Cliffs, Hostages, and Charts: Passing S. 3412 is good policy

The one element of the current fiscal flap which has attracted most people’s attention is the expiration of the Bush Tax Cuts, and the reversion to the tax rates of the Clinton Administration.  Senate Majority Leader Harry Reid (D-NV) commented today:

“It took four months, but Republicans are finally realizing the way back from the fiscal cliff has been right in front of them all along.  In July, the Senate passed legislation to give economic certainty to 98 percent of families and 97 percent of small businesses – to every American making less than $250,000 a year.  For four months we’ve been one vote away from a solution to this looming crisis.  And for four months, House Republicans have refused to act.  Instead they have held the middle class hostage to protect the richest 2 percent of taxpayers – people who have enjoyed a decade of ballooning income and shrinking tax bills.”(Senator Harry Reid, 11/29/12)

The bill to which Senator Reid is referring is S. 3412, passed in the Senate on July 25, 2012 on a 51-48 vote.   Interestingly, Senator Dean Heller (R-NV) voted against the bill.  The bill has since languished in the Republican controlled House of Representatives.

To restate the obvious, since the end of July 2012 the Congressional Republicans have made it abundantly clear that they will not accept any tax increases on the upper 2% of American income earners.

Every pundit from Bangor to Chula Vista has opined about the various political implications and ramifications of this GOP position.  If we step away from the Chattering Cable-ites momentarily, we can see that tax policy is (1) a rather blunt instrument by which to manipulate economic behavior, and (2) while a reversion to the Clinton area rates is advisable, there really is more that can be done to better secure fiscal stability.

With all due respect to the mathematicians who have crafted all manner of elegant algorithms to predict economic behavior — even if the entire transaction is computerized there is still a very human element involved.  An algorithm is written with a human purpose.  In this case it might be to automate the purchase or sale of particular “things” at a specific price.  The essential problem with capitalism is that prices are determined by human beings who pre-judge the value of the “things” in terms of their own desires and motives.  The motive might fall anywhere along the spectrum from pure speculation to pure long term investment strategies.

Given this context, consider momentarily the currently popular Republican refrain that if marginal tax rates are “too high” investment will be stifled and economic expansion constrained.   The essential economic question at this point is not how many petulant plutocrats does it take to impede any political action in regard to tax rates — but, at what marginal rate does tax information become a significant factor in the investment decision?

As the chart from the IRS indicates, the marginal rate of taxation on the highest income earners has dropped since the mid 1960′s.  The taxation on capital gains is now below 20%.   The next question: What is the statistical relationship between marginal tax rates and investment?

The Congressional Research Service (pdf) studied the relationship between top marginal rates and private savings ratios and created these illustrations of the data:

If the data points look a bit scattered — it’s because they are.  The CRS drew the following conclusion:

“The bottom charts in Figure 3 show the observed relation between the private fixed investment ratio (investment divided by potential GDP) and the top tax rates. The fitted values suggest there is a negative relationship between the investment ratio and top tax rates. But regression analysis does not find the correlations to be statistically significant (see Table A-1 in the appendix) suggesting that the top tax rates do not necessarily have a demonstrably significant relationship with investment.”

Translation: While the charts tend to lead the eyeballs toward seeing a negative relationship, when we actually crunch the numbers the results could just as easily be the result of good old fashioned chance.

There is a place for anecdotal evidence from financialists whose self interest dictates the championing of lower marginal tax rates as a significant factor in their investment decisions, however it’s not in the midst of a rational argument about economics.   Therefore, investor extraordinaire Warren Buffet’s question remains valid:  ‘If I called you in the middle of the night and told you I had the best investment opportunity ever seen in the world — would you ask me about the tax rate?

This ragged relationship between effective rates on capital gains and the returns investors receive as a percentage of GDP is illustrated below:

The first points to note are along the pink line (circa 1996) when the average effect tax rate on capital gains was 25.5% but the trend line for realized gains was going up.  The ‘conventional wisdom’ held for the period between 1996 and 2000, at which point the trend lines no longer support the contention that lower average effective tax rates mean greater realized gains.  Between 2000 and 2004 the average effective tax rates decline, but so do the realized gains, and from 2004 until the last data available from the Tax Policy Center in 2007 the tax rates remain essentially the same but the gains increase.  Go Figure?  What we could conclude with more certainty is that the tax rates and the realized gains aren’t operating in tandem, and there’s more to “economic decisions” than considerations about marginal tax rates on capital gains involved.   Again, Buffett is probably right.

If reducing the effective tax rates on capital gains isn’t a sure fire way to increase earnings and entice yet more investment, then what about tax rates in general?  That doesn’t quite work either as illustrated by the following chart from Business Insider:

… and we know what happened in 2007 through 2008.  If a relationship cannot be demonstrated between lower capital gains taxes and the gains coming from economic growth AND we cannot demonstrate a relationship between overall marginal tax rate reduction and economic growth, WHY are the Republicans so intent on preserving the tax breaks for the top 2% of the nation’s income earners?  George W. Bush may have stated more truth than he meant when he quipped during the 2000 Alfred E. Smith banquet attendees, “This is an impressive crowd. The haves and the have-mores. Some people call you the elite. I call you my base.”

For all of Senator Reid’s efforts to move the Congressional Republicans into the real world of average Americans, nothing has worked thus far to convince them to abandon frivolous pledges from scions of anti-tax activists, which at this point serve little purpose other than to widen the income gap, and to deplete the capacity of middle income earners to generate the aggregate demand necessary to stimulate the economy.

It really can’t be argued that all economic decisions are dictated by human behavior, but neither can it be successfully asserted that an economy is not essentially a very human institution.   There are reasons well beyond the political optics of S. 3412 for Republicans to give serious consideration to pass the bill in the House of Representatives; it’s good economic policy.

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