Sunday 12 February 2017

Do tax cuts for the rich help or harm the economy? It depends!

A frequent source of public policy confusion is the issue of whether corporate tax cuts/tax cuts for the rich (the two are similar but not quite the same) help or harm the economy. The issue is also of increased relevance at present given Trump’s pledge to significantly cut US corporate tax rates.

The typical argument from conservative republicans and neo-classical economists in favour of tax cuts for the wealthy is that they boost the economy by providing increased resources to finance investment. Higher investment, in turn, helps the economy and creates jobs. A virtuous circle is kicked off, with the lower economic tiers of society benefitting via the so called ‘trickle down’ effect.

On the other side of the spectrum, you have something akin to the argument expressed by Nick Hanauer in the link below – that rich people don’t create jobs, only customers. So who is right?

The answer - as is usually the case with complex issues of policy and economics - is that it depends. Nuance is important here, and unfortunately such nuance is too seldom found in the debate. In some cases tax cuts for corporates and the wealthy will help the economy, but in other cases they will harm the economy. And at the present time, the latter is more likely true than the former.

There was an excellent book written some years by Eliyago M. Goldratt called The Goal, that introduced the ‘theory of constraints’. The argument expressed in the book is that to improve the efficiency of any manufacturing product line, the best approach is to figure out where the largest bottleneck or constraint to faster or more cost effective production is, and then focus resources on addressing that issue. A framework somewhat akin to that is useful when considering how to redress economic woes – what is the main constraint holding back the economy at present?

There are two basic sub-optimal economic environments that can prevail – one of supply-side constraints, and one of demand-side constraints. In the former environment, there is plenty of demand, but there is not enough investment or supply-side capacity to meet that demand. This is usually an inflationary environment with high interest rates, reflecting a scarcity of both goods & services and capital. The latter environment is one where you already have more than enough supply-side capacity to meet existing demand, but a lack of demand is holding back growth. Corporates will not invest and hire people, after all, if capacity utilization is already low - why should they? This is usually an environment of low inflation/deflation and low interest rates. In an ideal world, both demand and supply would be in balance and growing nicely along side one another – a ‘goldilocks economy’ – but in the real world, things are seldom in perfect balance.

In a supply-constrained economy, tax cuts will indeed boost the economy and job growth. In such an environment, the cost of borrowing is high and corporates do not have enough capital to finance the investments they would like to undertake. Relieving this constraint by increasing resources for investment is the right policy prescription, and tax cuts for corporates/the rich, who tend to save a high proportion of their income, will certainly help in that regard. Investment will rise; inflation will come down as capacity constraints ease; and job growth will be robust. Furthermore, a larger tax base as the economy grows will offset lower percentage tax rates for government income, in typical 'Laffer curve' fashion. Everyone wins.

A supply-constrained economy is the environment that existed in the late 1970s. Inflation was high; interest rates were in the double digits; tax rates were extremely high - often above 50% at higher brackets; and labour markets were highly inflexible and excessively unionised. Dissatisfaction with the stagflationary status quo resulted in right wing conservative governments being elected – think Reagan and Thatcher – who proceeded to implement supply-side reforms via deregulation and tax cuts. The economy subsequently did well and inflation fell. This experience reinforced the ‘republican consensus’ that supply side reform is always good and needed.

The problem is that that policy prescription only makes sense in a supply-constrained environment, and there is an alternative economic ill that can prevail – one of inadequate demand. And if supply-side policies are pursued to address demand-side problems, such policies will not only fail to solve the problem, but will likely actually actively worsen the situation. Republicans and other conservative economists do not seem to understand this, and it is dangerous.

A demand-deficient environment is one that is usually caused by Keynes’ famous ‘paradox of thrift’. For any one individual, saving is a good and prudent thing. But in the aggregate, excessive system savings are destabilising and can be a total disaster. When someone saves instead of spends, they withdraw demand from the system and deprive somebody else of income. Increased savings is not a problem if there is a ready need to borrow and invest those saved funds – system demand is sustained – but if such a need is lacking, left unchecked, excessive savings can trigger a downward spiral into a deflationary depression. This is pretty much the dynamic that led to the Great Depression, as fiscal support - the only thing that can act as a 'circuit breaker' - was not forthcoming until FDR's 1933's New Deal. The same process was also set in motion after the 'Great Recession' in 2008, but fortunately Western governments ramped up fiscal deficits swiftly, moderating the pain (except in Southern Europe where mandatory EU fiscal deficit caps forced these countries into depression).

Inequality of wealth and income is a large potential cause of excessive savings. Wealthy people tend to only spend a small percentage of their income - i.e. they 'save too much' - whereas low to middle income earners tend to spend most of their income and 'save too little'. Rising inequality is therefore associated with rising excesses of system savings which, if left unchecked, will eventually crash the system.

Traditional economists do not understand this because traditional economics is based on the fundamental principal of perpetual scarcity. The choke point in economic growth is always assumed to be a lack of supply, not a lack of demand, and that presumed perpetual scarcity extends to the availability of capital. However, in the real world, it is entirely possible for the supply of capital to exceed the demand for its use even with interest rates at zero. We have seen that situation in Japan for coming up to three decades now, for instance. Traditional economists are still scratching their heads at negative interest rates, as their (deeply flawed) models deem that situation impossible.

The short term solution to demand side ills is higher fiscal deficits, but the longer term and more sustainable solution is a redistribution of income (negative interest rates also contribute to the solution by effectively taxing excessive savings). As noted, low to middle income earners have a relatively high propensity to spend, so in a demand-addled economy, a reduction in income inequality will raise aggregate spending (demand) and lower aggregate system savings, and help restore the system's balance. Higher spending will then allow ‘customers to create jobs’ a la Nick Hanauer. By contrast, pursing a policy of tax cuts for the rich in a demand-deficient environment would exacerbate the existing savings imbalance, reduce system spending, and likely trigger a recession.

What situation is the developed world in at the moment - a supply-constrained one, or a demand-constrained one? In my opinion, it is demonstrably clear that since the global financial crisis, the developed world (excluding Australia, NZ, and Canada, whose great recessions still lie ahead) has been in a demand-deficient environment, not a supply-deficient environment. Wealth and income inequality has continued to increase (and hence savings); interest rates have fallen to close to zero (and negative in some cases), and inflation has been all but non-existent. Consequently, what is needed are demand-side policies to improve wealth and income distribution, not tax cuts for the rich. At the present time, Hanauer is right.