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(Illustration by John Berkerly for The Economist, July 16, 2009)
To understand how the rich and powerful managed to replace the “invisible hand” of the open market with the invisible fist of their autocratic institutions, we have to look beyond their co-optation of the word “market.” We must also look at the word they appended to it: “free.” It was the act of combining these two words into the term “free market” that transformed the market from a political tool that exists within human society into something that exists over and around human society, something that acts upon human society like a sort of mechanical god. – Barry C. Lynn
Apologies for the title, but I chose it to remind me of the emotional, and often fearful, component of intellectual thought.
Barry C. Lynn’s fabulous book (Cornered: The New Monopoly Capitalism and the Economics of Destruction, 2009, quoted above at p. 140) provides a detailed account of how the U.S. economy and society has fallen under the control of mega-corporations and Wall Street. The concentration of economic power and wealth that Lynn documents lies behind the demise of small businesses, the destruction of the middle class, and the growth of economic inequality and poverty that threaten America today, as discussed in the last post “Why Reducing Inequality Is Government’s Most Crucial Job” (here). What has made these alarming developments even more unnerving is the associated mystical, quasi-religious quality that has overcome the “science” of economics, something that makes it almost unrecognizable as the discipline I began studying so fervently forty years ago.
The entire open-market premise of modern economic thought — competition, for goodness sake! — seems to have vanished right before our eyes. In his first chapter (“The Hidden Monopolies Everywhere”) Lynn relates:
Until we elected Ronald Reagan president, both Democrats and Republicans made sure that no chain store ever came to dominate more than a small fraction of sales in the United States as a whole, or even in any one region of the country. Between 1917 and 1979, for instance, administrations from both parties repeatedly charged the Great Atlantic and Pacific Tea Company, the chain store behemoth of the mid-twentieth century that is better known as A&P, with violations of antitrust law, even threatening to break the firm into pieces.
Then in 1981 we stopped enforcing that law. Thus, today Wal-Mart is at least five times bigger, relative to the overall size of the U.S. economy, than A&P was at the very height of its power (citation). Indeed, Wal-Mart exercises a de facto monopoly in many smaller cities, and it sells as much as half of all the groceries in many big metropolitan markets.
The specter of major manufacturing companies like General Electric, and “equity” firms like Bain Capital, buying up failing companies and dismantling or trading them or their component divisions, or bankrupting them and stranding their work forces for financial profit, was unimaginable to most of us back in the good old A&P days.
Although these developments arose in the name of a “free market,” as Lynn points out that concept was not developed by classical economists such as Adam Smith or Alfred Marshall, or by the Austrian economists Friedrich Hayek and Joseph Schumpeter. The term and its current meaning were developed and popularized by Milton Friedman, the prime mover behind the Chicago school and “Reaganomics,” and according to Lynn, he used it in Capitalism and Freedom (1962) more than two dozen times:
[A]nd he generally does not use it in the technical ways that Smith and Marshall used it. Rather, he uses it to paint a picture of a mechanism that serves humanity as a dispassionate determinator of economic outcomes and a beneficent bringer of bounty, hence something very unwise to interfere with (pp. 141-142).
Thus, the Reagan Revolution has not only drastically changed the way the economy works, it has also cleverly altered the way we think about economics. For most of America’s history, Lynn argues, we followed the “scientific method” of Sir Frances Bacon, who in 1623 wrote that “all depends on keeping the eye steadily fixed on the facts of nature, and so receiving their images as they are” (p. 251); however, once financiers seized control of our vital financial and economic institutions, Lynn argues, “they erected an institutional regime designed to hide their use of power against us.” Thus, today:
Instead of teaching people how to generate facts and process information, and think for themselves and with one another, our “science” of economics erects over us an icon of a mechanical determining god, and claims a priestly monopoly over interpreting the signs of this god. Instead of leading us to analyse the transcendent questions of political economics today – the monopolization, hence socialization, hence ruination of the complex industrial and financial systems in which all the peoples of the world depend – contemporary “scientific” economics broadcasts theories derived from theories derived from an intentional political lie (pp. 251-252).
That’s more than enough to rattle my amygdala. I think we all should wonder what is going on in the academic world today, especially when we encounter articles like the one in The Economist of July 16, 2009 entitled “What went wrong with economics: and how the discipline should change to avoid the mistakes of the past” (here), and its companion article on macroeconomics (“The other worldly philosophers, here) which speaks of “a clear case for reinvention, especially in macroeconomics,” and cites Paul Krugman’s suggestion that we are living through a “Dark Age of macroeconomics,” in which “the wisdom of the ancients” has been lost.
The Economist seems focused mainly on the potential lessons to be learned from the Crash of 2008 and its aftermath, overlooking the thirty years of growing inequality and stunted economic growth. The transcendent questions in American economics today certainly must be those relating to the rapidly growing concentration of wealth and incomes within the top 1% and the approach of Great Depression II. Scientific economics has available today substantial new compilations of relevant data, much of it of a kind and detail never before available, offering a wealth of opportunities for analysis; for example, Thomas Piketty and Emmanuel Saez have compiled detailed databases of a century’s worth of income and tax data for a number of countries, taken directly from tax returns. Beyond their initial reports and a study of the income elasticity of the top tax rate, however, little seems to be happening in the economics community.
It is as if economic science needs new perspectives to react adequately to the data, or is cowed by political pressure not to react to it. There is some evidence of the latter: A recent analysis of the effects of the Bush tax cuts issued by the Congressional Budget Office (Thomas L. Hungerford, September 12, 2012, here) was withdrawn by the CBO for further reflection, following a storm of protest from members of Congress who did not like the results.
Of course, it’s not just economics that is subject to denial and manipulation in today’s society. Other areas of scientific investigation, such as environmental sciences (air and water quality), climate science (global warming), geology (extraction impacts), and biological issues (evolution and reproduction), seem increasingly driven by the dictates of their own “mechanical determining gods” to conclusions that cannot be sustained by real world evidence. What is wrong with the science of economics may, to a great extent, be what is wrong in general with science today. Both data and theory can be corrupted or simply ignored because of ideological bias. When reality becomes inconvenient, people far too often reject it in favor of fantasy.
This post takes a look at a complicated, but crucial, issue – taxation. We will consider four basic points of view on the economic effects of taxation, ranging from the patently false to the eminently reasonable. For those not committed to accepting the truth, it appears, one’s stated beliefs depend not on the actual verifiable effects of taxation, but on the motives or goals of those espousing those beliefs.
FOUR PERSPECTIVES ON TAXATION
1. Tax reductions pay for themselves:
This one completely defies logic: Assume an income of 100 and an effective tax rate from that income of twenty, i.e., the taxing entity gets twenty. If the effective rate is cut in half, and revenue reduced to ten, it would take a doubling of income to 200 to produce the original revenue level of twenty, that is, for the tax reduction to “pay for itself.”
The idea is that reducing the effective tax rate produces more pre-tax income. But for one individual taxpayer, obviously, the saving of ten likely won’t double his or her income, or affect it much at all. Something else has to happen for that to occur. For an entire economy, that “something else” simply cannot occur: aggregate income (GDP) cannot and will not increase to such an extent because of a tax cut (in this example, ten times as much) even if we establish that tax cuts stimulate growth.
Consider also that tax cuts all the way to zero mean there would be no revenues at all coming in. So, assuming they ever do, at what point, as taxes are being reduced, might the reductions stop paying for themselves?
Let’s be clear: it’s one thing to argue that tax cuts stimulate growth, and quite another to argue that they pay for themselves. We might find it laughable that anyone would make such a claim, but it’s not funny. As Chris Mooney (The Republican Brain: The Science of Why They Deny Science – and Reality, 2012, Ch. 10, “The Republican War on Economics,” pp. 190-191) explains:
We’re talking about assertions that are rejected by a concensus of economic experts, or that are just outright false, but that we nevertheless find conservatives wedded to and unwilling to let go of because they backstop core beliefs. These are everywhere nowadays, and they’re hugely consequential falsehoods to boot. They lie at the very center of public debate over fiscal policy and the state of our economy.
It isn’t just misinformation about taxes, deficits, and how our economy came to ail so badly – though there’s plenty of that. But we’re also talking about putting the entire U.S. economy and way of life in jeopardy on the basis of questionable economics, the way the Tea Party debt ceiling deniers did. * * *
To show how Republicans have embraced faith-based economics, let’s start with one whopping false claim that we’ve already encountered in these pages. * * * I’m referring to the claim, straight from George W. Bush’s mouth and the mouths of many members of his administration, and many other conservatives, that tax cuts increase government revenue – or as [former supply-sider and Reagan advisor Bruce] Bartlett puts it, “pay for themselves.” Mitch McConnell, the Senate minority leader, put it like this in 2010: “That’s been the majority Republican view for some time. That there’s no evidence whatsoever that the Bush tax cuts actually diminished revenue. They increased revenue, because of the vibrancy of these tax cuts in the economy.”
McConnell himself asserts that most Republicans believe this – and if that’s true, then it’s very strong evidence for this book’s argument. Because the claim is completely without foundation.
The claim, in fact, has been dramatically disproved: In their April 27, 2001 report “The Economic Impact of President Bush’s Tax Relief Plan” (The Heritage Foundation, Center for Data Analysis Report #0101, April 27, 2001, here), D. Mark Wilson and William Beach predicted that the Bush plan would significantly increase economic growth and family income while “substantially reducing federal debt.” In fact, they predicted, the Bush plan would greatly increase government revenue, so much so that “the national debt would effectively be paid off by FY 2010.” In other words, they argued that the Bush tax cuts would more than pay for themselves, by an incredible amount.
What actually happened, however, is that the federal debt, which was at about $6 trillion in 2001, increased to about $13.6 trillion by the end of 2010 (Treasury Direct, here). The Heritage Foundation’s estimate of supply-side “stimulation” was off by almost $14 trillion, nearly one year’s GDP. In those years the economy suffered stagnation, not growth, climaxing with the Crash of 2008 and the Great Recession. So, whatever the actual isolated effects of the Bush tax cuts were, the Heritage Foundation’s prediction that they would more than “pay for themselves” was pure fantasy.
This fantasy line continued when Paul Ryan issued the House Budget Committee’s Fiscal Year 2012 Budget Resolution on March 20, 2012, entitled “The Path to Prosperity: A Blueprint for American Renewal” (here). An endorsement of the plan was released on the same day by James Pethokoukis of the American Enterprise Institute (here). The proposal was to keep the Bush tax cuts, and reduce taxes on top incomes even more (there would be only two tax brackets, 10% and 25%) and reduce the corporate rate from 35% to 25%, while funding these cuts by slashing federal programs. There was no explanation of how, exactly, this austerity program would stimulate growth, but the prediction was graphically displayed that, without these tax cuts, debt would rise to 300% of GDP by 2050, yet with them the entire federal debt, which is now over $16 trillion, will be paid off by 2050:
This time, the degree to which the proposed tax cuts would allegedly more than pay for themselves became astronomical: Without those cuts, the graph predicts, the debt would rise to about 300% of GDP by 2050. So these tax cuts would produce additional government revenues on the order of $45-50 trillion! It’s difficult to believe that these extraordinarily far-fetched numbers were the product of any analysis at all.
Paul Krugman dryly wrote In The Conscience of a Liberal (2007): “Supply-side doctrine, which claimed without evidence that tax cuts would pay for themselves, never got any traction in the world of professional economic research, even among conservatives.” Indeed, no sane economist would predict that growth on the scale predicted by either the Heritage Foundation or the American Enterprise Institute would occur while government taxing and spending is being curtailed. Alas, this singularly uneconomic perspective dominates today’s discussions, with Paul Ryan (who has gained a reputation for intelligence and economic acuity) getting enormous nation-wide media coverage as the wealthy fight hard to avoid tax increases and strive for more reductions.
Is this outright rejection of science mere duplicity, or actual denial? I personally find the expression “Republican brain” distasteful, because it’s a form of name calling. Nonetheless, taxation is a political issue, and the political group that has been hired on to support the interests of the very wealthy and lower their taxes calls itself “the Republican Party.” Rich people have hired, or at least bamboozled, many Democrats too. The point is that when a rationale for reducing the tax burden of the most wealthy so preposterous as “it will pay for itself” doesn’t ever happen, the people who keep insisting otherwise are either in denial, or they are unscrupulous liars.
2. Tax cuts tend to stimulate investment and growth:
The Bush tax cuts reduced not only the top tax rate, but also taxes on middle class incomes as well. The inclusion of the middle class not only leveraged support for the reduced taxation of top incomes, it obscured analysis of its effects. The idea of reducing everybody’s taxes is attractive to the Tea Party and libertarians, who want to see government shrivel up and go away, and facilitates Grover Norquist’s campaign for pledges never to increase anyone’s taxes.
Might it not be possible for some combination of tax reductions to create some stimulation and growth? That’s a more reasonable proposition than the idea that “tax reductions pay for themselves.” Still, even a modest “trickle-down” projection relies on the “supply-side” notion, traceable back to the classical theory of economics, that the impetus for investment and growth comes from the availability of money not spent for consumption, i.e., “saved.”
Correcting this idea was the main thrust of John Maynard Keynes’s General Theory. Put simply, his idea was that money isn’t invested and jobs created just because the money is available. Investors need to expect to profit from their investments, and for that they need to expect that whatever they intend to produce will be sufficiently demanded to generate an adequate rate of return. Such expectations decline with falling aggregate demand, so increased saving doesn’t produce growth, it increases unemployment. Aggregate demand is determined (actually defined) by the “propensity to consume” out of current income.
The relevance of taxation to employment and growth is that it affects the aggregate propensity to consume. This may seem like a subtle nuance, but it’s an all-important refinement that Norquist and fellow supply-siders gloss over. Middle class and poor people have a very high propensity to consume, and people at low income levels in times like these actually have negative savings. These people will spend all or virtually all of any increases in after-tax income. Conversely, the wealthiest people already have far more money than they need or even, in many cases, know what to do with. These people save much or most of the savings from tax reductions, and those near the top of the income ladder have the lowest “marginal propensity to consume” out of such savings.
This point has been emphasized by Joseph Stiglitz (The Price of Inequality) and Robert Reich (Aftershock) but by far too few others: Cutting taxes for the rich necessarily reduces aggregate demand and growth; for stimulation of investment, employment and growth government must place a considerably lower tax burden on the people with much lower incomes, the middle class and people at or near the poverty level.
This is the redistribution function of taxation, and it is important. The political right rants strenuously about downward redistribution of incomes and wealth by government, but what is routinely ignored by everyone is the tendency of “free market” capitalism to transfer excessive incomes and wealth up to the top; hence, progressive taxation provides the stabilizing influence.
This graph, provided by Piketty, Saez and Stantcheva (DP No. 8675, CEPR, November, 2011, (here), shows a close correlation of changes in the top marginal income tax rate with increases in the growth rate of top 1% incomes and decreases in the growth rate of bottom 99% incomes:
The overarching point here is that it matters whose taxes are reduced if the objective is finding “the path to prosperity.” As discussed in the previous post, overall growth was drastically reduced after 1980 when top taxes were reduced. Tax cuts on top incomes, therefore have benefited only the top 1% and facilitated their ability to lower the prosperity of everyone else. Not only do tax cuts for the top 1% fail to pay for themselves, they don’t even increase growth. Trickle-down is a myth.
3. Higher taxes on top incomes enhance growth and general prosperity:
As the previous graph also clearly demonstrates, high taxes on top incomes in effect from WWII until the Reagan administration enabled the growth of American prosperity. The only tax reductions that can help improve the economy are those for low income groups, as discussed above.
In his principal prescriptions for economic recovery, however, Keynes ignored the potential tool of taxation, as does Paul Krugman, currently America’s best known Keynesian. Keynes argued that government should borrow and spend more to stimulate growth and recovery from downturns. What we are starting to understand is that this approach to controlling the economy takes as a given a certain distribution of wealth and incomes and tax structure. Within any given distributional context, it would arguably be possible to modify income growth using monetary policy or fiscal policy (the latter consisting of government borrowing and spending).
The recently available data on income concentration, however, provide a stunning picture of how limited these Keynesian devices really are. The macroeconomic effects of growing income inequality and associated taxation policy are vastly more controlling of economic well-being than we had thought, and the use of Keynesian fiscal and monetary policies (mostly to smooth out the “business cycle”) now seems akin to rearranging the deck chairs on the Titanic. We did not, and could not, have suspected this until the income distribution data became available. Piketty, Saez and Santcheva presented this additional graph in their 2011 discussion paper:
Breaking down the top 1% income share into two components – ordinary income and capital gains, actually appears to improve the correlation between top 1% incomes and the marginal tax rate. Correlations this tight imply causation, and dispel the inference of coincidence. Coincidence is far too random.
The wealthiest people, actually highly concentrated in the top 0.01% of incomes, have been able to convert income gained from reduced after-tax incomes into wealth transfers and retire much of that wealth from active circulation, reducing the income share and wealth of everyone else and driving the economy of the bottom 99% into depression. As the last graph shows, that is exactly what happened in the early 1920s when lower taxes at the top, especially capital gains taxes, quickly drove the top 1% income share from 15% to 24%. And the GW Bush administration bears a striking resemblance to the pre-Crash 1920s.
In my last post (“Why Reducing Inequality Is Government’s Most Crucial Job,” here), I cited Mary Cleveland’s important idea of the “inequality trap” (“Is Paul Krugman’s Liquidity Trap Really an Inequality Trap?”, January 16, 2013, here). I’m looking forward to a greater development of her argument, but what I take from it so far is this: The “liquidity trap” concept, which describes a situation in which the economy is not doing well enough to stimulate growth and employment even at a zero interest rate, and implies that stimulated demand can lift the economy out of the slump, ignores the impacts of inequality. Until inequality growth is reversed, this suggests, the economy is doomed to lower levels of consumer income and demand.
The following graph provided by the Bureau of Labor Statistics shows that the six most recent recessions, with respect to unemployment, have been getting progressively deeper and longer:
As we know, the last recession, beginning in December 2007, is now a depression. So, with growing inequality, the economy has found it progressively harder to recover, suggesting that there is indeed an “inequality trap” at work.
Let’s be clear about what this means: If we think of corporations and their owners as “job creators,” it is increasing, not reducing, their taxes that leads them to create more jobs!
4. Tax we must, but tax reform is needed to tax economic rent, not work.
So, as we have moved through a series of viewpoints about the effects of taxation on growth, we have moved from today’s prevalent notion (which has no supporting evidence and is more or less absurd) that tax cuts on top incomes will pay for themselves, to a viewpoint (supported by a century’s worth of U.S. income and taxation data but as yet virtually unknown) that tax cuts on top incomes quickly lead to massive inequality, stagnation, and government debt.
The real path to prosperity is becoming clear: Taxation of top incomes, corporations, and wealth can both stimulate the demand needed for growth and counter the redistribution upward of the wealth and incomes that created this inequality mess, so it is the best policy choice. Further, it appears at this point to be the only workable policy choice: (1) As explained in the previous post, any stimulation through fiscal policy is up against a far more rapid decline due to inequality growth than could reasonably be countered with more borrowing, so taxation offers the only way out; (2) Recent discussions about income inequality growth focusing on proximate causes, like the exercise of monopoly power, the decline of unionism, globalization of the labor market, globalization of financial markets, technology growth, and so on, as Stiglitz has argued are “beside the point,” because inequality growth has gone way too far. Stiglitz argues for reversing these trends, to be sure, but there is precious little time to try to moonwalk back to the 1950s. As we stand near the edge of the inequality cliff, quicker action is needed; (3) Even with progress in any or all of these areas, increased taxation will be needed, for this is, fundamentally, a distributional problem.
That said, instead of merely increasing taxes under the current tax structure, there are major taxation reforms that will significantly improve future prospects for the American economy; and if ever there was a time for such reforms, it is now. In my view, some of the best ideas in contemporary economics are promoted by the “Georgists,” those who follow in the footsteps of Henry George, the 19th Century American economist (Progress and Poverty, 1879) who focused on the role of land as a factor of production. Modern Georgists recommend the taxing of economic rents rather than labor or productive capital. Their numbers include Mary Cleveland and Jospeh Stiglitz, whose views we have discussed, Mason Gaffney (After the Crash: Designing a Depression-Free Economy), and Clifford Cobb, among others.
Economic rent consists of payments made that do not result in increased real value, such as land rents and excess profits. In the field of regulation of private monopolies providing essential services like electric power or telecommunications services, those of us working in agencies around the country and in Washington set rates designed to permit such firms an opportunity to earn the return required by financial markets on investments of equivalent risk. A return equal to this “cost of capital” excludes economic rent, i.e., excess profit. Economic rent, however, is a major component of “free market” profits, especially those “earned” by firms with significant market control, and those excess earnings have been a major factor in the swift rise of income and wealth inequality over the last three or four decades.
In an article on the Robert Schalkenbach Foundation website (“How the Income Tax Became a Tax on Labor,” here) Clifford Cobb and Jonathan Rowe present a detailed history of the income tax, explaining how it has radically changed in the United States, losing its economic potential and becoming an instrument of repression:
In the first decade of the century, controversy over taxes gripped England. Winston Churchill articulated a novel guiding principle: “Formerly the only question of the tax gatherer was, ‘How much have you got?’” Churchill said. “Now we also ask, ‘How did you get it?’”
A tax system should reinforce the fundamental moral connection between contribution and reward, said Churchill. Did you earn your income through enterprise and toil, or at least by providing capital for these? Or did you reap where you did not sow-garnering profits from what nature, rather than you yourself, had created? “Was the income gained by supplying the capital which industry needs, or merely by denying, except at an extortionate price, the land which industry requires?” The issue wasn’t capital versus labor, as Marxists had it. Rather it was capital and labor versus something else-unearned gain that arose from the mere ownership of land and natural resources.
In 1909, with Churchill’s strong support, the British Parliament enacted a special tax on gains from land.
In the U.S. Congress the need to finance America’s entry into the First World War spurred a similar debate. Significant support for what might be called the Churchill view did much to shape the new income tax that eventually emerged. In concept, the tax would spare the earnings of the working person and productive entrepreneur, and fall on unearned gains that arose from land and resources or the exercise of monopoly power in all its subtle forms.
That was almost a century ago. Since then, the original vision has been turned upside down. The income tax has come to fall almost entirely upon the workers and entrepreneurs it was intended to spare. In 1918, some 85% of American households paid no income tax at all, and almost 80% of federal income tax revenue came from the top one-half of one-percent of households. Very little of the burden fell on work. By 1990, almost three-quarters of federal tax revenues came from work.
When taxes are collected on economic rent, investment and labor are not discouraged, and inequality is tempered. Capital gains are a form of unearned income that up until this year were taxed at 15%, the rate paid on ordinary earned income by people living at or below the poverty line. A large portion of corporate profits and top incomes is also economic rent. Thus, there is plenty of unearned income that can be taxed to stimulate growth and reduce inequality without penalizing productive investment or labor. So, a major restructuring of the income tax is called for, as well as increased, selective reliance on property and wealth taxes and corporate earnings.
All of this, of course, will be anathema to the wealthy plutocracy, so I recommend a piece of advice from Timothy Noah (The Great Divergence: America’s Growing Inequality Crisis and What We Can Do About It, 2012, p. 188): “If you really want to see the Great Divergence reversed, don’t vote Republican.” And educate your Democrats. We really do not want inequality growth to continue much longer: As Ronald Reagan (ironically) said, another Great Depression would be a “tragic mistake.”
When all of this is sorted out and modern economics has come to its senses, I believe that the best explanation for how a modern economy works, and how governments can avoid poverty and depression, will be found in a combination of some of the best Keynesian and Georgist ideas, and perhaps others as well. The “free market” myth, and classical-era myths like the myths of economic stability, market efficiency, and full-employment equilibrium, will have been discarded. The emotional rejection by Amygdalas Economicus as dreaded “socialism” of any collective response to public needs or agendas for the common good will have faded. That is, if we can get there.
In the interest of avoiding undue repetition, I’ll turn to other topics on this blog for a while. I’ll continue to work on my a PowerPoint presentation on “The Economics of Inequality” which I’ll soon be presenting in the Albany area, and which I hope will help us to continue learning together. And I’ll continue to read and write!
Thank you all.
JMH – 1/27/2013, ed. 1/28/2013
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