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Rein in the Rich: How Higher Taxes Could Lift the Economy

As the negotiations over the fiscal cliff continue, President Barack Obama has insisted on retaining the Bush tax cuts for the middle class, while letting the cuts for the wealthy lapse. Republicans have insisted that raising taxes on the rich would cost jobs – as many as 700,000, according to House Speaker John Boehner.

Obama, for his part, says that a tax increase would not cost jobs; that it would help the economy by reducing the deficit; and that it would be fairer than imposing new taxes on the middle class. “I’m not going to ask students and seniors and middle-class families to pay down the deficit while people like me who make more than $250,000 are not asked to pay a dime more in taxes,” he has declared.

Obama is right that a tax increase on the rich would not cost jobs; and he is certainly right that it would be fairer to tax the wealthy whose incomes have shot up, even during the downturn. And he is also correct that taxing the rich will actually benefit the economy--but not primarily for the reasons he cites. If the government extracts income from the wealthy, and then spends it on a $50 billion infrastructure program, an extension of unemployment insurance, and a Social Security payroll tax cut, as Obama has proposed, that will not only boost the recovery, but will also discourage the wealthy from rerouting their savings into the kind of speculative activity that helped create the Great Recession. A closer approximation of income equality is not only better for our souls—it’s also better for the economy. The question of fairness aside, the rich have been making relatively too much money for the country’s good.

Last September, the Congressional Research Service published a report countering Republican claims that lowering top tax rates would lead, or had led, to higher economic growth. “Changes over the past 65 years in the top marginal rate and the top capital gains tax rate do not appear correlated with economic growth,” the report concluded. Republican Minority Leader Mitch McConnell responded by having the report suppressed, but its findings were incontrovertible.   

The CRS rested its findings, however, on the lack of a correlation between marginal tax on the wealthy and growth. It didn’t try to explain why higher rates might have contributed to faster growth, and lower rates to slower growth, and even recessions. This view remains highly controversial today, even among liberals, but during the 1930s many New Dealers took this position. Recently, Rutgers economic historian James Livingston has reasserted it in an excellent book, Against Thrift. There is a weaker and a stronger version of the argument.

The weaker argument goes like this: The modern American economy is driven by consumer demand; the consumer sector, which includes services, is where new jobs emerge, and where growth is spurred. During economic downturns, purchases of consumer durables, including automobiles and new houses (which economists technically label investment), have been most likely to ignite a recovery. The lower a person’s income, the more likely he or she will use additional income to consume goods and services; the higher the income, the more likely it will be saved. In Keynesian terms, middle and lower income taxpayers have a much high marginal propensity to consume. Therefore, it makes much more sense to give them rather than the wealthy a tax break.

The weaker argument shows that it is better in a faltering economy to reduce tax rates on the less wealthy than the wealthy. The stronger argument shows that with incomes soaring in the upper brackets, it is a good idea to raise tax rates on the wealthy. This idea comes from historical evidence showing that today’s economy differs from that of the older pre-Great Depression industrial economy.

In the first period of American industrialization -- roughly from the Civil War through the mid-1920s -- the economy was driven by the production of capital goods, from steel and petroleum to machine tools and threshers. More workers became engaged in producing these goods than in manufacturing consumer goods. In countries that are rapidly industrializing in this manner – think of China today – both workers and owners have to sacrifice their consumption in order to provide consumer goods for the growing number of workers who are making capital goods that they cannot consume.

But sometime in the 1920s, these relationships were inverted. In 1890, consumer purchases accounted for about 36 percent of GDP; in 1925, 40 percent. (Similarly in China today, consumption accounts for only about a third of GDP and investment for half.) But in the United States today, consumer purchases account for about 70 percent of GDP, and investment for only 15 or 20 percent. And the growth of consumption at the expense of investment hasn’t entailed any decline in output, including that of capital goods.  

Due to modern technology –  from electrification to the computer and the Internet – and to the increasingly sophisticated organization of work, it has become possible to produce more goods without a net increase in workers and capital. The output of capital and consumer goods has continued to grow, but most of the increase in the labor force over the last eighty years has been in government and services. From 1990 to 2008 (before the recession), the United States lost almost a million jobs in capital goods production.  

As a result, the consumer sector no longer has to sacrifice its output and income in order to fund a capital goods sector that is growing more rapidly than it is. And instead of the economy being driven by the demand for capital goods, it is driven by the demand for consumer goods and services. The danger in the older economy was conspicuous consumption by capitalists and growing wage demands from workers, which threatened the funds available for investment in capital goods. The looming danger in the new economy in the failure of capitalists to consume or invest and the failure of workers, crippled by debt, unemployment or falling wages, to consume.

Government economic policy has to be, or at least should be, very different in this economy. It should not consist of giving tax breaks to the middle class and the wealthy, but of redistributing income downward--whether through tax policy, social programs, or labor regulations. If it doesn’t do that, or worse still, if it acts as if it were 1925 and encourages a growing gap between the rich and everyone else, it will threaten consumer demand. During the Coolidge and Hoover administrations, the top one percent increased their share of total income by 19 percent. And that happened, too, in George W. Bush’s administration. Such policies not only slow a recovery, but spur a slowdown by putting money in the wrong hands.

Regressive policies can also lead to financial crises. When firms suffer from global overcapacity or merely from domestic overproduction – when a glut arises of automobiles, ships, textiles semiconductors or fiber optic cable -- as happened in the late 1920s and again in the earlier part of the last decade, the wealthy, joined by corporate treasurers and bankers, have tended to pour their money into speculation rather than productive investment. The financial sector has become a casino for the rich, where they have gambled away funds that could have fueled the economy. So redistributing income through tax policy isn’t just fair; it is one way to began restructuring the economy to prevent future slowdowns and crashes.  

Republican pleas to retain tax breaks for the wealthy and corporations and to eviscerate social programs do suggest a Romneyesque indifference to the 99 percent; they also presume an economy that no longer exists. “These incentives,” Livingston writes, “are merely invitations to inflate speculative bubbles.” Obama’s concession to arguments about the deficit, which come from Tea Party Republicans and business groups like Fix the Debt,  is understandable, but unfortunate. There will come a time -- when unemployment dips, say, below six percent, and the countries’ businesses are at full capacity – when it will be important to reduce government deficits. And raising marginal taxes on the wealthy will be one way – along with other measures – to bring the deficit down.   

But bringing down the deficit should not be the principal objective right now. What’s important is to continue the recovery from the Great Recession and to take measures to prevent future crises. Supply-siders were right about one thing: the best way to reduce the government deficit is to create economic growth. Obama’s proposal to raise taxes on the wealthy and to transfer those revenues to workers and the unemployed isn’t just the fair thing to do; it is exactly what’s right for the economy.