Make Them Pay!

These critics don’t make the obvious complaint--that the tax increases would target high-value political contributors who are important to congressional Republicans and to Democrats who can’t depend on contributions from labor unions or liberal professionals. Instead, they focus their opposition on the economics of the proposal. The Republicans and Blue Dog Democrats, along with The Wall Street Journal, say it will hurt small business and discourage “entrepreneurial activity.” The Washington Post maintains that taxing the rich to pay for the health care program would deprive Congress of a revenue source it would need in the future to reduce the deficit.

These arguments make little sense. According to a study by the Center on Budget and Policy Priorities, very few small businesses would be affected. And small businesses that offer health insurance will see their costs reduced by the health plan. And as my colleague Jonathan Chait has pointed out, The Washington Post is arguing that we shouldn’t use an effective means for reducing future deficits to reduce future deficits. If you can figure out the reasoning there, you are smarter than I am.

But I want to take the argument a step further and address the Republican/Blue Dog argument that taxing the rich will--in the words of one clumsily written congressional letter--“kill the goose that will lay the golden eggs of our recovery.” I think it’s important to realize that during a recession, taxing the rich can speed a recovery as long as the revenue it creates is spent rather than saved. And during a recovery, taxing the rich can help stabilize the economy. It can be a good thing to do in either case.

If the Obama administration were to tax the rich, and then use the money to pay down the deficit, or keep it in the proverbial social security “lock box,” then taxing the rich would probably damage an economy in recession by reducing consumer demand--whether it is for necessities or luxuries. But if the administration were to take the revenue from a tax increase on the very rich and give it to the less well-to-do through government spending or a tax cut, then the result would be a net increase in consumer demand, because the less well-to-do are more likely to spend rather than save what they earn.

So the result of taking money from the wealthy and giving it to the middle class or the poor through government spending would be a net increase in consumer demand, and a boost to an economy in recession. The administration’s health care proposal would do this. It would create jobs and help many small businesses, which include physicians’ offices, pharmacies (if they are not part of nationwide chains), clinics, and a myriad of medical and hospital supply companies.

II. Taxing the rich won’t hurt investment

The Wall Street Journal editorial page has promoted the notion that the way to encourage growth is by putting more money into the hands of wealthy. By this reasoning, any proposal to tax the rich would threaten the economy. These arguments were made, of course, against the Clinton administration’s tax increases in 1993. But afterwards the country enjoyed an economic boom.

There is also, however, a theoretical point worth considering. If you look at economic recoveries during the 20th century, what you find is that they were often driven by increases in consumer demand (including residential housing) rather than by business demand for capital goods. The former eventually led to the latter. What was important in spurring recovery was government spending that made up for the decline in consumer demand.

If you look at the recovery that occurred in the middle of the 1930s and that was interrupted by Franklin Roosevelt’s budget balancing in 1937, and then resumed again, you can find a better model of what could occur now. As historian James Livingston has noted, the gross domestic product fell steadily from 1929 to 1933, but then began to rise rapidly from 1933 to 1937. It fell from 1937 to 1938, but resumed its rise through the war.

Yet during this entire period, net non-residential private investment (new business investments that don’t include replacing old plant and equipment) remained little above the levels of 1929 to 1933. For instance, it had plummeted from $4.1 billion in 1929 to $1.9 billion in 1930, but it was still floundering at $100 million in 1939, even though growth and employment were on the rise. Net investment didn’t reach the level of 1929 until 1946. What spurred the recovery was the growth in government investment and in consumer demand. The recovery was demand-driven, not supply-driven.

It’s likely that we are in a similar position today. Supply-side policies aimed at encouraging business investment through lowering interest rates on loans or through cutting taxes on the wealthy or on business are not likely to create the basis for a recovery. Just look at the effect so far of near-zero interest rates. What is needed is government spending that increases consumer demand and convinces entrepreneurs (big and small) that there are hungry consumers out there who want to buy golden eggs.

Raising taxes on the rich won’t stimulate investment by itself. That’s for sure. But in the present situation, it is not likely to depress it. And the combination of a tax increase on the rich and spending increases aimed at the middle class will increase consumer demand and eventually investment.

III. Taxing the rich can stabilize the economy

Of course, the tax increases in the House bill won’t take effect until 2011. By then, one hopes that the economy is in full recovery. If so, these tax increases can have another important effect. They can reduce, if only slightly or moderately, the wide disparities in wealth and income that have plagued the United States periodically over the last 100 years. These disparities in wealth have been an important cause of economic instability.

This is what has happened. When national income has gone disproportionately to the wealthy, that has encouraged saving at the expense of consumer demand. As long as these savings have been invested productively, the economy has moved ahead--but once outlets for productive investment have lagged, the disparities in income have not only aggravated an insufficiency of demand for goods and services, but have also laid the basis for financial bubbles. That’s because in the absence of opportunities in the real economy, income from the rich has been diverted into speculation. When these bubbles have burst, we’ve had a financial crisis.

Look at this graph showing the rise and fall of income disparity:

If you look at the rise and fall of wealth distribution, you’ll notice that the period of the greatest increase in disparity occurred from 1925 to 1929 and then, with an interruption from 1998 to 2000, from about 1994 to the present. The graph ended in 2003, but here is a rendering for the next two years:

In other words, the sharp rise in income disparity preceded a financial crash and steep economic downturn. What you also see from the first graph is that the period of the least disparity--from the middle of World War II to the late 1970s--was associated with the era of steadiest prosperity. A proposal that would reduce these income disparities by taxing the very rich has merit because it would address a major cause of destabilization.

Let me finish here by addressing a few potential straw men. I am not saying that it’s a good thing in all cases to raise taxes on the rich. If the rich are “just like us”--that is, if there weren’t the kind of huge disparities that have existed in the United States in the 1920s or since the early 1980s--then it would be less useful economically to target the rich for a tax increase. Or if a tax increase on the rich were not combined with a spending increase or with a tax cut on the less well-to-do, then taxing the rich right now could further depress the economy. But the proposal for a tax increase is aimed at the very rich and is being tied to a spending increase.

I am also not defending a confiscatory tax that would level incomes. According to a study by the Urban Institute and the Brookings Institution, the surcharge in the House proposal, combined with the Obama administration’s proposal to let the Bush tax cuts expire, would lead to the top one percent of households paying a 34.4 percent tax rate on their incomes, which is well below the tax rate that the top one percent paid during the golden days of American capitalism after World War II.

And finally, I am not saying that the Democrats can win or lose votes by taxing the rich. I am somewhat skeptical about how politically effective these kind of proposals are. (See the experience of New Jersey Governor Jim Florio in 1990.) Americans don’t tend to resent the rich; they resent people whom they believe have gained their wealth dishonestly or fraudulently or without working. I am advocating taxing the rich as a measure of good economics rather than good politics. And the House health care proposal, whatever its political merit, is good economics.

By John B. Judis