/index.cfm)