The other day my oldest brother, Ron (I have four), emailed me the following request:
The following is an argument by our brother, Steve, for not increasing taxes on the rich. Can you help me out with understanding how much he is (or isn't ) confused about this?
Steve is my youngest brother. He has become the most outspoken Republican in our family. Ron was asking for my help because I have a Master’s Degree in Economics and have studied economics at the Ph.D level.
I suppose part of the reason why Steve embraces Republican economic mythology is because his sales business took off about ten years ago. From what he has told me, I figure he has been earning between $150,000 and $250,000 annually over the past several years. Ron was trying to tell Steve that he probably wasn’t going to be paying higher taxes when the Republican tax hike goes into effect in January 2011. Steve responded with the kinds of arguments many of us have become familiar with, including...
My concern isn’t for just myself. I think that it is completely asinine to suck huge amounts of money out of the private sector when we’re in the middle of a recession. Lower taxes free up venture capital which creates jobs. More jobs create more buyers (demand). More demand leads to higher production. Higher production leads to more jobs, and so on.
I decided to publish nearly all of my response to Steve’s arguments in this diary, since Ron seemed to find it quite helpful. As I told Ron, I could simply respond with a list of counter-claims, but I thought Steve would want to debate all the underlying assumptions, so I provided him with the following lengthy, detailed response. The first time I published this (in the afternoon, about five days ago) several readers said it would help them to respond to their wealthy Republican friends/acquaintances.
Steve says that he thinks it is a bad idea to "suck huge amounts of money out of the private sector" when we're in the middle of a recession. He says this because he assumes, incorrectly, that all of the money that the government will be collecting from rich Americans in January [when the Republican tax hike takes effect] is money that would otherwise be put to productive use by the earners of that income.
Rich Republicans want very much to believe that the money they put into 'savings' or 'investments' is doing all kinds of wonderful things for the economy. Unfortunately, this belief is based on little more than wishful thinking. To understand why they are so very wrong, people need to understand the difference between financial investments and economic investments.
Economic investments are the kind of investments that actually end up "growing the size of the pie" They occur when money is spent on capital goods or other economic resources [like humans] that are then used to produce more capital goods or more of the final goods that consumers find desirable. In other words, economic investments either increase output or expand the supply-side's productive capacity. This happens whenever firms purchase machinery/equipment to improve productive efficiency or when they spend money on the construction of new stores or factories or on the salaries of new employees. However, . (e.g., money spent by firms on advertising that either (a) misleads consumers or (b) does nothing to help them with their purchasing decisions.)
Financial investments are purchases or commitments of money that provide the "investor" with an income stream. Saving money is a financial investment because it provides interest income; purchases of assets can be financial investments if they eventually provide a capital gain. Economic investments made by firms are usually also financial investments because they generate income that exceeds their cost. The economic investments made by governments that improve infrastructure or human capital are financial investments because they do not provide the government with an income stream.
Some financial investments are also economic investments, but many of them are not. The purchase of a piece of land, for example, is a financial investment if it appreciates in value over time, but it is not an economic investment if it just sits there, undeveloped. Purchases of stocks in secondary markets (e.g., NYSE, NASDAQ) are clearly financial investments if the stocks appreciate in value, but they are not economic investments because they involve nothing more than exchanges of titles of ownership of already existing assets. They do not typically put any money into the hands of firm managers that could be used for economic investments. That normally happens only when stocks are first sold by companies to underwriters, prior to an initial public offering.
Supply-Side theorists have taken advantage of the impreciseness of the word to craft tax policy proposals that sound as though they are beneficial to the economy, but actually are not. The famous Capital Gains Tax Cut, for example, is frequently promoted as an incentive that would stimulate "investment." Unfortunately, the only "investment" that such a tax cut is likely to stimulate is increased financial investment in stocks and other real assets. One financial investor hands money over to another financial investor for a piece of paper. Very little of the money involved in these transactions ends up being spent on capital goods that would increase output or the productive capacity of the economy.
When do firms need special incentives to motivate them to invest in new capital goods? The answer is never. In modern market economies, provides firm managers with the most powerful motivation to continually invest that they will ever need: fear. They ultimately face both the fear of bankruptcy and the fear of lost opportunity. If your competition lowers its costs by investing in new equipment, or improves the appeal of its products by incorporating new innovations, then you’d better do the same or you will soon find yourself driven out of business. With only a few exceptions, additional government-provided financial incentives are nothing more than an .
Entrepreneurs do not need special additional incentives provided by the government to encourage them to assume the risks of creating a new business. True risk takers believe that their ideas will succeed in the market and have so much of their identities invested in them, they really don’t care if they receive any return at all on their invested time and money, sometimes for several years, as long as they have hope of eventual success. The problem for them is not that they lack motivation; it's that they can't find someone who is willing to provide them with a loan that banks, venture capitalists, and angel investors find too risky.
In confronting this situation, Congress has a couple of options. It can choose to do nothing and simply allow the marketplace to reward firms-that-make-wise-investments with the market share of firms-that-do-not. The other option would be for lawmakers to help entrepreneurs [and already-established firms that are judged by banks to be 'too-risky'] to obtain the funding they need in the hope that they might end up becoming competitive with better established firms. The rational way to do this would be to provide these marginal firms with or perhaps with government guarantees on private loans.
These kinds of initiatives would put the money directly into the hands of those who will be economically investing the money. Compare this to the insane idea of throwing hundreds of billions of extra disposable dollars at wealthy savers in the hope that some small fraction of their extra savings might somehow make their way into the hands of true economic investors when private banks have already rejected their borrowing plans as too risky. Very little, if any, of those billions of dollars would actually end up helping needy entrepreneurs and firm managers.
Cutting the taxes of rich people is a profoundly way to put more dollars into the hands of individuals/firms that want to invest. And what about the money that banks get from savers? According to Republican economic mythology, increasing the amount of money that is put into banks by savers is a great way to get those $$ into the hands of entrepreneurs and firm managers. The reality is that very little of the money that rich people put into banks ends up in the hands of the people who make economic investments.
Empirical evidence reveals that:
- Between 1988 & 1997, an average of nearly 85% of the money that corporations spent on investment came from or other internally-generated funds. (Brealey & Myers, Principles of Corporate Finance, 2000, pp. 383-384)
This empirical fact strongly refutes the Republican suggestion that firms are desperately dependent upon borrowed money (and therefore upon savings) when they want to make investments. What is the ultimate source of the internally-generated funds? It would be the of consumers and firms and government, . If the government increases its spending to a high enough level, firms will finally have the incentive they have been looking for---an increase in demand for their products---and will begin to invest the money they've been saving.
(Simply throwing more money at businesses [tax cuts and subsidies] when demand for their products has not picked up is a ridiculous waste of government dollars. Over the past couple of years, firms have been showing us---once again---that simply making it 'cheaper' for them to invest is not enough of an incentive for them to actually do it, not when demand for their products is stagnant.)
- Between 1998 & 2001 (years that included cyclically high levels of business investment) the combined borrowing of all non-financial corporations and all non-corporate businesses varied between 20-34% of total borrowing nationwide. During the same period, the household sector of the economy accounted for 20-30% of total borrowing.
These statistics tell us that of total savings is directed, ultimately, to the noble purpose of improving economic efficiency. Much of the money that is saved is ultimately spent on credit card loans and installment purchases. If firms find that interest rates are too high, is it necessarily because there is a shortage of savings, or is it perhaps because lending institutions are quite happy to starve the supply-side of the economy if they can get higher yields by lending to consumers?
- Savings are not the only source of loanable funds
The ultimate determinant of the supply of loanable funds in the U.S. economy is the Federal Open Market Committee of the Federal Reserve System. Whenever The Fed buys securities in the open market, it pays for them with money that it creates out of thin air with a keystroke. It does not draw the money from some reserve account that is limited in size. It is "new money" that did not exist prior to the keystroke that created it. With any of its purchases of securities, .
There is no limit to the amount of money The Fed can inject into the loanable funds market. If savers were to suddenly pull most of their money out of banks and put it under their mattresses instead (equivalent to a dramatic reduction in savings), The Fed would still be able to easily maintain the supply of loanable funds or even increase it by simply buying every sort of debt instrument offered in the credit markets. Even if The Fed bought up all of the nation’s debt---something that would never happen---and there was still a shortage of loanable funds, it could maintain/increase the money supply by buying buildings or land or anything else it fancies.
The facts I've mentioned above help to explain why it does not hurt the economy when the government taxes the excess savings of the richest Americans. When can we know that there are excess savings in the economy? It's fairly simple, actually. . How do we know that is true? Simple logic.
Fact 1: Virtually jobs in the economy are ultimately dependent upon SPENDING. Almost all of the money that ends up in paychecks or profit margins can be ultimately traced to the expenditure decisions of consumers, firms, or governments. When aggregate spending drops, jobs disappear. That's what a recession is: a drop in spending (GDP).
Fact 2: By definition, all money-income that is NOT SPENT, is money SAVED.
Fact 3: Combining Fact 1 and Fact 2, whenever there is any level of unemployment, it is because aggregate spending has dropped, and when aggregate spending has dropped, by definition, savings are at excessive levels.
Some of the money that has been saved needs to be spent to keep the excessive savings from hurting the entire economy. One way to do that is to borrow the savings; another way is to increase the tax obligations of the wealthy. It is simply not true that there is no limit to the amount of savings an economy can safely tolerate.
When there is too much saving in the economy, this does not mean that everyone is saving too much money. The problem is that some people are saving too much money; even while others are not saving enough. In effect, these Super Savers (generally, the Uber-Rich) are ‘hogging all of the available savings’ that the economy can safely tolerate (without creating or worsening an unemployment problem).
Two things happen if we tax the incomes of the Uber-Rich at steeply progressive marginal rates: (1) the government has all the money it needs to finance increased spending on public ECONOMIC INVESTMENTS, and (2) all the rich people who are paying higher tax rates do not end up losing any of the purchasing power of their incomes.
(Since they are all paying the same extra percentage in taxes, none of them loses his/her 'ranking' within the hierarchy of all disposable incomes. Since they still have more disposable dollars than everyone else, they still get to consume the scarcest goods/services/experiences that the economy is able to produce. There aren't any fewer luxuries or miles of beach front property when rich people start paying higher taxes; the prices of all luxuries simply drop to a level that the now-poorer rich folks can afford with their reduced disposable incomes. In real terms, the rich give up nothing** when they pay significantly-higher marginal tax rates.)
**Nothing, in terms of lost purchasing power, in terms of material possessions and lifestyle.
The problem with the current recession is that a major source of aggregate spending has disappeared, perhaps forever: the reckless lending practices that banks became accustomed to when they owned the Bush administration. When the Republicans slashed the taxes of the wealthy under Bush, most of those extra disposable dollars ended up in the financial markets and the banks were awash with cash to lend.
With lax regulation and extra dollars to lend, banks happily took on riskier loans (including mortgages) because higher risks earned higher profit margins. For whatever reason, banks have now become very stingy in their lending practices, and that is perhaps a good thing. The only problem is that the $$ that those risky loans contributed to aggregate demand were substantial and they have to be replaced.
The best solution: increase the tax rates of the richest Americans and spend the money on ECONOMIC INVESTMENTS, e.g., infrastructure, human capital (education, health). Economic growth gets a big stimulus, unemployment drops, our standard of living improves, the national debt is paid down, and the rich actually give up nothing in real terms from paying the higher taxes. It's a solution that not only makes the non-rich better off, in real terms, but , in real terms.
Yes Ron, I still entertain the hope that I will someday have a chance to explain it all to Steve and he'll [somehow] see the truth of what I am saying. I'm sorry that the political party he came to identify with is so profoundly wrong in its economic prescriptions, but if it is any consolation to him, most Democratic politicians have been equally misguided in their understanding of the economy.