Sunday, April 04, 2010

The Terrible 1970s (Econoclasts, Part II)

#3 in an ongoing series on 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 was a colossal failure, wasn't it?

Brian Domitrovic's Econoclasts is a history book from beginning to end. Considering my interests, I had to remind myself several times as I read it because I had a much narrower purpose, going in, than Domitrovic had for writing it.

Part I, a 99-page "Reconsideration of the 20th Century," summarizes American monetary policy from 1913, the year in which the income tax was instituted and the Federal Reserve created, till about 1974. It actually begins in 1974 and describes the sorry state of the American economy at that time, then flashes back to 1913 and tells the story in between.

The history is interesting--Domitrovic talks specifically of government policies throughout the 20th century with particular interest in the post-World War II period. The entire history, I think, is worth one's while. But my personal interests here in my blog are limited enough that I want to focus primarily on the 1970s and following.

So, if you don't mind, I would like to bring you back to the mid-70s.

I am 53. I was still 17 when I first left home and began my freshman year in college. I had turned 18 just a few weeks before OPEC, the Organization of Petroleum Exporting Countries, shut off the oil spigots in October 1973.

If you are my age or younger, you may not have strong memories of many of the worst ravages of the economic upheaval of the mid- to late 1970s. I was aware of the dramatic price increase in gasoline that occurred beginning in October of 1973, and I saw photographs and read about the long lines of cars waiting to be refueled . . . and of gasoline stations completely out of inventory, . . . but these events didn't affect me personally a whole lot . . . I imagine because . . . I was in college, . . . because I rarely drove a car, . . . because my living expenses, overall, were rather low, . . . and, finally, because I was single.

Again, I was aware of the galloping inflation and felt the pall of economic difficulties (although, looking back, I wonder how much I attributed the pall at the time to the emotional impact of living in central Michigan where the winters are cold and interminably gray).

One event that comes to mind: I remember one day being told that Michigan State University might run out of its coal supply . . . which, if it had occurred, would have meant we would have run out of heat, hot water, and much if not all of our electricity on campus. I remember watching the large pile of coal slowly diminish that winter and wondering if the coal would come in time.

Happily, it did.

Domitrovic brought me back and, whether it is due to my more advanced years or, perhaps, because I was actually more impacted than I thought, the data points he shared stirred up some fairly strong emotions.

Perhaps you remember some of the titles of popular books from that era: Paul Ehrlich and his Population Bomb, William and Paul Paddock’s Famine 1975!, the Limits to Growth report from the “Club of Rome,” Lester Thurow’s The Zero-Sum Society, the Christian end-of-the-world blockbuster, The Late Great Planet Earth by Hal Lindsay, . . . and others. I would say the era was surrounded by a general pessimism.

But besides the feelings, on a more practical level, Domitrovic mentions at least eight economic and political problems of the 1970s whose solutions were not clear:
  1. Price and wage inflation.
  2. Tax bracket creep.
  3. Financial stress for business owners.
  4. Effective capital gains taxes above 100%.
  5. A preference for "stuff" over saving.
  6. A preference for commodities and "stuff" over capital investment.
  7. Resource shortages or scarcities.
  8. Terrible unemployment.
  9. Property taxes through the roof--and a tax revolt.
  10. Government consuming an ever-increasing share of the nation's productive capacity and wealth.
  11. Ever-increasing government intrusions into [formerly] private decisions.
I'll try to summarize these briefly, the first four in this post, the last seven (which I felt I was able to summarize in shorter order) tomorrow.

1. Price and wage inflation.

Concerning price inflation:
[I]n October 1973, . . . the Organization of Petroleum Exporting Countries (OPEC) signaled that it would triple the price of oil. The "oil shock" would soon become most economists' convenient catchall explanation for the raging inflation, recessions, and stock-market plunge that characterized the economy in the late Nixon and Ford-Carter eras. But in reality, the inflation crisis was in full swing before the OPEC shock of late 1973. OPEC moved to raise prices precisely because the currency instability emanating from the United States was already troubling the world. In the 12 months before the OPEC announcement, consumer prices in the United States increased by 8 percent, breaking out of the 5 percent range established in Nixon's first term, a rate that itself was quadruple the historical norm. . . .

[T]here was one great commodity, of greater importance even than oil to daily life, whose price rose the most in 1973, transfixing the nation in disbelief. That's commodity was food, which suffered 15 percent inflation that year. Food became the first major commodity to burst out of the 5 percent inflation band and to goad the general index up to unseen levels, a leadership role later assumed by oil, gas, and various metals naturally be limited in supply. The inflation laggard in 1973 was transportation (the price of which increased 3 percent), making it logically impossible that rising "energy" costs were responsible for inflation at the grocery store.

Eggs went up 49 percent in 1972-73, pacing the category of poultry, meats, and fish, which rose 25 percent as a group.

--p. 104

[I]n the recession years of 1974 and 1975, consumer prices somehow increased at World War I rates--11 percent and 9 percent, respectively. At the end of 1975, the economy was only marginally bigger than it had been in 1973, and prices were 25 percent higher.

--p. 105

With respect to wage inflation, Domitrovic reminded me of a term I had pretty well forgotten: COLAs--cost-of-living-adjustments.

I believe it was during this period--the mid-'70s--that COLAs first became bargaining issues in union negotiations. Living in Michigan at the time, and with the auto industry and auto workers being such a large presence in the state's economy at the time, I was very aware of unions, union activities, and strikes. People elsewhere in the country, I'm sure, were also aware. There were a lot of labor actions taking place at the time!

And our presidents--first Nixon, with his staggering, unprecedented-in-peacetime "wage and price controls," then Ford, with his "WIN--Whip Inflation Now" campaign, and, finally, Carter, with his attempts to get labor unions and corporate managers voluntarily to agree not to permit wages or prices to increase more than 7 percent in a year-- . . . our presidents, too, were deeply concerned about galloping inflation.

In high price-inflation environments, you need major adjustments in your salary if you are to be able to buy this year the same amount of "stuff" as you did the year before. And so, as prices rose at astronomical rates, so did wages.

This rise, first in prices and then in wages, created a terrible effect that the federal government at first--and for many years--refused to address. It was the problem of . . .

2. Tax bracket creep.

Domitrovic explains:
By the late 1970s, everybody had become acquainted with . . . bracket creep, [a term that] referred to the progressivity of the tax code in combination with inflation. . . . Inflation ran at 7.5 percent per year, 45 percent total, from 1973 to 1978. If a worker making $19,000 in 1973 had cost-of-living adjustments (COLAs) equal to the rise in consumer prices, the worker was making about $27,500 after five years. In 1973, a worker making $19,000 had an income tax rate that topped out at 25 percent. Yet in 1978, the worker would have found that every dollar of his cumulative $8,500 raise--a raise that covered only his rise in living expenses--was taxed at higher rates. The first $4,000 was taxed at 28 percent, the next $4,000 at 32 percent, and the remaining dollars at 36 percent.

The COLA meant to keep the worker even with inflation, but it failed. For the COLA was additional income, and higher marginal rates applied to that additional income. To have been a real COLA, it should have been taxed at the average rate of tax for all the worker's income, in this case 17 percent. But that is not how a progressive tax system works. All new income is taxed at the highest rate an income earner is subject to. A COLA could even vault earners into a higher marginal rate bracket than that at which their last dollar of income, pre-COLA, was taxed. . . .

The numbers were grim. For our 1973 worker to have maintained the same standard of living against inflation, the worker would have had to arrange for something like $29,400 of income in 1978. That is, a 55 percent raise (8.7 percent per year) was required to keep up with inflation as it mixed with the tax code.

For most workers, this was unthinkable.

--pp. 150-151

Domitrovic references research by Paul Craig Roberts who was working for Orrin Hatch at the time. Roberts noted that someone whose average income tax rate was 10% needed a raise 11% above the rate of inflation (i.e., if inflation was 7%, he would need a 7.77% wage increase) just to stay even. Better-paid workers would need raises worth 40% or more above the rate of inflation (if inflation was running at 7%, the better-paid worker would require a raise of at least 9.28%) to stay even.

A syndicated columnist at the Boston Herald-American described the cases of specific workers whose real purchasing power went down as their wages increased. "A businessman named 'Lawrence K.,' . . . saw his income go up by half in ten years and his after-tax purchasing power [went] down by a third."

And if the average wage-earner felt pressure, consider the . . .

3. Financial stress for business owners.

Domitrovic writes:
Since the 45 percent inflation of 1973-78 required a 55 percent increase in salaries, firms seeking to give real COLAs to their employees faced cash-flow problems, if not the stalking horse of bankruptcy . . . (p. 152).

In [the] ten-year period [of 1973 to 1982], the steel wage rate climbed 179 percent, while inflation rose 132 percent. Unless there was supercharged productivity, raises of this order meant raids on business profits. And given the way depreciation was treated in the tax code, there was not supercharged productivity. The stock market took due note and encouraged the likes of U.S. Steel to bail out to commodities. (p. 176)
We'll be telling the story of U.S. Steel in a few moments. For now, let's discuss the problem of depreciation.

4. Effective capital gains taxes above 100%.

Early in his book, on page 13, to be exact, Domitrovic makes a comment that blew me away when I first read it. "No way!" I said to myself.
In the 1970s, income derived from work was being taxed at a particularly acute rate. So was entrepreneurialism (in the form of a capital-gains tax that in many cases, incredibly, exceeded 100 percent).
It took me a while to find the data to back up this claim. Domitrovic provides it on pages 132 to 134 as he references work by economist Norman Ture (too-RAY) in Ture's The Effects of Tax Policy on Capital Formation.
In one of Ture's examples, a business owner contemplated buying a piece of machinery for $1,000. Because the top bracket taxed income at 48 percent, this business, if run by a top earner who took a salary, would have to earn $1,923 to buy the machinery. Yet this was only the first step in the long gauntlet of taxation.

Ture assumed, generously, that the machinery would yield 12 percent per year in profits, or $156. This $156 would itself be dunned at tax time. Ture crunched the numbers and concluded that to make a profitable investment in capital equipment of $1,000, this business owner would have to commit $2,450 of pretax income. If the owner spent the money instead, all that would be required was the original $1,923. The effective tax penalty on investment in lieu of consumption for a business owner was $500 for each $2,000 invested--an absurdity.

Depreciation told an even sadder tale. . . . [D]epreciation schedules . . . were extended to a standard of thirteen years . . . in the 1970s. This was brutal. Inflation averaged 9 percent in the stagflation era. After thirteen years, 9 percent inflation means that an initial price is depreciated, in the end, to 33 percent. On a depreciation schedule, this requires that businesses he ducked less and less of the real purchase price of equipment every year, culminating in a deduction that is one-third of the equipment's real value. . . .

Another example: A [privately owned] company gains income less expenses of $1,000. The corporate income tax takes 48 percent and the rest is paid out as dividends to shareholders, who must pay [if they were in the top bracket at that time] 70 percent tax on that type of income. The $1,000 [corporate net income before taxes] first becomes, because of the corporate rate, $520 [corporate net income after taxes], then $156 [net income after taxes to top income bracket shareholders] because of the dividend rate; $844 goes to the IRS.
Okay. The federal government got 84.4 percent of the this hypothetical company's $1,000 income.

Let me simply note that at those kinds of rates, I'm not highly motivated to invest in my company.

But remember, Domitrovic claimed, back on p. 13, that capital gains taxes could often exceed 100%. How does he come up with that number?

He suggests we take the same company we just described and look at expenses.

To make his example more understandable, I am going to make up some numbers. I am not going to attempt to create an illustration that perfectly matches the tax codes of the '60s and '70s/ I am simply trying to illustrate the general principle.

Suppose the company we just described had purchased a machine 13 years before that, at the time, cost $20,000. Now suppose, after 13 years, the company still had $1,000 of the original $20,000 purchase price to write off as depreciation. . . . --Here's where things get interesting.

Keep in mind that there was a lot--a lot--of inflation over the course of the 13 years since the company purchased that equipment! In current money, the machine that cost $20,000 13 years ago would now cost $60,000. I.e., every $1,000 of the original price should "really" be counted as $3,000 in today's money!

[I]f inflation had denuded the depreciation allowance by, say, two-thirds [i.e., the $1,000 depreciation allowance was worth one-third of what it "should" have been had the original $20,000 been valued at $60,000 in today's inflated currency--JAH]. . . , the real depreciation allowance should have been $3,000. [And i]f depreciation schedules . . . had been indexed for inflation, the company would have not reported a profit of $1,000, but a loss of $2,000, on account of a proper depreciation allowance of $3,000.

We have, in this case, a company and its owners paying $844 in taxes on a loss of $2,000.

--p. 133

That is a specific example of a single imaginary company's owners' predicament. On an aggregate (economy-wide) level, economist Martin Feldstein of Harvard wrote in the Wall Street Journal (July 27, 1978), "We found that in 1973 individuals paid capital-gains tax on $4.6 billion of nominal capital gains on corporate stock. When the costs of these shares are adjusted for the increase in the consumer price level since they were purchased, this gain becomes a loss of nearly $1 billion. The $4.6 billion of nominal capital gains resulted in a tax liability of $1.1 billion."

Domitrovic comments,
Feldstein found that only about half of the $1.1 billion in capital-gains tax revenue that went to the federal government was taken from investments that had made money in real terms. The other half had been taken from investments that merely kept up with inflation, in whole or in part. "Many individuals paid a substantial capital-gains tax," Feldstein wrote, "even though, when adjustment is made for the change in the price level, the actually receive less from their sale than they had originally paid."
Most disturbing according to Feldstein: "The mismeasurement of capital gains is most severe for taxpayers with incomes under $100,000" (p. 163).

Domitrovic multiplies these examples. The point, however is this: Anyone with the ability to invest in the stock market--i.e., anyone with the means to provide capital for start-up companies--realizes that it is all but impossible to come out ahead when inflation is galloping along and you'll be taxed not only on your investment's real returns but on the phantom "gains" of inflation.

With capital investments being taxed at such high rates, people who had money to invest did the only reasonable thing they could do in such circumstances: they invested in tangible assets rather than stocks and bonds. Put another way, the '70s saw . . .

5. A preference for "stuff" over saving.

. . . --To be continued tomorrow.
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