Will President Obama Have to Soak the Middle Class?

Both men knew "where the money is."

An article last Monday in the Wall Street Journal "[w]here the tax money is" examined President Obama's purported claim that raising taxes on the wealthy will result in meaningful deficit reduction, thereby making the sort of spending reductions proposed by others, including Congressman Paul Ryan of Wisconsin, unnecessary. To this end, the article calculates the impact on federal revenue and thus the deficit of a 100 percent confiscatory tax on indivduals who earn $380,000 or more per year and finds that such a tax would raise $938 billion annually, far less than the current deficit of over $1.6 trillion. Moreover, a 100 percent tax on those individuals in the top five percent of the income distribution would yield $1.89 trillion, just enough to cover the deficit.

Note that these calculations certainly overstate the impact on the deficit of such confiscatory taxation. For one thing, the "wealthy" individuals in question already pay a sizeable portion of their income in taxes, with the result that the net increase in revenue resulting from a 100 percent tax rate would be less than the $938 billion and $1.6 trillion figures, respectively. Moreover, at least some individuals who must pay their entire salary to the government would work less, or not work at all, and thus create less income, if the government simply confiscated their income under the guise of "taxation." Such a reduction in work effort, of course, will also reduce the rate of economic growth and thus reduce the income of other citizens as well, thereby reducing tax payments from lower income groups. In short, even a 100 percent tax rate on high income earners, whether "high income" is defined as the top 1 percent or top 5 percent, defined, will still leave the United States with a very large deficit.

How, then, will the United States close its titanic budget deficit, if that is what she chooses to do? One way, of course, is to reduce spending, along the lines suggested by Congressman Ryan. If, however, the United States rejects meaningful spending reductions, the article predicts that Congress will, to quote bank robber Willie Sutton (pictured above), "go where the money is," that is, raise taxes (either directly, or by eliminating deductions) on indivduals in the middle and upper middle classes. For, as the article points out, individuals in the $50,000-$200,000 range produce more taxable income than individuals who earn over $200,000. Such an approach, it should be noted, would be consistent with the observation of nobel laureate Friedrich Hayek, also pictured above, to the effect that a chief function of high (progressive) tax rates on "the rich" is to induce individuals in the middle classes to accept rates that, while high in an absolute sense, are lower than those paid by the rich. (There is, of course, precedent for such an approach. In 1960, for instance, the top marginal federal income tax rate, levied on incomes of $400,000 and above, was 91 percent. Moreover, the marginal rate on income between $12,000 and $16,000 was 30 percent; the marginal rate on income between $24,000 and $28,000 was 43 percent, the marginal rate on incomes between $36,000 and $40,000 was 53 percent, the marginal rate on incomes between $88,000 and $100,000 was 72 percent, and so on. It short, while rates on the "rich" were quite high, so too were rates on individuals in the middle and upper-middle classes.) As Hayek put it:

"It would probably be true, on the other hand, to say that the illusion that by means of progressive taxation the burden can be shifted substantially onto the shoulders of the wealthy has been the chief reason why taxation has increased as fast as it has done and that, under the influence of this illusion, the masses have come to accept a much heavier load than they would have done otherwise. The only major result of the policy has been the severe limitation of the incomes that could be earned by the most successful and thereby gratification of the envy of the less-well-off."

See F.A. Hayek, "Taxation and Redistribution," in The Constitution of Liberty (1960).

Instead of simply redistributing income from rich to the middle class, such an approach would presumably also redistribute income within the middle class.

Hopefully the nation will opt for reduced spending instead of the Sutton approach.

More Centralization/President Obama to Hit Non-Profits and Universities?

Michael Barone has amplified a recent report in the Wall Street Journal that the Obama Administration will propose additional tax surcharges on society's most productive members, over and above the higher tax rates he proposed during the campaign. To be precise, the new Obama plan would limit deductions for charitable giving and mortgage interest for individuals in the 33, 35 and 39.6 percent tax brackets. Such individuals could only deduct 28 percent of the value of such payments from their tax liability, instead of 33, 35 or 39.6 percent, as the case may be. As Barone notes in a blog post at U.S. News and World Report, the result of this change would be to divert Billions of dollars from the private charitable sector (including Universities and, I might add, hospitals) to the coffers of the National Government. Barone also explains that this change will tend to undermine one of America's great strengths --- a decentralized system of charitable giving and education, with neither government nor private entities dominating the other.

Barone's argument for decentralization reminds me of a famous judicial opinion that justified so-called "Corporate Social Responsibility," A.P. Smith Manufacturing Company vs. Barlow, 90 A.2d 581 (New Jersey 1953). There several shareholders challenged the corporation's gift of $1,500 to Princeton University. The New Jersey Supreme Court rejected the challenge, holding that, absent countervailing language in the corporate charter, a firm's directors were free to make such gifts. The opinion rested in part on testimony by former executives in other firms, including U.S. Steel, to the effect that corportate support for independent centers of learning helped create the conditions necessary for a thriving free society.

"Mr. Irving S. Olds, former Chairman of the Board of US Steel, opined that . . . . 'Capitalism and free enterprise owe their survival in no small degree to the existence of our private, independent universities' and that if American business does not aid in their maintenance it is not 'properly protecting the long-range interest of its stockholders, its employees and its customers.' Similarly, Dr. Harold W. Dodds, President of Princeton University, suggested that if private institutions of higher learning were replaced by governmental institutions our society would be vastly different and private enterprise in other fields would fade out rather promptly. Further on he stated that 'democratic society will not long endure if it does not nourish within itself strong centers of non-governmental fountains of knowledge, opinions of all sorts not governmentally or politically originated. If the time comes when all these centers are absorbed into government, then freedom as we know it, I submit, is at an end.'"

Let's hope that Congress rejects this proposal, and not simply because our most productive citizens already pay enough in taxes !

Robert Reich's Economic Goofiness

Robert Reich is back at it, praising the President's budget for raising taxes on the most productive members of society and transferring the proceeds to those who work hard but nonetheless produce less. Here is an excerpt from Reich's praise, offered on February 26:

"It's about time a presidential budget uneqivocally redistributed income from the very rich to the middle class and poor. The incomes of the top 1 percent have soared for thirty years while median wages have slowed or declined in real terms. As economists Thomas Piketty and Emanuel Saez have shown, in the 1970s the top-earning 1 percent of Americans took home 8 percent of total income; as recently as 1980 they took home 9 percent. After that, total income became more and more concentrated at the top. By 2007, the top 1 percent took home over 22 percent. Meanwhile, even as their incomes dramatically increased, the total federal tax rates paid by the top 1 percent dropped. According to the Congressional Budget Office, the top 1 percent paid a total federal tax rate of 37 percent three decades ago; now it's paying 31 percent.

Fairness is at stake but so is the economy as a whole. This Mini Depression is partly the result of a widening gap between what Americans can afford to buy and what Americans when fully employed can produce. And that gap is in no small measure due to the widening gap in incomes, since the rich don't devote nearly as large a portion of their incomes to buying things than middle and lower-income people. The rich, after all, already have most of what they want."  (emphasis added)

Let's think for a moment about the highlighted language. Reich tells us that we are in a "mini-Depression." Really? Our unemployment rate is less than 8 percent. How is that a "mini-Depression?" Are Italy and Germany, which always seem to have rates above 8 percent, in a constant state of (mini) Depression? If they are, should we really be adopting economic policies along the lines of the high tax and high regulation models of these countries ?  Hmmmmm.

What, though, about Reich's diagnosis of the cause of the current economic contraction, which he attributes to "the widening gap between what Americans can afford to buy and what Americans when fully employed can produce." This gap, he says, is the result of "the widening gap in incomes, since the rich don't devote nearly as large a portion of their incomes to buying things than [sic] lower income people." The remedy, then, is to raise taxes on the rich and ship the money to the non-rich, thereby narrowing the gap between what (some) Americans want and what they can afford to buy.

This is, for lack of a better word, goofy. It is certainly true, as I have pointed out earlier, that many Americans are consuming or trying to consume more than they produce. Indeed, here is what I said on January 29th of this year.

"When economic historians write the history of this past couple of decades, they will likely conclude that Americans lived high on the hog, consuming far more than we produced, with the gap financed by borrowing from China, Japan and the Middle East, who purchased government securities and bonds backed by mortgages and credit card receivables. The only way to reverse this trend is to reduce our consumption significantly (and unlikely scenario) or increase our productivity significantly."

It is incorrect, however, to attribute low or stagnant productivity in the middle class to a "widening gap in incomes" between rich and poor. For one thing, Reich has the causation exactly backwards. In a free society, income and thus income gaps are determined by relative productivity gains, and not vice versa. Moreover, additional productivity, and thus higher incomes, among those in the upper income brackets does not magically reduce or even slow the actual productivity of those in the middle or lower classes. (In the same way, reduced or stagnant middle class productivity does not increase the productivity of those in the upper brackets.) To take a simple example, when Apple and Steve Jobs invented and marketed the I-Phone, reaping tremendous profits for their efforts, they did not thereby REDUCE the productivity of barbers, autoworkers, airline mechanics and other hard-working Americans in the middle class. If anything, one might expect such increased productivity among the wealthy to increase the productivity of the middle class as well. For instance, by inventing the Windows Operating System and facilitating its distribution, Microsoft (and its shareholders) enhanced the productivity of millions of American workers, who previously relied on electric typewriters, hand-held calculators and the postal service !

What, though, about Reich's apparently separate claim that "the rich" already have most of what they want, and thus will spend a smaller proportion of their income than those in the middle and lower classes ? This is simply a replay of the old Keynesian theory of "secular stagnation," which predicted that, as societies became wealthier, average consumption as a percentage of national income would continually fall, as a more affluent citizenry would enjoy so many material comforts that individuals would be less inclined to spend their incremental income of consumption. As a result, it was said, government should tax the more affluent and spend the proceeds, thereby lowering the national savings rate and stimulating aggregate demand. The theory fell out of favor in the late 1940s and 1950s, as the economy grew despite massive reductions in the federal spending as a percentage of GDP compared to the period of 1941-1945.

There are a couple of things wrong with Reich's invocation of this theory in this context. First, the theory does not support or depend on Reich's claim that increased affluence for some reduces or stifles the productivity of others. On the contrary, individuals who consume less save more, and such savings will, over the medium and longer run, find its way into productivity-enhancing investments in plant and equipment, education, research and development, etc. Second, Reich's claim that we are in a period of secular stagnation assumes that current year incomes are a good proxy for the sort of permanent income that actually determines consumption. If, on the other hand, there is a high variance between annual and permanent incomes, then a snapshot of annual income data cannot tell us whether we have entered such a period. Third, the theory of secular stagnation would seem to predict that more affluent nations like the United States would have ever increasing rates of unemployment, unless offset by ever rising government spending, measured as a share of GDP. On the contrary, however, real per capita income has risen significantly over the past three decades, while government spending as a share of GDP has been relatively flat. Fourth and finally, if the rich have all that they want, why are they working so hard to earn so much income ?

To sum up, Reich's claim that increasing incomes for the rich has reduced or stultified the productivity of those in the middle class is nonsense. Moreover, the evidence does not support his "secular stagnation" thesis. Higher taxes on the more productive members of society will have to be justified in some other way.