A more progressive tax structure may help but the country needs a change in the structure of fiscal policy
Why do companies invest? To make profits, obviously. This means they believe there is—or will be—sufficient demand for their products or services at a price that would enable them to increase profits. So far so obvious.
Today—and for some years now—companies in developed economies are not investing, despite having oodles of cash. The Economist estimates that this year American companies will return over $1 trillion to shareholders by way of dividends and buybacks.
Clearly, US companies don’t believe there is—or will be—sufficient demand for their products and services, despite the fact that prices of most raw materials and money are extremely low.
So, why is demand so weak? For several years after the 2008 mortgage crisis bust, it was believed that the US consumer was paying down debt and so spending wasn’t up to par. That explanation is surely wearing thin by now. To understand the real reason, let’s conduct a small thought experiment.
Let’s say all income in the US economy is evenly distributed between all consumers, and let’s focus on something everybody likes and would buy – say, ice-cream.
Let’s say that in normal circumstances each person would buy 100 ice cream cones in a year; there may be some gluttons (like myself) who would go up to, say, 150 and some excessively figure-conscious persons who would buy only 50; but the average purchase would be 100 ice-cream cones per person per year. Now, suppose that the total income in the economy remains the same, but 80% of the income goes to 20% of the people and the balance 20% goes to the remaining 80%. Now, ice- cream is a discretionary purchase, so when income falls, it is likely that ice-cream purchases will take a hit—let’s say that the lower income group reduces their demand to 50 ice-cream cones a year, while the fat cats pump up their buying to 150 ice-creams a year. The net demand for ice cream would fall from 100 cones per person per year to 70. Now, and despite the comment about fat cats, there’s nothing political about this—increasing income disparity beyond a point leads to a decline in demand.
It is well documented today that income disparity in the US (and many other developed economies) is hugely higher than it used to be—indeed, Thomas Pilketty has become a star highlighting this. So, it should hardly be a surprise that demand is hugely sub-optimal.
So, how has the US government been addressing this problem? First off, and most loudly, the Fed has been reducing interest rates to, and holding them at, near zero for a long time, in the fond belief that at some point this will stimulate investment. The impact, as we all know, has been nada, zero, nothing—the amount of money US companies are not investing has been increasing every year. This is hardly surprising since, as already pointed out, low—or even zero—borrowing costs are not a determinant of whether or not companies will invest. To the contrary, the Fed’s process over the past several years has actually resulted in an increase in income disparity, making the problem even more difficult to fix.
It is remarkable to me that the obvious resolution of this problem is nowhere on the table. Very simply, extra ice cream needs to be taken from the fat cats—it would at least help their diets—and, somehow, be given to the rest of the people.
Socialism! Revolution! You cry out.
But, bear with me. I am not about to suggest the classic soak-the-rich higher tax rates. Higher tax rates are necessary, from time to time, to reduce a burgeoning fiscal deficit, but it is certainly not a solution to depressed demand. Making the tax structure more progressive may help but what needs to change is the structure of fiscal policy.
The current structure taxes unearned income—capital gains, dividends, interest income, rental or lease income—at a lower rate than earned income. This was, indeed, the correct approach in the past, when there was no shortage of demand. The US has always been a consumer-demand led economy and tax rates had to be calibrated, amongst other things, to control potential runaway inflation. At the same time, investment needed to be encouraged and fiscal sops—lower rates on unearned income—made sense.
But times have changed. Inflation is nowhere in sight and the lack of investment can be laid squarely at the feet of a lack of demand, as explained above.
Thus, the obvious solution is to reverse the tax treatment of the two types of income. Earned income should be taxed at the lowest possible rate—perhaps, even zero; and this should be true irrespective of the level of income. However, unearned income—capital gains, dividends, interest income, rental or lease income—should be taxed at a higher, and possibly much higher, rate. There could be many ways to do the arithmetic but, for a start, the target should be to keep the entire programme revenue neutral. [There could and should be exceptions for retired people below a certain income level.]
This would shift the ice-cream balance, and with larger numbers of people buying more ice-cream (spending on discretionary purchases), the overall demand for““““““““““““ goods and services would rise, which, in time, would inspire investment and, finally, reignite the growth cycle.
Of course, this approach would certainly soak-the-rich—they enjoy by far the largest share of unearned income—but it is fairer, since earned income adds value to the economy as compared to unearned income. More importantly, it is the only way to get US growth moving again.
The author is CEO of Mecklai Financial