The Misdiagnosis Of Our Economic Malaise

A comparison of tax rates, economic growth, and unemployment rates over the last 50 years has allowed me to reach the following conclusions regarding the tax cuts that are the core of Mitt Romney’s economic plan:

  • Tax cuts have little effect on either unemployment rates or the economic growth rate in the long run.
  • Making either the Bush tax cuts permanent, or worse, enacting new tax cuts now will significantly increase the deficit.

However, their approach towards taxes also illuminates a more fundamental difference between Romney and Obama, and it pertains to what each candidate has diagnosed as the problem with our economy today. And understanding this difference is key to making a decision on whose policies now are more likely to spur economic growth in the long run.

So what is the rationale for additional tax cuts? The essence of Romney’s argument as outlined throughout the presidential debates and during the primaries is as follows – cutting taxes will free up the money that businesses would normally pay the government, and they would instead use this money to expand their operations and create more jobs. The underlying implication is that a heavy tax burden and government hindrance is preventing businesses from acquiring sufficient capital to expand and create more jobs. Are there economic indicators that we can we look at to verify whether this claim is actually true?

As a first step, I looked at how the various US stock market indices have fared under Obama. As an example, I have included a chart depicting the value of the S&P 500, which is an index of the top 500 publicly traded US companies, over the last 5 years:

At its lowest point on March 2, 2009, the S&P500 closed at 683.38. Four days ago, it closed at 1411.94, indicating an almost complete recovery to the highs in 2007. This suggests that businesses have gradually accumulated value over the last 4 years. However, this has not translated into a corresponding increase in employment.

To further understand whether corporations have the resources to expand and hire new employees, I looked at cash reserves of US corporations over the last 5 years:

As of 2010, companies were sitting on more than a trillion dollars in cash, yet they had not utilized that money to significantly increasing their hiring. In addition to this, the federal reserve has cut interest rates to almost zero and intends maintain low interest rates until at least mid-2015. This allows companies to borrow the money they need to expand at much lower interest rates than they normally would. Furthermore, as I mentioned before, Obama has maintained all the Bush tax cuts during his first term. So businesses haven’t been burdened by higher taxes during the last 4 years.

Together, these economic indicators suggest that companies already have abundant resources to expand their operations, if they wish. For the same reason, it is improbable that freeing up more money by cutting taxes further will stimulate companies to hire more workers. So why aren’t companies hiring? Answering this question requires us to first ask why companies hire in the first place. Companies hire only when they see that there is a demand for their products and that meeting that demand requires them to hire more people. And what determines demand? Our incomes do – we shop when we have the money and when our incomes grow, we tend to shop more. Likewise, when incomes shrink, as they do in a recession, we hold back. Demand falls. Why then would companies increase their payrolls? They wouldn’t. So the problem with the economy has to do with demand. Can/Should government do anything to boost demand? And has Obama done enough? We shall examine this in the next post.

Revisiting “W” and Tax Cuts as a Political Philosophy

In my last two posts, I compared the top tax rates over the last 60 years and found that tax cuts correlate neither with economic growth nor with reduction in the unemployment rate. Does this mean tax cuts have no place in a president’s budget? Certainly not. However, the trouble arises when democrats and republicans hem tax policies into their core philosophies in ways that prevent them from coming to an agreement on how the government can support the economy, particularly during and after a recession. In this regard, the two tax cuts enacted by George W. Bush in 2001 and 2003 are particularly revealing.

The conditions in which Bush assumed office were as follows: the economy had witnessed an expansion not seen in decades; the federal budget was yielding surpluses; unemployment had dropped below the 5% mark (indicating “full employment”); poverty levels were on the decline; and the US was even apportioning some of its revenue to pay down the national debt. Given this scenario, what were the tax cuts exactly supposed to accomplish? Bush and his fellow republicans (who controlled both houses of congress) knew well that these tax cuts would significantly add to the deficit. Passing the bill required them to overcome democrat opposition, which they did by employing an arcane budgeting maneuver called “reconciliation”. Even then, because the bill would add to the deficit, senate rules required them to stipulate a 10-year limit (hence they were originally set to expire in 2010). The 2001 tax cuts were soon followed by the tragic events of 9/11 and the engagement of the US in Afghanistan. War is an expensive endeavor in many ways, including financially. Yet Bush did not seek for financial resources to pay for the war and did not roll back/suspend his tax cuts. Instead, he passed another round of tax cuts in 2003 and then engaged in another war with Iraq. Whether he was right to attack Iraq is another issue altogether; however, his reluctance to increase government revenue to offset the spending on wars unveils the troubling patterns in politics today. For it conveys that no circumstances, not even war, justifies a government to collect more revenue.

Is it surprising then that 95% of all republican congressmen and republican candidates who ran for president in this election, including Mitt Romney, lined up to sign Grover Norquist’s pledge not to increase taxes under any conditions? Or that Mitt Romney raised his hand when asked in the republican primaries if he would not accept even a $1 increase in tax revenue for every $10 in spending cuts?

Going back to “W”, in his final months as president, George Bush would pass yet another spending package worth $700 billion (known as TARP), this time to save the entire financial sector from extinction. It marked the beginning of a recession which rivaled the Great Depression. Like with the Iraq war, we could debate what really caused the most recent recession. However, there is no doubt that the government would have been better equipped to pass TARP, the stimulus, and numerous tax incentives if its financial resources had not been squandered in the Bush tax cuts. Likewise, Mitt Romney’s new rounds of tax cuts would further weaken the ability of the government to provide the necessary support not only during the current recovery, but also in future economic crises. The country needs a different course.

Tax Cuts and the Unemployment Rate

In my previous post, I tried to find correlations between the top marginal tax rate and the economic growth rate and suggested that the growth rate is largely independent of tax rates. However, it is interesting to note that the candidates rarely mention the growth rate. Instead, they mostly mention creating jobs, strengthening the middle class, etc. Why? Perhaps, because they have learned that issues like the unemployment rate, household income, and poverty rate, are the economic indicators that really matter to the electorate. So I examined how the unemployment rate has behaved over the last 50 years or so. I obtained this graph from an article in the Washington Post:

In this graph, the blue line shows the unemployment rate over time, and the vertical yellow lines indicate recessions – the thicker the line, the more severe the recession. The dark horizontal line in the middle indicates the 5% mark, a traditional threshold for “full employment” (i.e. If the unemployment rate falls below this mark, the economy has achieved “full employment”).

Some trends are easy to notice in this chart. For instance, the unemployment rate ticks up in every recession. In addition, relative to the duration of the recession itself, it takes much longer for the unemployment rate to reach its pre-recession levels. Note that the most recent recession is perhaps the most severe one we’ve had over the last 60 years (only the one in the early 1970s comes close). Now looking at how unemployment rates have reversed following recessions historically, what would we estimate to be the duration of our recovery from this recession? And how much control do we think the president of the Unites States have over this timeline? These are obviously questions to consider before voting. However, my reason for putting up this chart is to now see if there are correlations between the tax rates and trends in the unemployment rate over the same time. For this, I plotted the top marginal tax rates since 1948 based on information from Tax Policy Center:

Here too, some trends are really easy to notice. For instance, we have some of the lowest tax rates today since world war II. Also, since 1980, US tax policy has been heavily biased towards tax cuts, except for the Clinton years (1993-2000).

Now let’s compare the two charts. Going back to the first chart, between 1948 and 1975, the economy went into recession 6 times. And it witnessed 5 more recessions between 1975 and now. Yet, the behavior of the unemployment rate has been very different during these periods. Between 1948-75, despite those recessions, the unemployment rate remained quite low and there were long periods during which the economy maintained “full employment”. On the other hand, unemployment rates have risen more dramatically in the recessions since 1975 and the recovery from these recessions have been slower, resulting in prolonged periods with high unemployment. How do these trends correlate with the top tax rates in the second chart? Interestingly, the top tax rates were much higher between 1948-1975 than they were between 1975-2012. More importantly, for all the emphasis on tax cuts over the last 30 years, tax cuts have made it neither more difficult for the economy to enter into recessions, nor have they made it easier to recover from them.

Together, based on what I have found and described over the last two posts, it is hard to see how yet another round of tax cuts, which seems to be the cornerstone of Gov. Romney’s plan, are a solution to the country’s current economic problems.

Examining Romney’s Case Against Obama

My understanding of Mitt Romney’s case in this election is as follows – Obama’s policies have failed to produce a real economic recovery and create enough jobs. The solution is lower taxes on individuals and corporations, and fewer government regulations, which together will spur growth and create millions of new jobs.

As you can see, this argument is not new. Republicans have proposed and applied this solution for decades. Nevertheless, I examined its central premise, namely, that lower taxes are the solution to our economic woes. I first asked can economic growth occur in a capitalist economy with high tax rates? I found, in fact, that the US has witnessed significant economic growth at tax rates that were much higher than they are today. For instance, when Harry Truman was president (1948-52), the economy grew at about 4.8% a year and the top marginal tax rate was a whopping 87%; under Lyndon Johnson (1965-68), growth stood at 5% and the top tax rate was about 70%; for most of Ronald Reagan’s presidency (1981-88) the top tax rate was 50% and economy grew by an average of 3.4%.

I next asked whether raising tax rates has correlated with increased economic growth. In 1990, George H.W. Bush was presiding over an economy that had witnessed three rounds of tax cuts over the previous decade – the top rate had been cut from 69% to 50% in 1982, then to 38.5% in 1987, and finally to 28% in 1988. However, in July 1990, the economy went into a recession that lasted 8 months. As Reagan’s vice-president, Bush had witnessed and testified of the power of tax cuts. Yet, ironically, he was forced to raise the top rate from 28% to 31%. The move cost him the presidency. His successor, William Jefferson Clinton, then raised the top rate from 31% to 39.6% in 1993. And the economy? It boomed, growing at about 3.9% a year over the next 8 years, created budget surpluses, and even lowered the national debt. These incidents illustrate two points: the economy can grow significantly when tax rates are increased, and recessions can occur even when taxes are cut drastically. Overall, these numbers suggest that economic growth is largely independent of tax rates. Does this mean that the act of cutting taxes has not correlated with economic growth? No, it does not. Tax cuts can provide a temporary jolt to the economy. However, there is little evidence to support the idea that cutting taxes should be the policy for sustained economic growth.

If economic growth does not really depend much on tax rates, what does it matter whether the rates are low or high? It matters because taxes determine government revenue. And government revenue is an important source of its leverage – it determines what the government can do. In a recession, this could include providing unemployment benefits, assistance for needy families, and programs for the poor, all of which can help an economy recover from recessions. If government has enough revenue, it could provide these services without increasing the deficit significantly. And in proposing to lower taxes even further than the Bush tax cuts, Gov. Romney will not only increase the deficit significantly, he will also undermine the ability of the federal government to provide assistance in recovering from future economic crises.

In this post, I attempted to describe correlations between tax rates and the rate of economic growth. However, there are other economic indicators that are really important in this election, such as the unemployment rate and poverty rate. How will the candidates’ tax plans affect these indicators? I will attempt to address this in my next post.

Obama Has the Edge on Taxes

Having assessed the plans put forth by both candidates on taxes, I find Obama’s plan more appealing. But before I explain myself, it is important to note that neither Obama nor Romney will make major inroads into the federal deficit in the next four years. This is because cutting the deficit significantly requires the government to have a lot more money than it does now. Obviously, this can be achieved through a combination of revenue increases and spending cuts. However, neither candidate would allow all the Bush tax cuts to expire (hence no major revenue soon), nor will they specify spending cuts. This observation brings out a point that both candidates accept, namely, that reducing the federal deficit is a long-term priority for both, not a short-term one. Keeping this in mind, let’s compare their policies.

To erode the federal deficit, government must have a source of increased revenue. From this perspective, Obama’s plan offers a more direct source of revenue than Romney’s. Obama’s plan to selectively let the Bush tax cuts expire for high income earners would raise about $1.6 trillion over the next decade. In contrast, Romney has no direct revenue source. He assumes that economic growth from his tax policies will provide the needed revenue. However, this is highly speculative, and moreover, Obama could/would make the same claim about his own tax policies.

Obama’s plan is also more thorough than Romney’s. In a way, this is to be expected because as the sitting president, Obama is required to provide a detailed budget each year. However, while Gov. Romney deserves some leeway in this regard, it is reasonable for us to expect at least the details that will allow us to judge whether he has a plausible plan. Unfortunately, Romney comes up disappointingly short. For instance, if the federal deficit is as big a problem as Romney has been arguing, we would expect his plan would show how he would reduce it. Instead, his tax cuts would increase the deficit by about $480 billion a year. How would he pay for that? He says, by eliminating certain tax deductions and loopholes. Would he eliminate tax preferences for health insurance and 401K contributions that employers make towards their employees? Would he eliminate the mortgage interest tax deduction for homeowners? For these are the biggest deductions in the tax code right now, and are extremely popular.

Without eliminating these deductions or the tax preferences for capital gains, deficits would be significantly higher in the Romney plan. However, Romney has vehemently insisted that his plan will be revenue neutral. How could this be achieved? Cuts will have to be made elsewhere. Even if we give Romney the benefit that he will eliminate those remaining deductions progressively (i.e. eliminate the deductions for high-income earners first), there aren’t enough deductions available to offset the cost of his tax cuts, and so an unintended consequence of enacting his plan in a revenue neutral manner will be a rate cut for high income earners, but a tax increase for middle, and perhaps even, low income earners.

So judged on these criteria, Obama’s plan appears more practical than the Romney plan, at least in the short-term (this is my view with the caveat that neither candidate has addressed how they will solve the deficit problem in the long run). However, how does Obama’s plan measure up to the core of Romney’s plan, namely, that reducing taxes will boost economic growth and that the ensuing revenue will more than offset the cost of the tax cuts in the long run? This is the topic of my next post.

Mitt Romney’s Tax Plan

Like the president, Mitt Romney will also not let the Bush tax cuts expire. However, unlike Obama (see previous post), Romney would cut taxes even further. Here is a summary of how he would change tax rates based on analysis from the Tax Policy Center:

Here are some highlights of his plan. If elected, Gov. Romney would: 1) Make the Bush tax cuts permanent; 2) Further cut individual income tax rates by 20% across the board, bringing the top rate down from 35% to 28%; 3) Repeal the Alternative Minimum Tax (AMT). This is important because if the AMT is not repealed, any savings from his tax cuts would be absorbed because many people would end up paying the AMT; 4) Repeal tax provisions in Obama’s health care legislation and in the 2009 stimulus such as the American opportunity tax credit, the Earned Income Tax Credit (EITC) and the expanded child care credit. As I mentioned in my previous post, Obama would extend these credits; 5) Eliminate taxes on long-term capital gains, dividends, and interest for married couples with income under $200,000; 6) Eliminate the estate tax; 7) Reduce the corporate income tax rate from 35% to 25%; and 8) Like Obama, extend the Research & Experimentation (R&E) tax credit.

What would these tax cuts do? Compared to current law, under which the Bush tax cuts are allowed to expire in 2013, Romney’s tax plan would reduce government revenue by $900 billion or 24% in the year 2015 alone. On the other hand, compared to what would happen if we just extend the tax rates in 2012 (i.e. just extend the Bush tax cuts) to 2015, Romney’s plan would further reduce revenue by $480 billion.

Obviously, these numbers present an immediate problem because they indicate that the federal deficit will increase significantly under the Romney plan. Gov. Romney has assured us that he would remedy this defect by eliminating certain tax deductions and loopholes. He believes that these measures, together with the economic growth that would result from reducing tax burdens on individuals and corporations, would offset the cost of his tax cuts and make his plan revenue neutral for the government. Are there enough deductions that could be eliminated to offset the cost of his tax cuts? If so, what are they? On these questions, Romney has remained silent. Moreover, he has promised to not raise taxes on capital gains and dividends, and to not increase taxes on savings and investments (in fact, he would lower them). In the absence of these sources, the path to a revenue neutral plan even more difficult. Finally, even if his plan were somehow revenue neutral, Romney has not specified what he would do to reduce the federal deficit.

Having laid out the information we have from both candidates on their tax policies, my next post will detail my own opinion on the matter.