One economic theory has been repeated so often for so long in this country that it has become an accepted fact:
Tax cuts spur growth.
Most Americans have gotten so used to hearing this theory that they don't even question it anymore.
One of our two Presidential candidates is so convinced of the theory that he has built his entire economic plan around it--despite the huge negative impact additional tax cuts would likely have on our debt and deficit.
But is the theory true? Do tax cuts really spur growth?
The answer appears to be "no."
According to a new study by the Congressional Research Service (non-partisan), there's no evidence that tax cuts spur growth.
In fact, although correlation is not causation, when you compare economic growth in periods with declining tax rates versus periods with high tax rates, there seems to be evidence that tax cuts might hurt growth. But we'll leave that possibility for another day.
One thing that tax cuts do unequivocally do--at least tax cuts for the highest earners--is increase economic inequality. Given that economic inequality is one of the biggest problems we face in this country right now, this conclusion is very important.
Before we go to the charts, a few observations.
First, this topic has become highly politicized, so it's impossible to discuss it without people howling that you're just rooting for a particular political team. Second, no one likes paying taxes. Third, everyone would like a tax cut, including me.
So I think we can all agree that everyone would prefer that tax cuts actually did spur economic growth.
Okay, first let's look at the top marginal tax rates for the past 60 years or so. These are not effective or average tax rates--they're just the top marginal rates. As you can see, they've trended steadily down:
And now, average tax rates for the country's highest earners--the super-rich 0.1% of incomes. These have also trended steadily down:
So, have these declining tax cuts for the rich--the "job creators" who are being given a bigger incentive to invest by the reduced tax rates--led to faster economic growth?
The following charts show the correlation between tax rates and economic growth over the periods above. The slope of the solid line in each chart is the key.
The lefthand chart shows that there is no correlation between GDP growth and the top marginal tax rates. The righthand chart shows that there might be a very modest tendency toward faster economic growth with higher capital gains rates. (But those who love today's record-low capital gains rates will be relieved to know that the CRS does not find this correlation to be statistically significant.)
Along these lines, David Leonhardt of the New York Times recently put together a cool chart showing economic growth rates following periods of tax increases and tax cuts. The chart plots the average future 5-year economic growth rate from each point in time, which is known with the benefit of hindsight. You can see for yourself why Leonhardt (and any other sentient being) would conclude that the evidence does not support the idea that tax cuts spur growth.
(By the way, Leonhardt showed this chart to Republican VP nominee Paul Ryan, who, like Presidential nominee Mitt Romney, wants to stimulate the economy by cutting taxes. Ryan's reaction? "Correlation is not causation." That's true. But the point is that there's not even any correlation suggesting that tax cuts spur growth. It's just a theory. And it's a theory that a lot of real world "correlation" suggests might be wrong.)
And now for the really bad news...
Although tax cuts do not appear to spur economic growth, they DO appear to lead to greater economic inequality.
As this chart shows, inequality in the United States recently hit a level that has not been seen since the 1920s: The country's top earners are taking home more of the national income than at any time in 70 years.
And now let's look at the correlation between this rise in inequality and tax rates. As you can see, the lower the top marginal rates go (left), the bigger the share of national income that goes to the top 0.1% of wage earners. And it's the same for capital gains rates.
Meanwhile, the share of national income that goes to "labor"--a.k.a., most Americans--goes up as the top tax rates increase.
Why is the rise in inequality so troubling? Well, beyond the issues of fairness and stability, increasing inequality is hurting the economy. Unlike middle class and upper middle class folks the country's highest earners don't spend all the money they earn. So this money doesn't get circulated back into the economy, where it can become revenue for other companies and salaries for other workers. (If there were a dearth of investment capital, the money might get invested, but we've got plenty of investment capital right now. Our problem is a lack of demand).
So, what's the bottom line?
Well, the bottom line appears to be that low taxes do not spur economic growth and DO cause greater economic inequality.
So, although it sounds like heresy, presidents and Congress-people who actually want to fix the economy might want to consider raising taxes rather than cutting them. Or, at the very least, keeping them the same.
SEE ALSO: EXCLUSIVE: The Romney Plan Will Balloon The Debt And Deficit
There's a lot of sturm und drang these days about who wrecked the economy. And there is a lot of yelling about how to fix it.
But the economy is complicated, so it's easy to get fooled by someone who is yelling persuasively, especially if they play for your favorite political team.
And the truth is that the "government" is never going to fix our economy. The government can't fix our economy. The only people who can fix our economy are us.
So let's walk through some simple charts that show what's wrong with the economy.
Happily, these charts will offer a simple way to fix it--one that doesn't need to involve the government.
WHAT'S WRONG WITH THE ECONOMY?
1. The health of any business or economy depends on the health of its customers, and most American customers (consumers) are strapped or broke. Consumers account for about 70% of the spending in our economy, and the other 30% is tied to consumer spending (when consumers are broke, businesses don't spend--because there's no one to sell to.)
This sad state of affairs can be seen in the following chart, which shows that the vast majority of the income in the country goes to the top 50%. The bottom 50%, meanwhile, earn less than $30,000 per year.
2. Most American consumers are strapped or broke because most of the income gains in the past 30 years have gone to the top 10% (and especially the top 1%). The chart below shows the growth of incomes over the past ~90 years. The pink section is the 1%.
3. This increasing inequality has many causes, including globalization (cheaper labor overseas), a decline in the minimum wage, the decline of private-sector unions, changes in the tax code (tax cuts for the highest earners), and other factors. But the bottom line is: Average hourly earnings in America (adjusted for inflation) have not increased in ~50 years:
4. At the same time, earnings for the highest-income Americans have gone through the roof. For example, check out how compensation for senior executives has grown relative to compensation for "average production workers" and the minimum wage (which has actually declined after adjusting for inflation). And this is just since 1990.
5. Importantly, the problem here is NOT the weak health or profitability of American companies (which was a problem in the early 1980s). American companies are earning more as a percent of the economy than they ever have.
6. One of the reasons American companies are earning so much money is that they're paying very little to their rank-and-file employees. This is also why average earnings have been stagnant for 50 years and most American consumers are broke. Wages as a percent of the economy are at an all-time low.
7. Meanwhile, a lot of Americans don't even have jobs, so they're not earning anything. The employment-to-population ratio is lower that at any time in the past 30 years.
Put all this together, and the problem in the economy becomes clear:
- Too few jobs
- Too little pay
HOW TO FIX THE ECONOMY
Now, some people argue that the way to fix the economy is to give tax cuts to the highest-earning Americans--the "job creators"--so that they can invest in new companies and create jobs.
Well, we'd all like to pay fewer taxes, but unfortunately, the "tax cuts for the rich" approach almost certainly won't work. Here are a few reasons why:
- The richest Americans and companies already have plenty of cash
- The reason these rich Americans and companies aren't investing and "creating jobs" is that most American consumers (customers) are broke
- Rich Americans actually don't "create jobs"--the whole economy creates jobs
- We've been trying the "tax cuts for the rich" approach for three decades, and it is making the inequality problem worse, not better
Now, some other people are arguing that the way to fix the economy is to increase taxes on the rich and companies and "redistribute" this wealth to American consumers.
Well, we will probably need to raise taxes on everyone a bit to reduce the budget deficit (even if we reduce spending--the gap is that big), but this "wealth redistribution" approach also almost certainly won't work. Here are a few reasons why:
- The key to creating a sustainable economic recovery is to get the private-sector cranking, not the public sector
- Having the government collect taxes and write checks to more than half the country to make things "fairer" will understandably ruffle the feathers of those who are paying those taxes
- Class warfare won't help anyone
- This is America: We solve our own problems in this country--we don't wait for someone else to come along and give us a handout.
So, then, if the answer isn't 1) cutting taxes for rich Americans and companies, or 2) raising taxes on the rich and giving the money to the poor, what's the answer?
Let's go back to the problem.
Here's the problem in one simple chart:
Corporate profits (blue) are at an all-time high, and American wages (red) are at an all-time low.
This has created a situation in which American corporations and their owners are rich and American consumers are broke.
So, how do we fix the problem?
We persuade American corporations (and their owners) to hire more employees and pay them more, thus giving these employees (American consumers) more spending money. In other words, we take some of those surplus corporate profits and invest them in Americans.
Put differently, we instill a new value system in our companies, one in which employees--American workers--are treated as a constituency that is as important as the two other corporate constituencies that everyone already agrees are important--shareholders and customers.
Jerry Maguire might have put it this way:
"Lower profits, higher wages."
Persuading corporations to hire more Americans and pay them more will fix the American economy. It will not require the government to raise taxes or grow even bigger. It will not require us to "soak the rich." It will not even be a government solution.
All it will do is restore balance to a system that has become very imbalanced in the past three decades.
Of course, whenever you suggest that the answer to our economic problems is to persuade corporations to pay their employees more, most people howl with laughter. Persuade corporations to pay people more? What, are you insane? They'll never pay people more!!! They're in this for profit!
Well, when people laugh at you for suggesting that corporations should pay people more, you can just point out the following:
Eventually, this will help increase corporate profits.
Because paying Americans more will not just lead to a reduction in near-term profits. It will also lead to faster revenue growth. Because American consumers--the customers of all our companies--will have more spending money.
In other words, corporations don't have to suddenly become good citizens when they decide to pay Americans more. They can keep on being relentlessly competitive profit-seekers. They can pay employees more with the knowledge that this will eventually lead to faster revenue growth, which will eventually lead to higher profits. So they can do it in their own self-interest!
Make no mistake: The kind of inequality that we have developed in the past three decades is very destabilizing. When the vast majority of people feel as though they're getting shafted at the hands of a privileged few, they tend to rise up and rebel. This can lead to the election of radical leaders, or, worse, violent revolutions.
The inequality we have developed, in other words, will solve itself one way or another. The richest Americans and companies cannot keep getting richer while the rest of the country gets poorer without the entire system eventually collapsing.
So, it would be nice if we made the necessary changes voluntarily, before everything goes to hell.
And, besides, viewing employees as a very important corporate constituency isn't just good for the economy--it's also good for the soul. We're all in this together. And no one can do it alone.
So, how about it, corporate America?
How about taking a few percentage points of your record profits and use it to hire more employees and pay your existing employees more?
Henry Ford paid his employees more than he had to--so they could buy his cars.
And it worked out for him.
And "the Henry Ford way" is the way we're going to fix our economy.
SEE ALSO: Greed WAS Good--Then We Overdid It