The case for taxing the very rich

Our economic recovery will be slow because middle income taxpayers cannot generate the consumer demand necessary to get the economy moving quickly. This is the result of a shift in wealth from middle-income taxpayers to the very rich since the Reagan era, coupled with the high and increasing unemployment rate. The federal government will have to spend about $760 billion more to return the economy to full employment. That cannot be done, however, without increasing the federal deficit, unless the stimulus is accompanied by tax increases on those most able to bear them without significantly impairing spending — that is, the very rich.

 

The efficient market theory, which held our government and economy hostage for several decades, assumed the market would correct itself without government interference. This theory enabled financial institutions to take on far too much risk — risk that was ignored, if not encouraged, by government officials, who were among the efficient market faithful. There were no worries because the efficient market theory precludes the notion of systemic market collapse.

 

Thus, when faced with a possible systemic collapse of the financial industry, the Bush administration was forced to look beyond its guiding theory for a solution. Both the Bush and Obama administrations chose to throw money at financial institutions, hoping to avoid a liquidity and solvency crisis and get credit flowing again. Whether this rescue is Keynesian or not, the near collapse of Wall Street — indeed the very fear of its imminent demise—might be viewed as the obituary of the efficient market theory. That theory is now dead, buried by one of its grandmasters, Alan Greenspan, who not only admitted ideological failure, but who also now supports enhanced regulatory oversight of the financial products that he once believed reduced rather than created risks of an overleveraged economy.

 

For Keynes, the way out of depressions or recessions did not depend on unfreezing bank credit, although he would have supported such an effort. The essence of Keynes’s theory was to substitute the government for the consumer as the driver of demand for goods and services. Put simply, this means public works projects, which, by increasing employment, have multiplier effects in the creation of demand for goods and services.

 

The stimulus package enacted earlier this year was undeniably a Keynesian solution. Unfortunately, the legislation did not generate as much demand as it should have because, to attract Republican support (which did not materialize), at least one-third of the cost was in the form of tax rebates. Most economists agree that those tax rebates didn’t generate much spending because middle income taxpayers used them to pay down debts or to save. According to Keynes, we should be funding infrastructure projects that will create more jobs and demand for goods and services and will make our economy more efficient. Even if Congress did that, however, our economy would still recover slowly because middle income taxpayers have lost so much economic ground to the very rich over the last few decades.

 

Statistics indicate the magnitude of the income shift to the very rich. In 2007 Lawrence Summers, now the director of the National Economic Council, pointed out that, based on Congressional Budget Office data, income distribution since 1979 had raised the pretax incomes of the top 1 percent of the population by $664 billion or $600,000 per family — an increase of 43 percent. Lower incomefamilies were thus $664 billion poorer and suffered a 14 percent loss in family income. In 1980 the top 10 percent of families received about one-third of all income, but by 2007 the top 10 percent of families received almost half of the nation’s total income. To put it another way, between 1980 and 2007 the income of the top 5 percent of the population increased by 63 percent, while the income of the bottom 90 percent increased by less than 9 percent. And the gap widened rapidly. Between 1993 and 2007, 50 percent of the income growth in the nation was enjoyed by the top 1 percent, but between 2002 and 2007 those elite individuals were the beneficiaries of almost two-thirds of the entire income growth in the nation.

 

During that time, middle-income taxpayers maintained their spending by borrowing, primarily against the value of their homes. Between 2000 and 2007, U.S. households doubled their outstanding debt to $13.8 trillion, faster than the growth of their income, spending, or our GDP. Over the same period of time, the ratio of debt to disposable income grew from 101 percent to 138 percent, as much in 7 years as in the previous 25 years. Rising household spending served as the main engine of economic growth. From 2000 to 2007, annual personal consumption grew by 44 percent from $6.9 trillion to $9.9 trillion, or 77 percent of real GDP growth. From 2003 to the third quarter of 2008, homeowners borrowed $2.3 trillion against the value of their homes. Of that amount, $897 billion (an amount larger than the stimulus package) went directly to consumption, and the remaining 60 percent was used to pay down credit card debt and other liabilities.

 

Now that the housing market has crashed, middle income taxpayers, faced with high unemployment, are saving more and spending less. This has serious consequences for our economic recovery since the 50 percent of the population in the middle-income range is responsible for the same amount of consumption as the top 10 percent, while the 40 percent of the population considered low-income is responsible for only 12 percent of total consumption. This disparity is exacerbated by the fact that 90 percent of the population holds 50 percent or more of its assets in residential real estate which is increasingly at risk. Between July and September, more than 925,000 borrowers received foreclosure filings and 1 in 10 homeowners are a month or more behind in their payments. Thus, 90 percent of the population feels even more insecure as it sees the bulk of its assets deflating or being lost.

 

The Keynesian solution to this problem requires significantly more government spending focused on creating jobs to lower the unemployment rate and increase demand. Because state governments are almost all facing financial crises, the spending will have to be done by the federal government. However, we cannot continue to increase our deficit without serious adverse economic and political consequences. The solution, unpopular as it may be, is to increase taxes on the rich by closing loopholes and increasing rates. Hedge fund managers should no longer be allowed to pretend that their profits are earned in the Cayman Islands and that they don’t owe taxes on them until they repatriate them. Multinational corporations should no longer be allowed to use transfer pricing to avoid taxes by shifting their profits to low-tax countries and thereby increase their competitive advantage over domestic companies. We should revisit the question whether income from capital should be taxed at a lower rate than income from labor. Indeed, this would be an opportune time to simplify our tax code by eliminating subsidies. That would allow us to lower tax rates for most people and increase our revenue.

 

While the answers to our economic problems seem clear, it is not apparent that the political will to solve them exists. The Washington Post recently reported that after President Obama announced a financial regulatory reform plan that might cap corporate compensation, the Democrats suffered a decline in fundraising from those who contributed $10,000 or more. Whether rich campaign contributors can head off reform will say a lot about whether members of Congress are more interested in politics or governing and whether the media has done enough to alert the public about what is going on.