Friday, January 08, 2010

Wealth and Income Distribution

Now let’s talk about the other shoe. If the Budget Crisis (and it is a crisis) is the first shoe of impending calamity, then the current wealth and income distribution disparity is the second shoe.

At the root of the issue is the idea of “Supply-side” economics. The Supply-side theories say that cutting taxes for the wealthiest portion of the population, those most likely to make money available for capital investment, will stimulate the economy through the growth of production which will in turn spur additional production. This will lead to more jobs and a healthy and growing economy which in turn will eventually lead to an increase in tax revenues.

In other words you get a double bonus. By cutting taxes you stimulate the economy and increase tax revenues. This of course assumes that the economy is either on the down side of the Laffer curve or pretty close.

The Laffer curve plots government revenue against tax rate. Clearly if the tax rate is 0%, government revenues are $0. But just as clearly if the tax rate is 100%, government revenues will also be $0 because no one would bother to work and the entire economy would collapse.

Therefore there must exist some optimal tax rate that will maximize government revenue and if the tax rate ever exceeds that rate, government revenues will actually decline when you raise taxes.

According to the Supply-siders, the US tax rates were beyond the optimal tax rate in the late 1970’s so reducing taxes would both stimulate investment and increase government revenues. It didn’t quite work out that way when Reagan tried it in the 1980’s nor did it work out that way when Bush tried it in the early 2000’s. When Clinton went against the Supply-side theory and raised taxes government revenues increased and none of the dire predictions of economic recession occurred.

All of the empirical evidence indicates that daddy George H.W. Bush was absolutely correct when he called the Supply-side theories “Voodoo Economics.” Yet, incredibly, most Republicans, and virtually all conservatives, continue to pound the Supply-side drum.

Most economists agree that supply theories probably aren’t correct. Personally I believe the problem is with the shape of the Laffer curve. For illustration purposes it’s usually shown as a symmetrical curve with the optimal point near the center. In reality I suspect it’s an extremely non-symmetrical curve with the optimal point way out near the 90% or 95% area especially when one is talking about a progressive tax structure with only the marginal tax rate that high.

One unintended effect, or at least I think it was unintended, of the Supply-side tax cuts appears to have been to cause a sort of reverse wealth redistribution. An anti-socialism if you will which took income from the lower income brackets and gave it to the upper income brackets.

The web site of Professor G. William Domhoff of the University of California at Santa Clara, called “Who Rules America?,” provides some fascinating data from a variety of sources which I quote below.

A New York Times analysis of an Internal Revenue Service report on income in 2004 concluded that overall income had grown by 27% since 1979. Unfortunately only the top 5% made any significant gains with income growing by 53%. The bottom 60% of the population was actually making less! Their income had gone down by 5%.

In 1982 the top 1% received 12.8% of the income; the next 19%, the professional and small business class, received 39.1% of the income and the bottom 80%, the working class, received 48.1% of the income.

By 2006 these numbers had shifted dramatically. Now the top 1% received 21.3% of the income, the next 19% received 40.1% and bottom 80% received only 38.6%.

Let’s take a look at CEO compensation between 1990 and 2005. In real terms, in other words adjusted for inflation, the income of CEOs has increased by 298%. That means it has just about quadrupled.

In the same time frame the income of production workers has risen a modest 4.3%. The Federal Minimum wage actually DECLINED in real terms by 9.3%. In other words it didn’t even keep up with inflation.

If you’re thinking, ok, but think about all the profits and wealth this new brand of exciting CEO has brought to the economy, forget it. Corporate profits only rose 106% and the S&P 500 only 141%.

Now think about this for a second. Corporate profits went up 106%. But the CEO gets a 298% increase and the guys actually producing the product only a 4.3% increase. Whatever is left over goes to capital gains for the folks that got the tax cuts and invested their excess income. People at the lowest rung of the economic ladder, those making minimum wage, actually get a decrease and effectively contribute to the gains for everyone else.

Marx was wrong because he didn’t take into account the emergence of a large and strong middle class. At least that was always the simplified stock answer when I studied economics. However the redistribution of income from the lower and middle income brackets to the upper income brackets is effectively squeezing out the middle class and creating precisely the sort of gap that Marx predicted.

We need to get both this reverse income redistribution and the budget deficit under control. The way you do this is to reverse the policies of the Reagan and Bush eras. Raise taxes significantly on the upper income brackets by introducing new brackets over $372,000 with significantly higher rates than 35%. Income over $1 million should probably be in the 50% range and income over $5 million in the 75% range. It’s probably not a good idea to go higher than 75%.

The danger here of course is stifling small business by drying up the available capital. Small businesses aren’t supplying $1 million plus incomes to anyone. If a business is providing that kind of income, it’s not a small business. Small businesses are lucky if they have that kind of revenue so the taxation itself probably isn’t an issue. Making it harder to get working capital when it’s needed could be though and this has to be taken into consideration when establishing the new brackets and some mitigation strategy, perhaps a small business loan exchange, has to be established.

Certainly we should expect a period of stagnation or at best limited growth. What has to be guarded against is sending the economy into a tailspin and a deep recession. The trick is to manage expectations and get the American public to recognize that we’ve been living beyond our means for too long and we need to get things under control.

Ok, I may not be an expert but it’s clear we need to change the direction we’re going in. To continue to do the same thing while expecting different results is a pretty good definition of insanity. We have to start by stopping the bleeding and balancing the Federal budget. Then we can start chipping away at the debt.

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