Who is declaring “class warfare” in “America Today?

            During recent political debates on jobs, taxes, and the budget deficit President Barack Obama has called for increased taxes on “millionaires and billionaires” to help pay for increased government spending and to reduce the federal deficit.  Such calls have been followed by Republican claims that the President is trying to start “class warfare” by pitting the poor and middle-class against the “rich”.  Even though polls show a majority of voters favor increased taxes as part of any deficit reduction plan, and as a means of helping pay for programs to increase job creation, Republicans continue to insist that tax increases on the very wealthy will never be acceptable.

            But what is “class warfare” and who are the “rich” and the “middle-class”?  First, Democrats have tried to define the rich as those who earn over $250,000 a year, while Republicans have attempted to define the middle-class to include those who earn anywhere from $500,000 to several million dollars a year.  In 2005 Forbes.com tried to estimate what it would take to provide a family with an “upper-middle-class” lifestyle that would include a spacious home, a vacation residence, two late-model luxury cars, and private schools for their children.  Such a lifestyle could be had for somewhere between $300,000 and $800,000 a year depending on what city the family lived in.  But they also assumed that the family would save only one percent of their income and give nothing to charity.

            In a similar Forbes article in October 2011, publisher Rich Karlgaard attempted to describe “What is Wealth in America?  He identifies the “rich” are those who are billionaires and those with wealth of half a billion or more.  For those with only $100 million he claims, “You’ll have to watch your budget” because that number is a “tweener number”.  You’ll have to give up your Aspen and Maui homes and private jet because you are between upper middle-class and the superrich.  Wealth of only $20 million would provide an annual income of $1million if invested at 5 percent, while $5 million net worth invested at 5 percent “buys an upper-middle-class life”, but those in this category will need to “keep your day job”, in addition to your $5 million if you want to maintain your lifestyle.  Finally, $2 million is “the great dividing line between middle-class comfort and worry in America right now”.  That $2 million would provide an annual income of only $100,000 a year if the family had no income from work.

            But are Democrats more accurate in defining “rich” as those who earn $250,000 a year or more?  Most families in that category are professionals, entrepreneurs, small businessmen, or middle corporate executives whose annual income is high, but who do not live off of investment returns.  Wealth of $5 million invested at 5 percent would also provide a $250,000 annual income—the “upper middle-class” lifestyle according to Forbes.  But only two and a half percent of American families (about 7,700,000 families) earn incomes of $250,000 a year or more.  And the wealthiest one percent earns about $375,000 a year.  Meanwhile the median family income (where half of all families earn more, half less) is about $61,000 a year.  While $250,000 a year is four times the national median family income, more than 97.5 percent of families earn less. At the very least, it must be considered the borderline for being “rich”, but exact definitions depend on individual value judgments.

            When President Obama asks for new taxes (or expiration of the 2003 Bush tax cuts) on those earning $250,000 or more, is he trying to declare a class war and pit the rich against the poor and middle-class?  Consider a number of economic trends that have occurred over the past thirty years since President Reagan asked for his original supply-side tax cuts.  At the time, marginal tax rates ranged from 14 to 70 percent (reduced by the Kennedy tax cut of 1964 from a previous range of 20 to 91 percent) and the Reagan cut reduced rates to a range of 11 to 50 percent.  His 1986 tax reforms further reduced the highest marginal rates to 33 percent, but President Clinton introduced two new higher brackets in 1993 of 36 and 39.6 percent.  Finally, President Bush’s 2001-2003 cuts reduced the highest rate to 35 percent, where they are today.  Taxpayers in the highest marginal tax bracket now pay taxes at a rate only one-half of the rates that existed before the Reagan bills.  Since the incomes of the wealthiest Americans are also the ones that have increased the most over the same period, the wealthy now pay taxes at the lowest rate in the past sixty years.  Meanwhile, incomes, jobs, and economic security of the majority of Americans have stagnated or fallen as wealth and economic power have shifted upward.

            An argument can be made that class war between the wealthiest Americans and the poor and middle-class actually began in 1980 with the election of Ronald Reagan, and the middle- class has been a consistent loser over the past thirty years.  Reagan’s emphasis on deregulation of important industries, the decline of labor union membership and influence, the decline of American manufacturing and the resulting outsourcing of jobs, and the fundamental shift in the economy toward production and output of “financial” rather than “real” goods and services have all contributed to a decline of the middle-class and the rise of the super wealthy.

            While Republicans have historically favored limited government and a free market economic system, Reagan’s presidency transformed those beliefs into something close to religious devotion.  When Reagan said, “Government is not the solution, government is the problem” he introduced the idea that government cannot be relied on to solve or deal effectively with any problems.  He further said, “The nine most feared words in the English language are, ‘I’m from the government, and I’m here to help’”.  Conservative Republicans since that time have adopted the basic philosophy that less government is always better than more government.  In addition, Reagan believed that the absence of government always meant a free market; where market forces could be relied on to always provide the best outcome at the lowest possible cost.  Government regulation of business then was always a poor option since market forces would always provide the best and most efficient regulation.

            But Reagan failed to consider the fact that free markets do not have a tendency toward pure competition, but toward monopoly.  No business executive or entrepreneur wants more competition in their relevant markets, but constantly strive to control an ever expanding share of their market.  Left unchecked by any outside influence, businesses will become larger and larger and gain greater and greater monopoly power, which they can then use to generate and expand political influence and power.  The thirty year deregulation of banking and financial markets and the resulting financial collapse of 2008 are proof that markets do not always regulate themselves and guarantee the public good over private greed.

            When Reagan broke the airline controllers union during the eighties he ushered in the long term decline of labor union power and influence.  During the 1960s labor union membership included over one-third of all workers, but today union membership has declined to only 12 percent of workers, mostly in the public sector and the largest industrial industries such as auto, mining, and transportation.  Corporations have discovered that the easiest way to reduce union power is to transfer union jobs to other nations where unions do not exist and where wages are low and benefits nonexistent.  So middle-class jobs in manufacturing have been outsourced abroad and U.S. corporate taxes have been blamed for the shift.

            By placing blame for loss of American jobs on high U.S. corporate taxes, corporate executives and Republican politicians have been able to transform the American tax base from business taxes to personal taxes.  In the 1950s for every dollar in taxes the federal government raised from individuals they raised $1.50 from businesses.  Today business pays only $.25 for every dollar of taxes paid by individuals.  And the corporate tax rate of 35 percent is used to argue that U.S. corporations still pay the highest taxes in the world, but existing loopholes, deductions, and exemptions allow many of the largest companies to pay little or no actual taxes.  Lower corporate taxes are argued to be necessary to bring manufacturing jobs back to the U.S. but there is little evidence that lower rates would lead to more jobs rather than to higher profits and corporate dividends and stock buybacks.

             A further consequence of rising income and wealth inequality is that the very wealthy become disconnected from the middle-class and increase their resentment of government programs designed to benefit the poor.  The super rich do not want to help pay for government services and programs that they do not personally benefit from, such as public education and medical services.  Their children attend private schools and they receive the best medical care and can provide for their own security and protection.  Even government provided infrastructure such as highways, bridges, and airports are viewed as government waste that use funds better suited for private investment and increased profit.

            Increased political power by the super wealthy has also led to decreased willingness to help provide basic public services.  If they can continue to reduce tax rates that lead to reduced government revenue, they can then argue for the necessity of reduced government services due to lack of revenue and the need for a balance government budget.  The recession of 2008 and the resulting financial collapse and loss of government tax revenue have also led to reductions and even eliminations of state and local programs that benefit primarily the poor, such as medical and education and day care subsidies.  Arguments that the poor are only poor because they are lazy and lack a work ethic are now common, as are arguments that expansion of benefits for the unemployed serve only to encourage idleness and postpone any job search.

            Declining taxes on business and individual capital gains and dividends have also led to increased investment in “financial” assets such as stocks, bonds, and financial derivatives where profits can be made through manipulation and leverage.  As financial institutions have become larger and larger, and government regulation and oversight reduced, speculation in financial assets has increased and profit from buying and selling of paper assets has become one of America’s largest industries.  The best and brightest graduates from the most prestigious universities are often lured into corporate finance, where annual incomes of millions a year have become commonplace. 

The financial collapse in September 2008 proved that a perceived government policy of “too big to fail” was a reality, where speculative financial profits could be earned and kept by individuals and corporations, but where losses would be absorbed by government and paid for by taxpayers.  The resulting bank bailout protected bank profits and executive bonuses but failed to protect individual homeowners and other customers.  Any attempts to increase government oversight and reduce incentives for speculation are met with Reagan style complaints about government interference with free market forces. 

           Republican politicians have become so closely allied with the super rich and large corporations, and so tied to Reagan conservative philosophy concerning government and taxes that they now seem to follow a practice of demonizing the poor and dismissing the middle-class while deifying the wealthy.  The poor are poor because they won’t work harder, the middle-class is simply resentful of the rich, while the rich are the ones in society who work hard and deserve what they receive.  The rich are called the “job creators” even though job creation may or may not be related to wealth, since a majority of the super rich are not new entrepreneurs or owners of expanding businesses, but investors and corporate executives where any new jobs created are as likely to be created overseas as in the U.S.

The middle-class “American dream” of owning a home, one or two cars, providing an education for your children, taking a family vacation once a year, and being able to retire and live comfortably has become a declining reality for millions of American families.  Loss of political influence, declining job and educational prospects, vanishing home equity and lifetime savings, and the need to postpone retirement are the new reality for most families.  It is clear that increasing income and wealth inequality and the expanding political influence and power of the super wealthy have been major contributors to the declining economic dream for a majority of families. 

Whatever “class warfare” there is in America today was begun in 1980 by Ronald Reagan and his anti-government and anti-tax philosophy.  It has been waged successfully over the past thirty years by his most ardent disciples in their desires to shift tax burdens away from the rich and corporations, to create an unencumbered and unregulated market system, and to protect and elevate the interests of the very wealthy while demonizing and dismissing the economic interests and programs that benefit everyone else.

Do Tax Cuts Pay for Themselves?

            In a USA Today article published on December 14, 2010 titled, “Why tax cut is a bad deal,” Mitt Romney states, “In many cases, lowering taxes can actually increase government revenues.  If new businesses, new investments and new hiring are spurred by the prospects of better after-tax returns, the taxes paid by these new or growing businesses and employees can more than make up for the lower rates of taxation.”  The philosophy that tax cuts can pay for themselves has become pervasive among Republican politicians over the past 30 years, and is the direct result of the original Laffer curve argument that led George H.W. Bush’s to state that Ronald Reagan was following a policy of “voodoo economics”.

            Economists have long accepted the view that a reduction in tax rates can stimulate the economy and lead to increased output and employment.  But the extreme view that such a stimulation will lead to an increase in the tax base large enough that total revenues will actually rise has never been supported by facts or reality.  Yet, when Laffer first made his proposals in the late 1970s politicians like Reagan could not help but endorse a proposition that would allow a reduction in tax rates while also claiming to be able to balance the budget, or even increase spending.  And virtually every Republican politician since Reagan has used the Laffer argument to propose constant reductions in taxes.
            Let me review again the original Laffer curve arguments.  Laffer argued that a decrease in tax rates will lead to an increase in the incentives for taxpayers to work and produce since they will keep a larger share of the income they earn. In addition, any production and income that has been unreported as part of the underground economy will also surface and become part of the tax base.  But Laffer argued that this increase in the tax base will more than offset the decrease in tax rates, so total revenue will actually rise rather than fall.  Laffer could therefore argue that it was possible to cut tax rates, raise spending, and still not increase the size of the budget deficit.  Hence the now popular Republican phrase that “Tax cuts pay for themselves”.

             A number of questions and objections have been raised by economists. For example, the curve is extremely difficult to test empirically. At tax rates below some “optimum” tax rate, increases would lead to increases in revenue, as the rate increases more than offset any fall in the tax base.  At tax rates above the optimum, rate increases would cause a fall in the base that would offset the rate increase, so revenues would fall.  Above the optimum the opposite is also true: a decrease in tax rates would lead to an increase in tax revenue.  But even Laffer did not know for sure where the optimum tax rate was, and therefore did not know if rate increases would lead to revenue increases or decreases. But recent Republican arguments imply that any tax rate is too high and a cut will lead to an increase in overall revenues.  So even when current rates are at a maximum of 35 percent, and rates on dividends and capital gains are at a 15 percent maximum, they continue to call for a reduction as a means of raising more revenue.

            Further, Laffer did not argue that the process was instantaneous, i.e. that tax cuts would lead to instant increases in tax revenues. It takes time to create new investment and production incentives and for new income and tax revenues to be raised. But how long does it take? If tax revenues fall for the first few years is the theory disproved?  If tax revenues after one year are equal to previous projections without a cut, has the theory been proved or disproved? What about two years or three years later? Many forces work on the tax system, and the incentives to produce more or less are some of the most difficult to measure.
     
             But while economists recognize the truth in the arguments that reducing high marginal tax rates will increase saving and investment, it is not obvious that the additional production and income generated by that saving and investment will yield enough new tax revenue to offset the revenue loss of the original cut in tax rates. For example, assume that the marginal rates are cut enough that tax revenues are decreased by $25 billion. If the tax system collects an average of 20 percent of income, total incomes must rise by $125 billion before the lost revenue will be recovered. In the extreme case, this would require that all of the original tax cut would be saved, invested, and then generate $5 in new income for each dollar invested. It is more likely that less than half would be saved and invested and that the new income generated would be less than $5 for each $1 invested. Thus, part, but not all, of the tax cut would be recovered during the first year.

             While most economists would accept the logic that says tax cuts for the rich will increase saving and investment incentives, few accept the Laffer position that those incentives will be adequate to cause total tax revenues to rise rather than fall in the short-term. But incentives could certainly be great enough to cause output and incomes to rise. The question is not whether the chain of benefits exits, but rather the magnitude of those benefits. 

            But aside from the logical shortcomings of the Laffer argument, has experience with such tax cuts led to a surge in revenues that resulted in the Laffer predicted budget outcome?  There have been two Laffer experiments with tax cuts for the rich that were argued to produce an increase rather than a fall in tax revenues.  The Reagan 1981 tax cuts and the 2001/2003 Bush tax cuts were both predicted to have a Laffer response and rising tax revenues.  We will examine the growth in output, tax receipts, expenditures, and the overall budget for a five year period following each tax cut to test the validity of such claims.

 Table 1

Impact of the 1981 Reagan Tax Cut

Year   GDP    % Change  Taxes   % Change   Spending % Change  Deficit  % Change

1981    3126.8      --            599.3        --              678.2           --             79.0          --

1982    3253.2      4.0         617.8        3.1            745.7          9.5            128.0        62.0

1983    3534.6      8.6         600.6       -2.8           808.4          8.4            207.8        62.3

 1984    3930.9      11.2       666.5       11.0         851.9          5.4            185.4       -10.8

1985    4217.5      7.3         734.1       10.1          946.4        11.1            212.3        14.5

1986    4460.1      5.7         769.2        4.8          990.4          4.6            221.2          4.2

81-86     --         42.6            --          28.3            --            46.0               --         180.0
Source:  Economic Report of the President, 2010

            Several things stand out in this table.  In the first two years after the 1981 tax cuts tax revenues increased slightly and then decreased by virtually identical amounts, so the 1983 revenues were the same as the 1981 revenues.  Revenue then increased substantially in both 1984 and 1985.  But 1981-82 was a recession period when GDP grew slowly and government spending increased significantly, both contributing to a rising budget deficit, which nearly tripled from 1981 to 1983.  Both GDP and tax revenue increased by 11 percent in 1984 and the deficit fell by almost 11 percent as well.  Overall, for the five year period following the tax cuts GDP increased by 42.6 percent, tax revenue rose by 28.3 percent, and expenditures rose by 46 percent.  Do these numbers prove or disprove the Laffer prediction? 

            Revenues declined before rising, but then rose by a substantial percentage.  But was the rise a result of the tax cuts or other economic factors?  Examination of the five year period prior to the tax cuts is useful.  From 1975 to 1980 GDP rose by 70.2 percent, tax revenues rose by 85.3 percent, and government spending rose by 77.8 percent.  All of these increases are substantially greater than those following the tax cuts in 1981.  In particular, tax revenues rose more than three times as fast during the late 1970s and they did after the Reagan tax cuts.  If that percentage had continued through the eighties tax revenues would have been over $958 billion by 1986, or 24.6 percent greater than they actually were.  The argument for supply-side tax cuts is certainly not strengthened by the Reagan experience.

Table 2

Impact of the 2001/2003 Bush Tax Cuts

 Year    GDP    % Change   Taxes   % Change    Spending % Change    Deficit % Change

2001    10286.2       --        1991.2         --             1862.8           --          +128.2         --
2002    10642.3       3.5      1853.2        -6.9           2010.9           7.9         157.8      223.4
2003    11142.1       4.7      1782.3        -3.8           2159.9           7.5         377.6      139.3
2004    11867.8       6.5      1880.1         5.5           2292.8           6.2         412.7          9.3
2005    12638.4       6.5      2153.6        14.5          2472.0           7.8         318.3       -22.9
2006    13398.9       6.0      2406.9        11.8          2655.1           7.4         248.2       -22.0
2007    14061.8       4.9      2568.0         6.7           2728.7           2.8         160.7       -35.4
2008    14369.1       2.2      2524.0       -1.7           2982.5           9.3         458.6       185.4
01-06        --         30.3       --                20.9          --                 42.5          - -           293.6
03-07        --         26.2       --                44.1          --                 26.3          --            -57.4
01-08        --          9.7      --                26.8          --                   60.1          --            457.7

Source:  Economic Report of the President, 2010

            Do the Bush tax cuts prove the Laffer thesis?  For the first two years following the initial 2001 cuts, revenues fell by over 10.5 percent before increasingly substantially in 2004 and 2005.  But expenditures rose significantly between 2001 and 2004, so the budget deficit increased from a surplus of $128.2 billion to a deficit of $412.7 billion.  But the rising deficit was clearly a result of both falling revenues and rising expenditures.  Deficits then declined for three years as revenues grew faster than spending, but the 2008 recession caused the deficit to balloon upward again to its highest level of the decade, as revenues fell and spending expanded.
            Again, it is helpful to look at the five year period prior to the Bush tax cuts to compare growth in GDP, revenues, and expenditures for the two periods.  From 1995 to 2000, GDP increased by 34.2 percent, tax revenues rose by 49.8 percent, and spending increased by 18.0 percent, and the budget deficit moved from a $164 billion deficit to a $236.2 billion surplus.  Again, part of the budget change can be attributed to rising revenues and part to slower growth in spending.  But if the 1995-2000 trends in tax revenues had been continued, total revenues in 2006 would have been $2983, or 24 percent higher than they actually were.

            What these figures prove is that supply-side tax cuts lead to an initial decline in tax revenues, but to an increase in the third and fourth years out from the cuts, but then a slowing to a more historical trend.  But the initial fall in revenues results in lower total revenues during the five year period than would have been the case without the cuts.  GDP also grows at a similar or slower rate following such tax cuts as it did prior to the cuts.  The deficit growth is a combination of falling revenues and rising expenditures during the initial years, but as spending growth slows so does the deficit.  It is clear that the deficit will not fall unless tax cuts are also accompanied by spending cuts, but that is what economic theory would have predicted long before the Laffer curve became popular Republican theology.  The evidence clearly does not support the theory that tax cuts pay for themselves.