My academic background in economics consists of 2 semesters of Introduction to Economics which I took more than a few decades ago, so I readily admit, many of the nuances of the "Dismal Science" elude me.
Further, as I was a rabid and vocal socialist in my college years, I avoided any class that I perceived was associated with the "corrupt capitalist system" - like finance, marketing and any class with business in the title.
Despite those short comings, I believe there is little dispute that there are some serious "bugs" in the Free Market Economics theology.
Bug study on the flip...
One of the really nasty "bugs" is the Trickle Down delusion which posits that a low marginal tax on those incomes that are in excess of the highest tax bracket will put more money into the economy which, in turn, will stimulate the economy through increased investment in business infrastructure, new businesses, higher rates of employment and higher wages.
On the surface that seems to be a logical and sound concept, and one easily supported by examination of US economic history since 1913 (ratification of the 16th Amendment – and the advent of the income tax).
The cockroach in the cheese dip is that history shows that concept has little if any validity. The history may, in fact, suggest the exact opposite to be the truth.
When the marginal tax on the highest income bracket is high economic growth and wealth creation is high. While it seems counter intuitive, the actually facts of history suggests it to be the truth.
The converse of that is when the highest marginal tax is low the economy experiences stagnation, recession or depression. And, although there is little or no wealth creation, there are enormous profits to be made for a limited number of the citizenry at the top.
In 1922, a series of rate cuts began. During and after WWI the highest marginal tax rate was 73 percent; by 1925 it was reduced to 24 percent.
In 1924, Secretary of Treasury Andrew Mellon wrote, ]
It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the Government, and that more revenue may often be obtained by lower rates." ..
{snip}
...he pushed for the reduction of the top income tax bracket from 73% to an eventual 24%.
Four years later came the crash of 1929 and the economy did not recover until after the onset of WWII – 12+ years later.
So why do high taxes on the top bracket create a stronger economy?
When taxes are low the incentive is to take out profit as the tax penalty for doing so is significantly less. Business income is more readily put into dividends and individual profits as well as high salaries and bonuses for corporate executives. Further, short sighted and greedy executives looking only at the bottom line sell off some of the company’s properties and assets (the wealth) to maximize profit, enhance the quarterly report and attract investors.
While when taxes are high the incentive is to put income into tax protected areas such as R & D, retooling, worker benefits, new products, increased production and the like.
The only way to retain a company’s wealth is to reinvest in the company (the central point of capitalism, IIRC). Reinvestment allows long term planning and increases the company’s wealth, stability, potential and over all value.
So, as the tax rate goes up the wealth and financial stability of businesses also goes up, and history appears to back that up.
As a consequence, a company focused on long term planning also sees the advantage of having a skilled, stable and loyal workforce and a cooperative union, which can be assured if the workers are well paid with decent benefits and a solid pension plan.
During the period between 1940 and 1964 when the top rates exceeded 90% the US enjoyed a run of historical economic prosperity and the explosive growth of the middle class. The rich got richer and the poor got richer, it was a tide that raised all boats.
Profit and wealth are two different critters. Profit is the amount of money that can be extracted from a business, wealth, on the other hand, is the total assets of the business. The greater that wealth is the greater will be the ability of the business to create more products or services and more assets, thereby, increasing long term, steady and reliable profitability.
The current financial crisis is the result of huge profit taking while producing no real wealth.
Not only was no wealth created, no product was produced except reams of convoluted financial instruments that allowed the manipulation of the country’s financial system to the advantage of the few at the expense of the many.
So where do those profits, pulled out when the tax liability is low, go? They are not locked away in safety deposit boxes nor stored under the mattress. They go where the profit will be further enhanced – the market.
Rather than examining the long term prospects of a company, its debt load or the quality of the management, only one criteria is important – how fast can a profit be made.
Investing in a business’ infrastructure is a long term affair and ties up money that could be churned in the market for quick profits. The choice between long term investment and deferred modest profits and short term investments with the chance of high profits is a no brainer for even for the only slightly greedy.
As to where those opportunities for quick cash are, anywhere there is a hot sector – dot com’s, housing, oil futures and other commodities, derivatives (and other financial aberrations), etc. The money flocks to the hot sectors de jure – the value goes up – people see others making money - even more money drifts to that sector- wash, rinse, repeat - and we have a bubble.
The life expectancy of bubbles is tragically short and when reality intrudes the whole house of cards crashes (and mixes metaphors).
Another downside of a lower marginal tax and the profits realized from the reduced tax liability is that it changes the nature of how business is done, which further reduces the desirability of investing in business infrastructure.
This, also, seems counter intuitive but a business with state of the art equipment, excellent productivity, little or no debt load, and a cash surplus (under any normal situation this would be a business worth investing in) is in serious danger of a hostile take over by corporate raiders. Such takeovers are not designed to enhance the business; they are designed to make a maximum amount of profit as quickly as possible.
The procedure for profit maximization might follow this scenario:
Cut salaries and benefits - if it’s a non-union shop that’s a piece of cake; it will make the balance sheet look spectacular and even better when the retirement fund is raided.
Cut the workforce which will reduce productivity but it will make the bottom line for the stockholders and rating agencies look great, and it’s irrelevant to the short term plans of the corporate raiders.
Sell off all but bare essential assets for further profit.
Locate the business offshore (receiving tax breaks for so doing) - move the remaining assets to the offshore site. Then sell the whole package to local buyers - huge profit. This then places the wealth in another country.
Another inane position taken by the proponents of tax cuts for the aristocracy is that taxes remove money from the economy. Apparently they are under the impression that the government has a giant treasure room where they hoard the money for all eternity. The money goes directly back into the economy, just not where the aristocracy would like it to go.
Where that money goes is important. The infrastructure of this country is for the common good and it is, in fact, a subsidy to business, in that they could not function without it - it is, therefore, wealth.
From 1936 until 1982 - from FDR’s administration through the Carter administration the highest bracket ranged between 70 to 92%
In 1982, Ronald Reagan cut the highest tax bracket to 50 percent. The economy went into a recession, in fact the worst one since the Great Depression."
In 1987, Reagan compounded the problem by dropping the highest bracket to 38.5 percent in the false belief that it would stimulate the economy (you know trickle, trickle). The market exploded, and a bubble grew which in turn brought about the crash of October 1987 - Black Monday - the worst crash since 1929.
So where did the profits go that created the 1987 bubble ? The profits went into real estate and housing speculation fueled by lax regulation (and lax enforcement) of the Savings and Loan industry.
The results were the Savings & Loan companies went into the toilet and the housing market went on life support. John Q. Sucker Public picked up the tab to the tune of several hundred billion dollars to bail out the S&L’s. And, during those happy times, there were more bank failures than during the Depression of 1929.
George W. Bush came into office with, arguably the healthiest economy in American history.
He immediately cut taxes. The top marginal rate went down from 39 percent to 35 percent. He also cut capital gains taxes and inheritance taxes. A recession immediately ensued; but he "stayed the course"
Eventually, some segments of the economy began to grow, and Bush declared,
I think when people take a look back at this moment in our economic history, they'll recognize tax cuts work. They have made a difference.
Well.... employment didn't grow very much if at all and median income went down. The stock market was pretty flat. But the financial sector -- and only that sector, was enjoying a spirited growth, which should have made it obvious, that it was a bubble in the making.
The bubble grew – popped, and the bank failures ensued.
And then, in the finest tradition of "disaster capitalism", an immediate, no time to waste, solution to the situation had to be found. Enter Hank Paulson, armed with 700 billion of OUR money to save the financial industry from the "couldn’t be predicted", "to big to fail" disaster – the rest is the unfolding history in which we are now living.
The three worst economic events in American history (1929, 1987 and now) follow the exact same pattern: tax cuts on the highest income bracket, followed by a boom in the market, a bubble grows, and then the crash. OTOH, the four periods of greatest economic growth in American history, by pretty much any measure, occurred during the periods of high taxes on the highest income brackets.
The first was during the first two Roosevelt administrations (1933-40). When Roosevelt came into office in 1933, Hoover had already raised the tax rate in 1932 from the pre-depression rate of 24 percent to 63 percent. Roosevelt raised it again in 1936 to 79 percent.
The second was during World War II (1942-45), the top tax rate varied from 88 to 94 percent. And while the cost in lives and money was huge, the US had at the end the largest industrial capacity in the world.
The third came in the post-war years under Truman and Eisenhower the top rate bounced around from 81 to 92 percent
And, the fourth period was during the Clinton years when Clinton raised G.H.W. Bush’s top rate of 31 percent to 39 percent. Bush had already raised it from 28% to 31% (read my lips).
I found only one person that examines the relationship between high marginal tax rates and economic growth, Larry Beinhart (author of Wag the Dog). I don't know for sure if there is a valid correlation between the two factors - but it seems there is a case to be made that there is an apparent causal relation between the two based simply on the history.
Anyway, it makes as much sense to me as do all the other economic theories - which don't seem to pass the test of surviving in their real world application.