Cross-posted from Real Economics.
One of the centerpieces of Trump’s economic plan is to, once again, try the Republican experiment of cutting taxes. Now, I know it is hard to argue against cutting taxes, but Democrats have really dropped the ball by not pointing out the amazing historical fact that every single time the Republicans have cut taxes, a financial crash and economic depression followed within a few years. This time, Trump wants a trillion dollar increase in spending on infrastructure that will boost the economy. But increased infrastructure spending will probably not make this experiment work better, because it does not address the microeconomic factors which cumulatively cause Republican tax cuts to create macroeconomic disasters.
There have been three grand multi-year national experiments with Republican / conservative tax cutting over the past century. All three experiments resulted in the average American becoming poorer, the real (industrial) economy in tatters, and spectacular financial crashes.
Tax Cut Experiment Number 1
In 1921, President Warren G. Harding proposed ending the wartime excess profits tax which had been imposed during World War I. When Harding died during a speaking tour in California in August 1923, Calvin Coolidge became President, so it was Coolidge who actually signed into law the Revenue Act of 1924, which lowered personal income tax rates on the highest incomes from 73 percent to 46 percent.
Two years later, the Revenue Act of 1926 law further reduced inheritance and personal income taxes; eliminated many excise imposts (luxury or nuisance taxes); and ended public access to federal income tax returns. The tax rate on the highest incomes was reduced to 25 percent.
The result was a speculative frenzy in the stock markets, especially the application of structured leverage in what were called at the time "investment trusts." In September 1929, this edifice of false prosperity began to wobble, and finally crashed spectacularly in October 1929.
Coolidge did not seek re-nomination in 1928. Faced with a wildly gyrating stock market, a worsening collapse in farm incomes, and faltering industrial orders, the new Republican President, Herbert Hoover, responded with more tax cuts. Personal income tax on income under $4,000 was cut by two thirds; personal income tax on income over $4,000 was cut in half. The tax rate on corporations was cut by a full percentage point.
How did the economy respond to these tax cuts? It sunk further and faster into the First Great Depression.
Tax Cut Experiment Number 2
In 1981, Ronald Reagan reduced the top marginal income tax rate, which affects the very wealthy, from 70% to 50%. In 1986, Reagan convinced Congress to reduced the top tax rate yet again, to 28%. Contrary to the Reagan / Republican / conservative argument that the tax cuts would pay for themselves by boosting economic activity, the budget deficit and federal debt exploded. Federal government debt grew from 33.3% of GDP in 1980 to 51.9% at the end of 1988.
Reagan's tax cuts failed to revive American industry, which was also being hammered by the Reagan / Republican / conservative blind faith in free trade. A number of American industries actually disappeared. By the end of Reagan’s presidency, the American textile, apparel, and footwear making industries had been reduced to less than one tenth the size and sales they had just two decades earlier. During Reagan’s tenure, the U.S. lost its trade surplus in consumer electronics, and began to also lose its advantage in industrial electronics.
Meanwhile, the average American family began working more hours to maintain its standard of living. The phenomena of latch-key kids took hold as mothers sought jobs to help keep their family afloat. Wikipedia notes that the number of Americans below the poverty level increased from 29.272 million in 1980 to 31.745 million in 1988, increasingly slightly as a percentage of total population, from 12.95% in 1980 to 13.0% in 1988. The number of people in poverty under the age of 18 increased from 11.543 million in 1980 (18.3% of all child population) to 12.455 (19.5%) in 1988.
The most important industry of all, the machine tool industry—which is needed to make all other production equipment—slipped into a death spiral from which it has never really recovered. At the beginning of the 1980s, the ten largest machine tool makers in the world were all American. By 1997, only one of the top ten was, and it was ranked seventh by sales. In 2009, China became the world’s largest producer of machine tools.
In industry after industry, under Reagan, the U.S. lost its world lead: steel, auto, printing equipment, construction equipment, farm equipment, power generating equipment. Only the aerospace industry, the key component of the American empire’s military-industrial complex, managed to maintain its world lead.
Oh, and the banking and financial sector? In October 1987, the worst stock market crash since the First Great Depression shook Wall Street.
Tax Cut Experiment Number 3
Republicans and conservatives of course contend that the two Bush tax cuts of 2001 and 2003 created the economic boom of 2002-2006. But they prefer we not remember the financial crash of 2007-2008. As discussed below, the financial crash is actually the inevitable result of cutting taxes the way Republicans do.
But first I want to expose the “economic boom of 2002-2006” for what it was: a frenzy of borrowing based on the rise in home value that was largely speculative. The amount Americans borrowed against their homes more than doubled from $627 billion in 2001 to $1.428 trillion in 2005. From 2001 to 2005, the cumulative amount of home equity extraction totaled just under $5 trillion. This was more than double the total $2.3 trillion growth of GDP in this same 2001-2005 period.
Economist Paul Krugman wrote in December 2008: "The prosperity of a few years ago, such as it was — profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks."
Meanwhile, U.S. industries continued to weaken and falter. Even the semiconductor and computer industries—the crown jewels of the American industrial economy in the late 1980s—collapsed under Bush, fleeing offshore. As the late Andy Grove, one of the founders and former chairman of semiconductor pioneer Intel wrote in July 2010 (How to Make an American Job Before It's Too Late):
Today, manufacturing employment in the U.S. computer industry is about 166,000 -- lower than it was before the first personal computer, the MITS Altair 2800, was assembled in 1975. Meanwhile, a very effective computer-manufacturing industry has emerged in Asia, employing about 1.5 million workers -- factory employees, engineers and managers.
The largest of these companies is Hon Hai Precision Industry Co., also known as Foxconn. The company has grown at an astounding rate, first in Taiwan and later in China. Its revenue last year was $62 billion, larger than Apple Inc., Microsoft Corp., Dell Inc. or Intel. Foxconn employs more than 800,000 people, more than the combined worldwide head count of Apple, Dell, Microsoft, Hewlett-Packard Co., Intel and Sony Corp.
Most important to note, wages and earnings for all but the richest Americans continued to stagnate, and actually declined for the bottom quintile of wage earners.
And, in late 2006, the sub-prime mortgage crisis began to unravel the very fabric of the world financial system, leading to the crashes of April and September 2008.
The failure of our national debate on tax cuts
Most discouraging about this entire national debate on taxes, has been the complete failure of Democratic Party leaders to point to these clear facts, and ask the obvious question:
Why do Republican tax cuts lead, counter-intuitively, to industrial decline, stagnant wages, and finally financial collapse?
The fact is that high marginal tax rates strongly correlate with economic growth. In December 2010 Mike Kimel examined the effects of cutting the top marginal tax rate:
….real GDP also grew faster under Bill Clinton, who raised taxes, than it did under Ronald Reagan. In fact, from 1981 to the present, the period in which Reagan’s philosophies have reigned triumphant, the correlation between the top marginal tax rate and the annual growth in real GDP has been positive. That is to say, higher top marginal tax rates have been associated with faster, not slower real economic growth. Conversely, lower top marginal tax rates have coincided with less economic growth.
The positive relationship between the top [higher] marginal tax rate and the growth in real GDP is very nearly bullet-proof. For instance, it extends all the way back to 1929, the first year for which the government computed GDP data. Additionally, higher marginal tax rates are not only correlated with faster increases in real GDP from one year to the next, but also with increases in real GDP over the subsequent two, three, or four years. This is as true going back to 1929 as it is for the period since Reagan became president. In fact, since the Reagan Revolution took hold, similar relationships have existed between the top marginal rate and several other important variables, like real median income, real private investment, consumer sentiment, the value of the dollar relative to other major currencies, and the S&P 500. Lower tax rates in any given year are associated with slower growth rates for each of these variables, whether those growth rates are measured over periods of one, two, three or four years.
If you look under the hood of the industrial economy, you can see why there is this counter-intuitive relationship between tax rates and economic growth . With high taxes, the only way to retain the bulk of the wealth created by a business is by reinvesting it in the business -- in plants, equipment, staff, research and development, new products and all the rest. But if tax rates are low, then there is more incentive to pull the wealth out, by declaring it as profits that are taxed at what turns out to be too low a rate. In other words, low taxes create an incentive for profit taking, not for business expansion and capital investment.
This in turn creates an incentive for short-term horizons in business planning. If you’re going to be taking all the profits out of a company, and take home a few million a year, why bother to reinvest anything in the business? You’re going to be rich, and never have to work again, even if the business goes bust. Or gets packed on a boat and shipped to China. Or goes "virtual" and lets all the hard work, like, you know, actually making something, be done by the lowest bidder. Employees? Don’t need them.
But employees are also customers. If enough businesses "take profits", after some length of time, the former employees also become former customers. Meaning, they stop buying. As economists phrase it, the economy's aggregate demand generation is crippled. From examining the effects of the three Republican tax cut experiments this past century, it appears the length of time for this to happen is five to seven years.
If tax rates are high enough to discourage profit taking, the best way for investors and owners to keep the profits created by a business, is to invest those profits back into the business: buying new plant and equipment that will be used for many years, and hiring and training new employees. This in turn pushes businesses toward longer-term planning, beginning to counteract the infamous quarter-to-quarter short term fixation of the financial markets. And you do not get the absurd situation you have now, where companies are posting record breaking profits, but are not buying new equipment, nor hiring new employees.
Low tax rates encourage taking wealth out of industrial companies; the wealth taken out must then be "put to work." That means more money chasing "investment" opportunities (instead of real investment in capital goods and employees), leading to price increases in financial capital or real estate or some other asset. In other words, an asset bubble. The rise in prices of an asset bubble has nothing to do with the creation of real wealth. It all looks like prosperity—until the asset bubble bursts.
The virtuous economic cycle that was destroyed by Reagan
The central economic assumption of Reagan’s economics is the same as that of neoliberalism: the people in the private sector who have become rich by profitably “investing” do a much better job allocating society’s financial resources than the federal government. Reagan flatly asserted that , "government is the problem." Bill Clinton signaled his acceptance of this assumption by declaring that the “era of big government is over.” Bush Jr. of course imitated Reagan by cutting taxes. And Barack Obama declared “I am a pro-growth, free-market guy. I love the market."
Reagan, the Republican Party, and American conservatives in general have developed a simple-minded faith in tax cuts, especially in reducing taxes on the highest incomes. The rich, according to their assumption, are the people in the private sector who supposedly do a better job investing than the government can do by planning. Not unreasonably, therefore—given the assumption of their economic thinking—their major goal is to get as much of society’s financial resources into the hands of the rich.
The reality, as shown by the three Republican experiments in the past century, is much different. Tax cuts only work to build bubbles that enrich mostly the financial sector. Tax cuts do nothing to help the real, industrial economy. Judged from the perspective of long-term national interests, the rich have proven that they are not very good at investing: they prefer credit default swaps over investing in sustainable energy start-ups. The major political-economic challenge of the past three decades has been to create a new economy that is not dependent on burning fossil fuels so as to halt climate change. Measured against this challenge, the Reagan / Republican / conservative / neoliberal theory that the rich are best at allocating our society's financial resources has been a disastrous failure. Scientists working on climate change have concluded that we have passed the tipping point, so it is more accurate to write “catastrophic failure” than “disastrous failure.” We have wasted thirty years testing the Reagan / Republican / conservative / neoliberal theory. We are about to waste at least another four years under Trump.
Another reason tax cuts do not create economic growth has to do with the distribution of income in the economy. The Republican / conservative religious belief that "tax cuts create jobs" has become so shallow and so insipid, that they don’t even understand the actual process of job creation contained in their own lousy theory. Tax cuts do NOT create jobs. It is the response of business to growth of aggregate demand in the economy that creates jobs.
In August 20109, Dave Johnson explained a crucial flaw in the economic assumptions behind the Obama / Republican / conservative deal that made over 80 percent of the Bush tax cuts permanent:
Tax Cuts Are Theft
The American Social Contract is supposed to work like this:
A beneficial cycle: We invest in infrastructure and public structures that create the conditions for enterprise to form and prosper. We prepare the ground for business to thrive. When enterprise prospers we share the bounty, with good wages and benefits for the people who work in the businesses and taxes that provide for the general welfare and for reinvestment in the infrastructure and public structures that keep the system going.
We fought hard to develop this system and it worked for us. We, the People fought and built our government to empower and protect us providing social services for the general welfare. We, through our government built up infrastructure and public structures like courts, laws, schools, roads, bridges. That investment creates the conditions that enable commerce to prosper – the bounty of democracy. In return we ask those who benefit most from the enterprise we enabled to share the return on our investment with all of us – through good wages, benefits and taxes.
But the "Reagan Revolution" broke the contract. Since Reagan the system is working like this:
Since the Reagan Revolution with its tax cuts for the rich, its anti-government policies, and its deregulation of the big corporations our democracy is increasingly defunded (and that was the plan), infrastructure is crumbling, our schools are falling behind, factories and supply chains are being dismantled, those still at work are working longer hours for fewer benefits and falling wages, our pensions are gone, wealth and income are increasing concentrating at the very top, our country is declining.
This is the Reagan Revolution home to roost: the social contract is broken. Instead of providing good wages and benefits and paying taxes to provide for the general welfare and reinvestment in infrastructure and public structures, the bounty of our democracy is being diverted to a wealthy few.
So, what about Trump’s infrastructure investment?
This time around, Trump wants a big tax cut, but at the same time, he wants a massive boost in spending on infrastructure. It appears to me unlikely that this increase in infrastructure investment will counteract the ill effects of any tax cut.
First, it is not certain that the Republicans in Congress will give Trump what he wants. While they will happily cut taxes yet again, they are ideologically opposed to increasing government spending of any kind unless it is to help USA military and CIA kill non-white people overseas.
Second, much of the increase in spending is supposed to come from private investors. Trump's plan is actually not an increase in government spending at all, but giving $140 billion in tax credits to construction companies. We have yet to see to what extent Trump and the Republicans in Congress change government policies so that investors actually have incentives to invest $140 billion in tax credits and their new tax-cut windfall in infrastructure rather than financial speculation. There is also the question of whether any new investment in infrastructure actually adds new productive capacity to the economy, or merely becomes another form of economic rent seeking. For example, if new investment takes the form of privatizing already existing infrastructure, there will be no net national economic gain. Even if that existing infrastructure is repaired or even upgraded, the economic gain will be limited only to whatever increase in employment occurs. In a program constrained by the ideology of Republicans in Congress, that employment bump will be minimal.
Third, outcomes also greatly depend on how much, and how soon, Trump changes U.S. trade policy. Ian Welsh, who has been consistently accurate about economic and political developments in USA since editing FireDogLake over a decade ago, explained years ago that a large portion of tax cuts end up outside the U.S. economy:
The past 30 years, and the past 10 years in particular, have been a huge experiment in tax-cutting, and for ordinary people, the result has been stagnation and now an absolute decline. Because ordinary people do not have pricing power, either as workers for their labor (since there are plenty of people who need jobs) or as consumers (because the oligopolies who sell food, energy, telecom and so on know you must have their services) every single red cent of tax cuts which go to the middle and lower class will be taken away by corporations and the rich. Those corporations and rich will then use that money to either play leveraged financial games or to offshore jobs to low cost, low regulation domiciles. Not only do tax cuts not do any good, they accelerate the loss of US jobs. No, this isn’t what you’ve been told, indeed propagandized, for the last thirty years. But how has trickle down economics worked out for you? Are you going to believe your lying eyes, or the talking heads who tell you that tax cuts create jobs?
This will obviously change as Trump discards TPP and renegotiates NAFTA. The former will have no real impact, because TPP was never approved, let alone implemented. But renegotiating NAFTA and other other free trade deals will take time, probably a couple years minimally. The leaves Trump with the power of the bully pulpit—which he has twitterized—and which he is already claiming has forced some American companies to keep jobs in USA or even start bringing them back.
Democrats have to oppose Trump from the left
On TPP and economics generally, if Trump actually manages to force companies to return production to USA, the Democratic Party is dead meat if it continues to respond as it has. I’ve already seen people at DailyKos regurgitate some “free trade” drivel from the Koch-funded, market fundamentalist American Enterprise Institute. If Democrats are going to oppose Trump by allying with market fundamentalists to defend the tenets of conservative / neoliberal economics, then they will be useless in opposition and voters will treat them accordingly. The only way Democrats can successfully oppose Trump is from the left: by pushing single payer health care; a tax on Wall Street speculation; and a massive $100 trillion world-wide program to stop climate change by building new energy, transportation, and industrial systems that do not use fossil fuels.
The Democrats can wreak havoc on the Republicans by repeatedly introducing a tax on Wall Street, and either force Trump and Wall Street into each other’s arms, or driving Trump and Wall Street further apart. If the former, the Tea Party base of the Republicans will boil over in revolt; if the latter, the Democrats will maneuver Trump and Wall Street to be at each other’s throats.
David Rolf, president of one of the fastest growing union locals in USA, Seattle-based Local 775 of the Service Employees International Union, representing health care workers, recently told Owen Jones of the London Guardian, Democrats will only win if they embrace and promote “progressive economic populism—they have to stand up for what’s good for the majority of Americans even if it’s not good for the donor class of the Democrats”. (Rolf is also an international vice president of SEIU, and was one of the organizing forces behind the successful ballot measure that dramatically raised wages and won paid sick leave for thousands of workers at Seattle’s airport, SeaTac.)
Besides a tax on Wall Street, Democrats should counter Republican proposals to “reform” the social safety net by introducing and pushing for expansions of existing programs. An excellent start, though much too small, is the ten-year $1 trillion infrastructure spending bill being prepared by eight Democratic Senators.