Friday, April 09, 2010

Tax cuts v. tax cuts (Econoclasts, Part V)

#6 in an ongoing series on Brian Domitrovic's Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity. First post in the series: Econoclasts: The Rebels Who Sparked the Supply-Side Revolution, Intro. Previous post: Supply-Side Economics: What is it? (Econoclasts, Part IV)

I concluded my last post with an extremely brief summary of the solution proposed by the supply-side economists to the economic problems suffered by the United States in the 1970s. To wit: stabilize the dollar and cut taxes. If you want people to work, you need to incentivize them. And to incentivize them, you can't just cut any taxes or offer just any tax relief. The supply-siders were very explicit about this. To get people back to work and the economy back into a productive mode, government leaders had to cut the marginal tax rates--the tax that income-earners pay on their "next dollar of income"--the edge, the margin (p. 290).

It took me a while to understand what Domitrovic and the supply-siders were saying. There are at several issues at work, here. And they have to do, primarily, with incentives.

As Robert Bartley explained in a Wall Street Journal article, to encourage growth, you have to reduce taxes at the margins. Reducing taxes anywhere else--or, as President Ford's administration did (and so many others have done since), offering "rebates" or special bounties from the government (remember the $300 per person tax rebate offered by the federal government to low- and middle-income taxpayers via the Economic Stimulus Act of 2008?): such "backward-looking windfalls" don't change basic incentives. They don't encourage recipients to go to work and earn more money or invest for future productivity. Such windfalls merely encourage a (relatively minor) one-time spending spree or--as I'm told happened quite a bit in 2008--they provide a means for over-extended consumers to pay down some of the debt they have already contracted.

The greatest Keynesian verity in the realm of taxation is that tax cuts raise "aggregate demand." This is why tax rebates, in the Keynesian mindset, are legitimate. Put money in people's pockets, and they will spend it, the logic goes, to the extent that people have a "marginal propensity to consume."

--p. 200

As we noted in The Terrible 1970s, Part II, however, people in the '70s and early '80s were already spending at prodigious levels. The high rate of inflation ensured that kind of behavior. People didn't need more stimulus to spend. They needed stimulus to save and to invest for the future.

As John Paul Roberts argued in "The Breakdown of the Keynesian Model," an article he wrote in 1978, "rebates would probably cause people to work less, since, given the high marginal rates, giving up extra work was virtually painless from a financial perspective. If people were simply given more money through a rebate, they might cut back on work, because the last work they were doing was barely paying anyway" (p. 200).

And, as Robert Bartley also argued: the government had to start looking at changing long-term behaviors.
A rebate . . . was . . . nil or counterproductive in its [long-term] economic effects. Indexing the [tax] code for inflation or cutting marginal rates, however, promised a different outcome. These moves foretold changes in the ways people organized their economic activity, and the outcome would be growth.

--p. 124

In the '70s and early '80s, "taxes were so arranged as to make one's next activity virtually unremunerative. . . . With marginal rate cuts, there would be incentive for individuals to go ahead with new economic activity." Reduced marginal rates increase the rewards for working and for taking risks by investing one's capital for future returns, "and higher rewards produce more effort and more economic activity" (p. 290). Conversely, "If taxes were cut at the margin, the price of not choosing to take advantage of an economic opportunity would rise" (p. 200; emphasis added).

While we're on the subject, let me comment: the supply-siders were not only concerned about where taxes were to be cut, they also noted that taxes had to be cut on a long-term basis. "[T]emporary tax changes will at most move activity around from one [tax] period to another. For stimulus, you need to change future incentives, [which means] the tax cut has to be permanent," wrote Bartley (p. 290).

And one final comment about taxes--something Domitrovic did not emphasize but that struck me as I read his book. It has to do with . . .

A Bias in Terminology

Throughout the book, Domitrovic speaks, and the supply-siders he quotes speak, of capital investments and financial and productive assets. As I wrote in The Terrible 1970s, Part II, the supply-siders recognized a contrast between investing with an eye to future production and investing in tangible assets and "stuff"--a future- vs. past-orientation.

And then, suddenly, I ran across a phrase I've heard often while doing or reviewing my taxes, but that I had not thought of during all the discussion of capital investments and future-orientation. Domitrovic mentions a proposal by Democratic Representative William Brodhead of Michigan in March 1981 to bring "an end to the distinction between wage and investment income--'earned and unearned income' " (p. 225).

Oh, wow! That's right!

I sat there, stunned. Can you imagine a more negative characterization for the return on an investment in future productivity? "Unearned income." "Unearned income" is a form of stealing, isn't it? What right does someone have to hang onto income they haven't earned?

Now, the wages one earns through investing one's time in one's own labor . . . now, that's legitimate. That's "earned." But you want to risk your money by purchasing equipment or investing in the labor of someone who has an unproven idea for a new business (start-up capital, risk capital, venture capital)? If you make money from that kind of investment, that's "unearned."

Another biased term: "passive" vs. "active" income. Very much the same kind of distinction: one has to do with rental income you might receive on a building you paid to have built. That's "passive income." Totally different from "active income" which you earn either by your direct labor or by your direct participation in a business. Marxists refer to people who receive such passive income as "rentiers" . . . with the implication that they play no productive role in the economy but are mere parasites.

Kind of negative! But where would we be if they were unwilling to live below their means, aggregate their capital, and put it to use through investment in potential productive enterprise?

We need merely look back to the 1970s and early 80s to see where we would be. Recall the story of U.S. Steel (The Terrible 1970s, Part II, Item #6). Without appropriate investment, we’re looking at massive unemployment.

As Domitrovic writes (p. 7):
It was no accident that during [the 1970s and early '80s] Bill Gates could get his company out of the garage only by signing a contract with IBM. If you did not have a lifeline to the biggest, richest, most established companies, like IBM, you could forget about raising capital. With marginal income-tax rates upwards of 70 percent, there was no such thing as venture capital.
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