Taxes and a Healthy Economy

The relation of tax rates to the health of our economy is and has long been contentious. I was interested to see a recent post by Norm Becker which contained the summary remarks of the Congressional Research Service report on tax policy. A key finding was that, “the real GDP growth rate averaged 4.2% and real per capita GDP increased annually by 2.4% in the 1950s. In the 2000s, the average real GDP growth rate was 1.7% and real per capita GDP increased annually by less than 1%.” They compare these rates of GDP growth to the income tax rates from those two periods to make the point that, “analysis of such data suggests the reduction in the top tax rates have had little association with saving, investment, or productivity growth.” This is important because the income tax rates from 1945 through 1970 were significantly higher than they have been in the last 40 years, and yet real GDP growth, and particularly GDP growth per capita, have slowed with the decreasing tax rates on the top income earners in this country. Why is this and why all of the heated debate about income tax rates in recent years?

I have several proposed reasons which, oddly enough, come from a study of neo-classical macroeconomics, or the very school of thought that those in the U.S. who argue for reduced tax rates for the wealthy are supposed to be champions of. First, let me sketch out the basic model: the production of goods and services by firms (output) creates payments to households (income). This income is put towards either consumption or Savings. Savings create the capital stock which firms can use as investment in their production operations (intended investment). Total consumption by households and intended investment by firms equals spending or aggregate demand. If there is full employment and if all savings are efficiently used as investment by firms, then the aggregate demand should equal output, where we started.

One very important thing to understand about all economic models and schools of thought is that they are theoretical. That is to say, not necessarily representative of what really ends up happening in an economy. For instance, taxes and government spending are not represented in this model. So, proponents of lowering taxes in general argue that taxes just reduce the income of households which then decreases the overall level of spending which can result from consumption and investment. This would be unhealthy for the economy because then aggregate demand would not be sufficient to meet the total output of producers, which would then ripple through the whole cycle causing unemployment, recession, and reduced or negative growth. The other argument used for lowering taxes specifically for the top income earners in society is that the savings of those top earners becomes the investment stock of firms and is also directly invested to create jobs and increase spending, thus increasing the health of the economy.

To respond firstly to the issue of government taxes in general, we must realize that if taxes and government spending were properly represented in this theory, all monies diverted to the government from incomes, also end up both as incomes for government employees and as consumption and investment in the economy through government services and programs. Thus, taxes still work through the cycle to increase aggregate demand. In fact, all taxes get spent in the economy unlike some of household income which is diverted to savings (called a leakage in the model).

More importantly, when we look at the incomes of top earners in the U.S. we find several reasons why the argument for diverting less and less of their income to taxes as a policy for a healthy economy, holds no water. Leakages as savings from the incomes of the wealthy can create the investment stock for business expansion, operation or creation. However, this does not happen when a large share of their income is stored in off-shore bank accounts for the purposes of avoiding taxes. The money in those accounts is not accessable as the capital stock for investment in job creation or expansion in our economy and it is not available to be spent by the government if it had been taxed. Also, when the untaxed incomes of top earners is used extractively through investment in venture capital endeavors which require rapid growth of industries through measures of austerity and reckless abandon (low paid employees, turning quick profits through risky activities, tax avoidance) the long-term health of the economy is decreased. As we saw in the lead up to the recent crash and recession, much of the untaxed incomes of the wealthy were invested in derivatives and other clever financial instruments which do not play any part in aggregate demand or the actual production of goods and services. Often now the excess wealth of top income earners is invested in private equity firms spurring mergers and acquisitions which succeed through rapid and extensive off-shoring of more expensive U.S. jobs and outsourcing company functions to the lowest bidder globally.

John Maynard Keynes had a slightly different, but still limited take on the classical macroeconomic model. In his line of thought, households do not just automatically direct all of their incomes to savings and the rest to consumption. They automatically consume at a level called “autonomous consumption” which would account for basic necessities regardless of their income. Then they also have a “marginal propensity to consume” which changes with their income level and confidence in the health of the economy. In line with this theory I would argue that we could more effectively stimulate aggregate demand by raising the incomes of the majority of folks who cannot even meet their required autonomous consumption levels (ie. a living wage) let alone a very significant marginal propensity to consume. Plus the majority of households in our economy which have low to moderate incomes, spend all of their income, contributing directly to aggregate demand thus increasing aggregate demand. So, it would be much more effective to tax a larger share of the incomes from top income earning households in the U.S. in order to stimulate aggregate demand. The decrease in their excess income which would would have been put towards the detrimental activities described above, would instead be spent in the economy by the government.

Even if my argument and logic make sense, you may then wonder why this argument to lower taxes overall and specifically those of the top income earners seems so loud. In an Economist article called “The Rich and the Rest,” they state that, “one analysis suggests that 80% of the total [campaign spending] comes from fewer than 200 donors.” They also point out that 90% of the income gains since the recession have gone to households in the top 1% of income earners. This paints a very clear picture of where power in our society lies. If there are 200 people at the top that control 80% of the financial sway in elections, and are part of the small group which not only caused the recession, but now are the only ones recovering from it, then it would be in their direct but narrow self-interest to reduce taxes on the wealthy.