If we consider that the US is in a negative Net International Investment Position, that is, it’s a net receiver of investments (from foreign investors), a growing trend over the last years, it should also tell us something about the identity of the stockholders and what this actually means for partially or totally foreign-held assets, which are obviously driven by: productivity and profitability, not necessarily on job creation, even if one would like to assume this is a by-product, but is it? In the past, that relationship was clearer. The current employment increase has been a trend that started before the new administration. It’s wrong to attribute it to the current administration. This takes us to a related topic that is often ignored: savings and its relationship to investment. Over the last decades, savings and investment have been falling in the US. Household savings had its peak of 17.3 in 1975 and a low of 2.25% in 2005. The current rate is 2 points below the 1959-2018 average of 8.83%. The 2013 to 2016 period reflected a recovery, towards that average (with some fluctuations), but 2018 so far shows an overall decline towards 2014 values.
It’s very important to understand that wealth comes from acquiring more assets than liabilities. And, not to forget, assets generate income for the future. And the US has been falling behind on this front for too long. To understand the equation must take into account the net effect of savings and government borrowing. There is an underlying correlation that has kept net-savings very low, even at 0 level in some years during the last decade. So, if supply-side tax reform does not equate to a government spending reduction, dollar for dollar, the result is that the nation becomes more in debt. And the problem with debt is that it’s translated into future taxes (especially if, as expected by some, the borrowing interest rates increase), and also less leverage if the government has indeed to borrow in order to stimulate a possible scenario of deflation and lesser growth. And, as we have seen, the US is already highly in debt.
Another point I like to bring up is that when we think “business”, we must not just think of larger companies and corporations. Think of all the medium and small businesses spread across the whole nation. Can they grow, can they invest, can they hire?
TAX REFORM ON THE DEMAND SIDE
Tax cuts on the supply side do not have a stable one-to-one correlation to economic growth. In other words, the effect of tax cuts depends on where you stand when those tax cuts are introduced. In the “worst” type of scenario, tax cuts will have the greatest impact on government revenue and the deficit will increase. And by “worst” (intentional qualifier) I mean a very high tax scenario as a starting point. So, how high is “worst”? How does one measure it? It’s not just a matter of considering top marginal rates. The “income” brackets for the different taxpayers (married, single, etc.) and the nominal tax rates all feed the equation. Despite some stability over a number of years, taxes today are considerably lower than what they were in the previous century. (Keep in mind that US debt is very high and growing as we saw, with three peaks, current, 1992, and WWII. In fact, the upward trend in Debt started during the Reagan era, went down during the Clinton years, and started again – though at a slower pace – during the G.W. Bush administration, and made then a big jump up after the Great Recession during the Obama administration and still projected for next years with the current administration).
So, if looking back we see that periods of high taxes are followed by periods of lower taxes, and vice versa, then from a historical perspective what should follow now is a period of higher taxes. The current high spending and the high debt, the highest in 60 years, would also suggest higher taxes not lower.
The fact is that statistics over the last 60+ years reveal that the decrease in the top bracket tax rate has not led to sustainable economic growth, nor to income, wage growth or job creation.
One of the hot tax topics going around is the greater wealth and income disparity and the question of whether top income earners should also benefit from tax cuts. And not to be forgotten is that the top-income bracket already has the lowest taxes in many decades. The fact is that statistics over the last 60+ years reveal that the decrease in the top bracket tax rate has not led to sustainable economic growth, nor to income, wage growth or job creation. This is what’s being sold now, but historically there is no basis for it. During the 1950’s and 1960’s, the top bracket rate was at a high of 90%, yet those were boom years for the economy. There were brief periods of booms, for example in the 1920’s, when taxes on top brackets were low, but these short periods were followed by big busts, and very high wealth and income inequalities.
The trickle-down economic theory that lower taxation for the highest bracket(s) will improve life for the poorer doesn’t hold. In the last 50+ years, we have seen the top rate falling from 90%+ to 35%. If the effect was real, we should see some type of effect on economic activity, overall income, as well as wage and job creation growth. By each of these indicators, the answer is that that particular trickle down theory has no historical basis whatsoever.
If tax reform is to take place, please do consider the ONE-MARSHMALLOW-NOW vs. the TWO-MARSHMALLOW-LATER idea. The following points should weigh in somehow:
- The US has very high spending and is heavily in debt.
- Decreasing taxes, whether on the supply or demand side, will not produce a dollar-to-dollar reduction in the deficit, far from it. So, unless spending is dramatically cut (with all of the implications), the deficit and the debt will grow.
- The American economy is increasingly dependant on foreign investors and any deficit will only accelerate that trend. Americans are also highly in debt. The nation’s net saving is treading waters and that doesn’t create real wealth.
- The most recent experience on corporate rate reductions and bailouts (2008) did not create jobs, even if the latter part, the bailout, did not have that as an objective. Any reference to 2001 and 2003 cannot be isolated from the huge drop in the Fed’s interest rates, from 6% to 1%, though lately the trend is being reversed.
- Lowering the highest income tax brackets will not have any positive effect for the economy and for the rest of the Americans, no matter which indicator we consider.
- Lowering income tax for the middle class and lower income brackets will affect the deficit negatively, even if the reduction is welcome. On another front, any reduction in indirect forms of compensations, such as health plans, Medicaid and all other federal programmes, would offset tax reductions. If what one is shooting for is higher net disposable income one cannot talk of one without considering the other. If lower personal income rate tax rates would increase consumption enough to generate more investment and job creation that is welcome, but if the deficit increases and the trade war has an adverse reaction on prices and hence on consumption, the gain might be lost or even reversed.
- When compared to its OECD counterparts the US corporate rate is high. Given all the points highlighted above, and other ones, tax reform should not just focus on the rates. Other measures should be included in order to increase investment and wealth creation. Investments are needed, not just to finance expansion, but also to replace obsolete and worn-out assets. Something must be done with infrastructures, existing and new, all of which is not private spending and falls, therefore, under public spending. How can that be financed without increasing the deficit? Entrepreneurship, as well as R&D and investment in new technologies, should be incentivized.
- And what about Capital Gains tax reforms? If you don’t know its intricacies, or how it’s calculated, it would be worthwhile to take a closer look at the system, the loopholes and the possibilities for offsetting and carry-over losses in time, and then to consider whether a reduction is really going to generate more investments in order stimulate the economy and whether this stimulus works best for the shorter term or the longer term business cycle, as this will determine whether the eventual increase in investments will contribute in any significant way, for example, to create more long-term jobs or not.
Why is all this important?
There is the automatic assumption that capital gains taxes hinder investment. But this idea does not answer the right question. The question must be focused on whether a change, upward or downward, from where we stand now, will have any significant effect. There are recent studies that based on a broad set of data from many firms, across many business sectors and countries that consider additional aspects, one of them what the researchers call the “risk effect”· In few words, this effect, especially for firms that bear higher systematic risks, the higher capital gains tax entails a risk absorption that reduces volatility in their investment. The higher capital gains tax, even when taking into account the increased pressure on firms to increase returns to offset the reduction in net dividend pay-outs, can be considered as investors as a risk premium in order to diversify their risks. And this consideration is accentuated in periods where the fed rates are low, as it is now.
A lower capital gains tax, which is already at its lowest since WWII, will increase wealth and cash-flow disparity, as it would affect the wealthier, who in addition have at their disposal financial advisors that are clever to exploit all possible loopholes, something that average Americans are not taking advantage of. In sharp contrast with this, the IRS estimated three years ago that 20% of Americans are missing out on available tax breaks that the wealthier are exploiting more fully. Hence, the effects of lowering – or increasing – current capital gains tax is not a black and white matter.
9. Lowering both, income tax and capital gain taxes, must be seen in the context of where we are at now, low-interest rates, deflationary pressure, high deficit and high debt with the perspective of increased costs for its financing. From a historical and theoretical perspective, there is absolutely no reason to consider that such tax reductions would have a positive impact on the deficit, or that the much-needed increase in investments would go towards job creation. In this context, the cause and effect relationships involved must also be considered. Job creation and wage increases take longer to consolidate. On the other hand, the fiscal aspects have a shorter-term impact.
A simplification of taxes, and greater transparency, is a welcomed thing, but tax reform is not only about changing rates and brackets, it involves many others aspects that if tackled with the right purpose in mind, keeping all other factors in mind, should maximize its positive effects which should:
- Increase productive investment and savings.
- Re-activate the economy to counter-balance a deflationary cooling down of the economy.
- Encourage maintenance and replacements of assets to increase job creation and wage increase and not just productivity.
- Seek a greater equalization of wealth and income, taking into account that more disposable income towards the bottom generates more demand and savings, whilst lower taxation at the top does not have that effect.
- Eliminate unfair loopholes that benefit the wealthier making effective tax much lower than the nominal rates would imply.
The next article will deal with manufacturing investment and opportunities for greater production in the US versus production abroad, about how foreign investment in the US has been increasingly on the rise, and about how all of this could change the current economic indicators for the worse, if the trade-war escalates and what are its effects over time.