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A Horse Won’t Drink from a Dry River

July 25th, 2010

There is something that I have been wondering about tax cuts for the wealthy supposedly driving an economic recovery. Somebody explain to me if I have this wrong.

The idea behind giving tax cuts to the rich is that they would then invest that money into new businesses, thus generating jobs, which in turn create tax revenue and spending to spur the economy.

However, it seems to me that if the economy is stalled and sales of goods and services is slow, then the last thing you would want to do is give money to rich people.

Here’s how I see it: if most people–lower- and middle-class Americans, in this case–do not have much money to spend and are not going out and buying stuff, then no amount of money given to the wealthy will lead to new jobs. Why not? Because it does not matter if you give a rich person a billion dollars, they are never going to invest in a new business to make stuff if they think no one is going to be able to buy their product. If inventories are sitting on shelves and new products would never sell, it simply wouldn’t make sense. They would find some other way to make that money work for them, but it wouldn’t involve creating jobs, either directly or indirectly.

Now, turn that around. Let’s say that you don’t give wealthy people any money–in fact, let’s say that you raise their taxes and cause them to have less money. But the lower- and middle-class Americans have money to spend and are buying products faster than they can be made. Demand is high. Will businesses say, “Gee whiz, I’d like to invest, but darn it if my taxes are too high”? Of course not. they will use what capital they have, or they will get others to invest in their business, or they will borrow the money somehow–but if there is demand, there will be investment.

So, explain to me exactly why giving money to wealthy people ever makes a stalled economy take off?

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  1. Troy
    July 25th, 2010 at 05:37 | #1

    While the problem you identify — rich people having all the money — of course is the biggie, just “stimulating demand” isn’t going to solve anything either.

    Any economy — local, national, global — lives and dies by the differential between wealth creation/rehab and wealth consumption/destruction.

    Even with their massive internal deficits I think the Japanese economy as a whole is in better balance since they get more GDP per energy input and the Japanese consumer is pretty frugal, at least after twenty years of recession.

    I created a graph to demonstrate the twin “stimulus” packages of the Bush Economy, the 2001-2003 tax cuts and the resulting 2002-2006 real estate boom:

    http://i.imgur.com/hAmYJ.png

    The tax cuts were good for $2T, but most of that went to the wealthy (40% went to the top 1%). Did we get a sustainable economy for this deficit spending? The answer of course is no.

    While the middle class didn’t get the big bucks from the tax cuts, we did get an even bigger stimulus from the housing bubble. It is estimated that a $4T debt overhang was created 2002-2007 — this is the negative equity in the system at present — and during the peak around $500B/yr was being taken out as cash-out refis, or about double the stimulus from the Bush tax cuts.

    But this $500B/yr (plus all the ancillary real estate sector employment) didn’t give us a better economy, either. We spent the money on useless cars, boob jobs, swimming pools, trips to Las Vegas, etc etc.

    To get a better economy we’re going to have to think on the 30-year horizon, direct our efforts to where we want to be in 2040.

    Government spending is around $6T right now. That is, notionally, 100M $60K/yr jobs. I don’t really understand this number since there are only 110M households.

    But to answer your question, we need a more productive middle class, a middle class with more actual value-add and not just paper-pushing. The big inefficiencies are the profit margins in medical care and real estate. Between a third and a half of our incomes are consumed by these sectors, as they are wall-to-wall rentierism basically. Energy is a distant third, but the actual rentierism is rather large here, too.

    But the problem is that Chinese workers can make stuff for $1.50/hr. Theoretically, it is better we pay these low labor rates and use the difference domestically, but due to the rampant rentierism in the present economy any savings we get importing from cheap-labor countries is just ending up in higher rents and mortgage payments.

    Without fixing the twin real estate and medical services rent-drains we’re not going to have a sustainable economy.

  2. Troy
    July 25th, 2010 at 06:49 | #2

    re: my “wealth creation/rehab and wealth consumption/destruction”

    With “wealth” being that which provides services that human needs and wants.

    Technically, IMO, “wealth” is really the state of having ones needs and wants satisfied, but we call the goods that produce this state “wealth” too, AND, more confusingly, we also call the money and assets we hold “wealth”.

    But money is not wealth, money is a claimcheck to wealth.

    Similarly, assets have valuation, and while valuation can be monetized, valuation is not wealth, either.

    Capital is a fascinating form of wealth. I think of it as “indirect wealth” since capital is involved in the production of wealth but by itself in isolation does not have any utility that satisfies human needs and wants. This capital serves as a labor-multiplier, eg. how a large whiteboard is more effective in teaching than a tiny chalkboard.

    So any economy is a balance of wants and needs vs. labor and existing capital to satisfy them.

    Much of the present economy is service-provision, like what Luis does. His employer’s resource and capital requirements are very low so the dominant overhead is employee wages.

    A service economy is very efficient at creating wealth, which is why middle-class economies have relatively high GDPs, but there are bleed points in the system that drain.

    Food and energy are consumed in our daily life. Incidental supplies have to be paid for too.

    To understand the health of an economy you have to, basically, follow the money flows.

    Looking from the outside, Japan is a fantastically wealthy country with $800B of US Treasuries, and a strong yen that can buy billions more for free. Just the interest on this holding is worth about $300/yr per person, or $1000 for the average household. Not a lot, but not nothing either.

    This wealth is due to the productivity of the Japanese export sector and the trade surplus the country still enjoys, $4B/mo as of May.

    Of course, looking INSIDE the country the picture is not so pretty. Japan’s Gini index is right between the Euro utopias of Scandinavia (20s) and the US (45). Tokyo may be surviving but the periphery areas are largely dependent on national “stimulus” spending to remain populated.

    Taxes are too low so still too much money is being directed into real estate.

    To cut this off before I write a novel, what the Republicans (and even Krugman) are missing is that REAL ESTATE is the source — and sink — of all wealth.

    It’s no accident that the US RE boom got going soon after the 2001/2003 tax cuts, as real estate will suck up any and all excess surplus in the system, since the supply of real estate is always fixed but the demand is unbounded (we all want to live in a better neighborhood, nicer house, bigger land, or pick up a second house, . . .).

    Just cutting taxes will not necessarily cause the creation of new capital wealth that expands the productive base. If history is any guide, this new money will just push itself into real estate valuations and we will be no wealthier in the end, just poorer as the real estate sector absconds with the gains.

  3. Geoff K
    July 26th, 2010 at 14:59 | #3

    The issue is this. If the rich have money to invest, than they will invest it. It doesn’t do them any good sitting in a mattress, so they will either invest in their own business or in someone else’s (via stock, bonds, etc.). Or they will spend it on goods and services, stimulating the economy in that way. No matter how bad the economy is, there will always be *some* companies that are doing well, so there will always be plenty of potential investments.

    What they *don’t* want to do, is see their money go up in smoke, as punitive taxes. So if you overtax the rich, they get defensive with their money. They shift it to states or countries where taxes are lower, they put it in trusts or other defensive constructs; whatever they can do to keep it from being stolen from them.

    But, you say, “if the market is hot, won’t the rich invest anyway, despite the taxes?”. Maybe. It depends on if the return, minus the new taxes, outweighs the value of leaving it somewhere safe. If all of your capital gains are taxed away, then investing in stocks is *much* less attractive–your gains go to taxes and there’s a risk of loss.

    Most people aren’t able to invest enough capital to make a serious dent in the economy (although collectively, people deciding that the market is too risky–as many have recently done–can make some difference). Only the rich really do have enough capital to expand business and create jobs, if they’re allowed to do so. So giving money to average people may make them happier, but it doesn’t expand the economy overall. If the economy is really bad, they will neither invest it nor spend it–just sock it away in case it’s needed. This is another reason the Obama “spread the wealth” policies have failed.

    The issue of real Estate is a tricky one. Obviously, that’s one way that the Rich can invest, and it is very lucrative in a bubble market. But property is also taxed, often heavily such as in the Northeast US and Europe. And most of the time property appreciates fairly slowly–markets like the US from 2000-2008 or Japan in the early 1990’s are very unusual. So other investments besides real estate are usually more attractive–unless higher taxes make the alternatives even worse.

    Anyway, the final proof is that lower taxes nearly always result in a net economic improvement. Compare the economy of Texas with NY and California and you can see that right now.

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