Why the Economy Grows Like Crazy Amid High Taxes
November 16, 2008
The real-world effects of tax policy are counterintuitive.
They run exactly opposite the conventional wisdom. They defy what the Heritage Foundation calls common sense and what the American Enterprise Institute calls logic.
Reality laughs at the Laffer curve, calls Ronald Reagan wrong and says George W. Bush is a loon.
High marginal tax rates correlate with economic growth.
Examples include World War II and the Truman-Eisenhower years, when it was around 90 percent, and the Clinton years, when it was high relative to the preceding and following administrations.
Tax rate increases are followed by real economic growth.
Examples include Hoover in 1932, Roosevelt in 1936 and 1940, Bush the Elder in 1991 and Clinton in1993.
Moderate tax cuts are followed by a flat economy.
This is a generalization from one example: Johnson in 1964.
Large tax cuts are followed by a boom, a bubble and a crash.
1929, 1987 and 2008 are examples.
These are covered in more detail in the first part of the article "Tax Cuts: The B.S. and the Facts."
Why do high taxes create a stronger economy?
I used to run a small business -- a commercial film production company.
Every time we took a dollar out as personal income, it instantly turned into 50 cents.
If we didn't really need the money, that was an incentive to keep it in the company and to find ways to spend it that took it out of the taxable profit column but increased the value of the company.
High taxes create an incentive to reinvest profits into long-term 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.
The higher taxes are (and from 1940 to 1964 the top rates were around 90 percent), the more this is true.
This creates a bias toward long-term planning.
If a business is planning for the long term, it wants a happy, stable work force. It becomes worthwhile to pay good wages and offer decent benefits.
Low taxes create an incentive for profit taking.
It is easy to confuse profitability with wealth creation.
They are not the same.
President Eisenhower built the interstate highway system. There is no doubt that this gave the country an asset of great value, one that was very productive. It created great "wealth." But, aside from the construction companies that contracted the work, it was not profitable.
Selling subprime mortgages, trading in derivatives, packaging mortgage-backed securities and "flipping" condos were all very profitable but did not create wealth.
The theory is that if the rich can keep their money, they will invest in businesses that create jobs, more businesses, more tax revenue and greater "wealth" for the nation.
That sounds like logic and common sense. But is it, in practice, what happened?
Once tax cutting began, the culture of business changed.
It was no longer enough for a business to be a reasonably good business, making steady, reliable profits.
Indeed, that became a very bad condition for a business to be in. It made it a target for takeovers by people who were willing to milk them of their profits.
Among the ways you can get more profit out of a going business are:
- Cutting the workforce -- possibly sacrificing long-term productivity
- Cutting salaries -- who cares if the employees are unhappy? The balance sheet improves.
- Selling off assets -- who cares what happens in 10 years? We can take the money now.
- Outsourcing -- which sends the "wealth" somewhere else.
A whole host of devices were developed to do all of the above: junk bonds, leveraged buyouts, hostile takeovers, greenmail and the like.
Lots of money could be made that way -- for a small number of individuals. But it doesn't produce "wealth."
An environment in which profit-taking is cheap creates the conditions for a bubble.
Once you've taken your profit, and you have the cash in hand, you look for a place where you can get profits quickly, then again and again. Instead of examining how sound a company is, how well it's run, its debt load and its long-term prospects, other things become important -- such as the speed at which you can profit and the ease of entry.
Instead of investing in business -- which is difficult, slow and complicated -- investors go into markets.
They look for sectors that are hot. When investors find such an area, they flock to it. It heats up even more. People are seen making money, quickly and easily, simply by buying and selling, and they don't want to miss out.
Then there's a bubble -- which is followed by a crash.
Proponents of tax cuts take the position that taxes take money out of the economy.
That's flat out not true.
Governments don't keep the money they collect; they spend it. It goes right back in. It just takes a different route. It goes to different places.
The places that government puts money are important. More to the point, they are important for business.
All infrastructure is an invisible subsidy for all business.
It's easy to understand this when we're talking about roads.
It doesn't matter if your business doesn't ship anything by truck or even by bicycle. The fact that you can get to your office quickly and easily, that your mailperson can get to you without traveling on the back of a mule, is a subsidy of your business.
It's a little harder to see that when we're talking about soft infrastructure.
Laws, regulations and their enforcement. Social Security, unemployment insurance, public health and welfare. Education, research, support of sports, arts and culture. Parks and playgrounds. All of them create a society that is safer, more stable, and more able to produce and consume. They produce a better place in which to do business.
Tax cutters also claim -- and I paraphrase the essence of the argument -- that the money government gets disappears in wasteful stupidities.
There's some truth in that.
They might point out all sorts of cultural and scientific projects, like a museum for the Woodstock Festival, counting the fish in Waldon Pond or studying the sex life of prairie dogs. I would point to the Star Wars missile defense shield, farm subsidies, the ethanol program, the privatized non-reconstruction of Iraq and all of Halliburton's contracts.
But it is also true that businesses spend money on all sorts of wasteful stupidities.
I am sitting here wondering how anyone -- in fact, a succession of people -- could run a company with the power and resources of General Motors into the ground.
In the mythological marketplace, they should fail and suffer for their faults. In the real world, the arrogant fools who ran the place will walk away with millions, and the hundreds of thousands of people who worked for them and their suppliers, who offered services and goods to those in turn, will be the ones who suffer.
The point is that relying on the magic of the marketplace is like relying on any other kind of magic.
There are things that are necessarily done for the common good.
Clean water, sewer systems, garbage collection and public health initiatives create a healthy population, able to work and consume. Take those away, and we return to the plague years. Imagine what that does to business.
Polluted air, toxins in the groundwater, viruses and bacteria jump the borders of even the wealthiest communities.
Bad health created by lack of care for the common good becomes an economic drain on society.
This is not to say that a full-out, state-run economy is better than capitalism. It's not.
That produces different problems that are even worse.
It is not even meant to imply that all "sound" investments in "real" businesses stopped with tax cuts. They didn't. Start-up money and venture capital were relatively easy to come by. Lots of new and good businesses were built in low-tax environments.
But low taxes produced great excesses of negative activity as well. There is a propensity in business, and as a nation, to hollow out our businesses, and mortgage and sell off our assets, in order to grab short-term profits.
A sound economy is based on a mix of market and government actions -- and a host of other factors as well.
These explanations are speculative, a search to explain what is observed in nature, if you will.
What is certain is that tax cuts on the top brackets, and in particular on unearned income, do not produce healthy economic growth. Contrary to all expectations, tax hikes seem to produce the desired growth. All the explanations in the world, funded by all the right-wing anti-tax think tanks in the world, won't change that reality. If these explanations don't suit you, then supply a better one that will.