Obama, The Buffett Tax, And Economics

The controversy over the “Buffett tax” on “millionaires” and “billionaires” continues since my post, “The Obama Plan To Increase Poverty”. The media have been full of interviews and commentary about this. The President continues to hammer away at his claim that the lack of wealth redistribution is a “drag on the economy.”

The issue is framed such that increased taxes either won’t hurt the economy or will hurt the economy. That is, it is about supply-side economics. Both sides are (mostly) wrong. Our problems aren’t about taxes. But a higher tax on our most productive citizens at this moment is wrong for the economy.

Look first to the history of tax rates. Here is a chart from Wikipedia showing the highest marginal income tax rates on ordinary income since 1913.

You can see they have been much higher in the past. They went sky-high during WWI, went down post-war, and were sent back to the stratosphere during the New Deal and beyond. They reached 94% in 1944 and didn’t get below 70% until the Reagan Administration. The Bush II tax cuts got it down to 33%. It goes back up to 38.5% in 2013, assuming they let the Bush cuts expire.

The proposed 30% minimum tax on income in excess of $1 million is aimed at the capital gains rate (now at 15%, going up to 20% in 2013). Mr. Buffett and Mitt Romney pay lower taxes because their income comes in the form of capital gains. The tax would also negate tax benefits on dividends and on depreciation and depletion allowances. Lower capital gains rates and investment write-offs were given by Congress in order to induce investment in the economy.

Here is some background for the discussion (latest data, 2009):

• The top 10% pay 70% of all income taxes.
• The top 1% pay 37% of all income taxes.
• The bottom 50% pay almost nothing (2.25%).
• 233,435 taxpayers reported at least $1 million of Adjusted Gross Income.
• Those filers represent only 0.2% of all tax payers.
• Those 0.2% pay 20% of all income taxes.
• Their effective tax rate in 2009 was 25% ($176.4 billion paid on $702.2 billion of income).
• If you increase that rate to 30%, then, all things being equal, they would pay an additional $34 billion (210.7 billion vs. $176.4 billion). Other estimates range up to $50 billion in additional revenue.
• In a world of $3.7 trillion budgets, that means the additional revenue from the Buffett tax would amount to only 0.9% of total federal expenditures.

The President is attempting to define the problem in terms of income “fairness”, but as we can see that isn’t true because the class he deems as being unfairly rich already pay most income taxes.

The proponents of the Buffet tax increase say that it won’t harm the economy: since the economy grew when we had 70% or 90% tax rates, what’s the harm in raising taxes now?

The answer is that it depends. There are many factors other than taxes that are more determinative of economic growth. These people are comparing apples to oranges.

The concept that lower taxes promote economic growth (and v.v.) is called supply-side economics. It has has some validity in that high taxes at some marginal rate will hamper economic growth because they reduce incentives to report or achieve higher incomes. They also redirect valuable savings from productive private activities to mostly unproductive government-directed activities.

If the supply-siders were right, why haven’t the Bush II tax cuts had any significant impact on economic growth? The answer is that there are other more fundamental factors at play.

I have prepared two charts to illustrate why both side are wrong.

This first chart shows the growth of the economy measured by GDP (blue, all spending), the effect of price inflation (red, CPI) and money supply growth (green, since 1980) on growth, and the maximum tax rate on ordinary income. 

A cursory reading of the above chart would appear to show that as tax rates declined, the economy grew more than before. This is what most policy makers would look at to conclude a cause and effect between taxes and GDP. But that is not necessarily the case when you factor in price inflation. 

Here is a simple table that shows the effect of price inflation on growth at the various tax rates¹:

 As you can see there is no correlation between taxes and GDP. For example, despite high taxes, post-WWII real GDP grew more than the period from 1980 to the present when taxes were lower (GDP: 2.9% p/yr vs. 1.8%).

How could that happen according to supply-side economics? Higher tax rates should result in lower economic growth. The reason is that confiscatory taxes didn’t hinder growth because of “other factors” which occurred in the post-War period and which do not exist today.

After WWII there was huge pent-up demand from wartime rationing, restrictions, and price and wage controls. When the “boys” came home as victors, the opportunities seemed endless. You will note that price inflation was low because monetary growth was low (monetary base only grew 34% over 19 years, about 1.8% per year). And there was sufficient real savings to drive that growth since there was little to buy during the War. Despite rapid growth of private consumption, in a low inflation environment gross private saving grew by 79% (avg., 4+% p/yr) in those years.

Another significant factor was the loosening grip of government on the economy: price and wage controls, rationing, and production restrictions were imposed during the War and the Great Depression. Thus, the market was given a freer rein to meet surging demand. There was also the Baby Boom: the rate of population growth reached its highest level since the 1920s (population had been falling since the early 1900s). Further, the U.S. had a substantial advantage over its competitors in world markets because of wartime destruction. It wasn’t all roses; there were five recessions resulting from government interference in the economy. The DJIA didn’t reach its 1929 high until 1954. Much of that related to the continuing relatively heavy hand of regulation.

Another reason is that because of various loopholes, the wealthy were able to avoid the impact of confiscatory taxes. Their effective tax rates were much lower. While the data going back to the post-War period aren’t available, data from 1979 and on show that the effective tax rate for One Percenters is about 20%±. It is likely that was the case earlier since the effective tax rate for the median bracket is consistently at about 10%± from 1947 and on. Unfortunately many of the loopholes required using tax strategies that directed investment to less productive “tax dodges”. Lower taxes could have helped the economy grow even more during the post-War period.

These forces were powerful enough to overcome the negative impacts of a confiscatory income tax rate. It is unlikely that those underlying forces will be repeated again.

The period of 1980 to 2011 was entirely different. While the common belief is that the U.S. has had substantial real growth, it actually was slower, and there were 5 substantial recessions. Real GDP grew at only 1.8% per year on average. Price inflation was the culprit and that was driven by the Fed’s off and on monetary stimulus.

If you measure the current economy against the post-War boom, you have a different picture:

• Population growth has been steadily declining.
• Competition across international boundaries is much stiffer.
• There has been high price inflation.
• Successive recessions were met by further Fed monetary “stimulus.”
• Successive rounds of monetary stimulus have weakened our reserves of real capital/savings.
• Our economy is plagued by recurring boom and bust cycles due to monetary stimulus.
• Debt levels among consumers and government has exploded.
• Unemployment is high and is likely to remain higher than before.
• The percentage of civilian workers to the total population peaked in 2000 (64.6%) and has fallen ever since (58.5% presently).

It isn’t the same America. Today reckless fiscal and monetary policies have resulted in an economy with far less stability, high debt, and diminished real savings which makes us weaker and more vulnerable to external factors, such as higher taxes.

If there is one thing that would harm the economy right now it would be higher taxes on those who create jobs. Jobs, productive jobs, can only come from the private sector. The data also show that of those at the million dollar income level, one-half don’t show up on the list the next year. They are millionaires because they sold a company or had a big earnings year, and those circumstances aren’t often repeated. Redistributing wealth from those who have been successful in life only discourages them from entrepreneurial activities. The $35+ billion raised each year would be wasted on nonproductive projects by the government.

This furor is not about economics. This is all about politics and raw power. The President is using wealth redistribution to show his left wing base that he is one of them. This is a sordid turn to class warfare. Mr. Obama, like most politicians, is eager to ignore economic truths to gain and perpetuate his power.

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1. The percentage rates are simple averages of growth from the beginning of the period measured to the end. Consider it to be a rough estimate for comparison purposes rather than a rigorous statistical measure.