Is the key to economic growth keeping taxes low on savings and investment? That's what James Pethokoukis argued here at The Week, when he took issue with the capital gains tax hikes President Obama plans to use to pay for a new middle class tax relief package — tax hikes that will fall almost exclusively on the wealthiest Americans.
In recent decades, America's economic growth has slowed to 2 percent a year versus the more robust 3 percent it tended to see mid-century. According to Pethokoukis, Obama's tax hike will make business expansion, and especially entrepreneurial creation — the next Apple or Google or what have you — all the harder. Pethokoukis also took a swipe at "middle-out economics," the mantra that's gaining ground in progressive economic circles, which blames sluggish economic growth on rising inequality and the way it degrades Americans' ability to spend. "America doesn't need more ‘buying power' stimulus as much as it needs a higher growth potential," Pethokoukis concluded.
But a quick tour of what's actually going on in the U.S. economy suggests there's a lot more to "middle-out economics" than Pethokoukis allows.
Let's start with the basic theory: investment provides the money that creates new jobs and builds the capacity for new economic activity — no doubt about that. And Pethokoukis' worry is that taxing the rewards people get from investing — a.k.a. capital gains and dividends — will hamper the incentive to invest.
But why does investment happen in the first place? Businesses don't just start or expand for the sake of starting or expanding. They do so because they believe there is untapped demand in the market. They believe that providing a service or good that's new or better — or providing it at a greater scale — will bring in a bigger profit.
In other words, investment happens in reaction to consumers' ability to spend on goods and services in the here and now. Economic growth is an ecological feedback loop between customers and businesses. Present demand by consumers spurs investment, which then creates more jobs and incomes and the capacity for more demand in the future — and around we go.
Furthermore, while a rich person who makes 10 times as much as you can at least theoretically save and invest 10 times as much as you, they can't possibly consume 10 times as much as you. They're not going to buy 10 times as many cars, or houses, or meals, or gallons of gas. Inequality, by funneling more of the income the economy generates to the top, throws an imbalance into the ecological loop, threatening to degrade it on the consumption side.
What's strange about Pethokoukis' swipe at middle-out economics isn't that it gets the value of investment wrong — it's his suggestion that consumers' buying power is not itself a key part of an economy's growth potential. Indeed, Pethokoukis' argument seems to suggests that the investment side of the loop is the only one that can break down, and thus could ever conceivably be in need of a policy assist. Obama's middle-out policies, by contrast, seek to shore up consumers' buying power.
Recent events show what happens when policy-makers wrongly diagnose where the flaw in the feedback loop is.
Kansas' state government, for example, recently cut its business taxes to zero, in an effort to spur investment and job growth. It hasn't worked, and a computer chain owner in Wichita gave NPR a pretty succinct explanation why: "I didn't really notice any more business purchasing, you know, around here. So it didn't really trigger anything to hire more employees."
We ran a similar experiment at the national level, when the Bush administration massively cut dividend taxation from 38.6 percent to 15 percent in 2003. Because of a quirk in how the cut was designed, the shareholders of some corporations were affected, and others weren't. Yet following the tax cut, there was no discernible difference between the two groups of firms in either investment or employee compensation. But the affected corporations did wind up paying out way more cash to shareholders.
In fact, the top capital gains tax rate bounced around all over the place during the 20th century — from 25 percent to 40 percent to 30 percent to a basement-low 15 percent in the 2000s — and there's no evidence that the investment rate ever changed significantly in response to any of those shifts. That doesn't mean capital gains taxes have no effect at any level, but it's a strong case that the 28 percent tax rate Obama is proposing will have negligible impact.
In short, we've been cutting these taxes on the theory that the supply of investment isn't high enough. And in response, the money just keeps piling up at the top of the income ladder, as opposed to actually getting plowed back into new economic activity. The rather obvious conclusion is that the supply of investment isn't the problem, it's the motivation to invest — i.e. consumer demand.
Meanwhile, inequality plays out through the economy in myriad ways. Access to the ecological feedback loop becomes more and more concentrated at the top, the parasitism of the rich shareholding classes is permitted to increase, and all the while Americans lower down the income distribution are squeezed to the ragged edges of economic activity — forced to either rely more on a social safety net that a distant and cloistered elite is loath to provide, or to borrow more heavily and thus increase the risk of a systemic economic collapse. And when those collapses happen, the jobs often fail to return.
Middle-out economics, anyone?