Friday, August 13, 2004

Why Bush's top-heavy tax cuts don't work

This entry is in response to a blog posting, where a comment was made a while back objecting to my assertion stating that the rich save more than the poor, and as a result the Bush tax cuts is not an effective stimulus for a slow-growing economy.

The Economic Irrationality of Supply Side-driven Tax Cuts
Setting aside the fact that jobs growth has been slowing down tremendously (as evidenced by the latest monthly jobs report of an anemic 32,000 new jobs) despite *record* monies spent on tax cuts, I think tax cuts are perceived in fundamentally different ways, one of which does not jive well with the economic data. I believe too many go through a certain thought process or experiment where one analyzes things at the margin and make assumptions leading to the belief that the rich are actually more likely to spend than the poor, thereby justifying the top-heavy tax cut approach.

Here is an alternative view. For a point of reference most of us can agree to, here is a set of time-series data from the Bureau of Labor Statistic's Consumer Expenditure Survey:

[Column #'s]
[1] Income quintiles (fifth)
[2] Share of total income
[3] Fraction of income saved
[4] Contributions to overall savings rate

1981 TO 1983 AVERAGE
lowest 3.9% -108.2% -4.2%
second 10.1% -15.4% -1.6%
third 16.7% 6.3% 1.1%
fourth 24.8% 18.4% 4.6%
highest 44.4% 31.3% 13.9%
Overall savings rate (1981-83) 13.7%

1987 TO 1991 AVERAGE
lowest 3.8% -122.6% -4.7%
second 9.3% -28.1% -2.6%
third 15.8% -0.9% -0.1%
fourth 24.3% 12.2% 3.0%
highest 46.9% 30.6% 14.4%
Overall savings rate (1987-91) 9.9%

Source. Consumer Expenditure Surveys, Bureau of Labor Statistics,U.S. Department of Labor.

Besides the obvious fact that the rich do save significantly more then the poor, here's some context behind this trend that should leave little room for doubt.

A Little Economic History
Beginning in the mid-1970s the share of their incomes which U.S. households save steadily declined, and this drop accelerated in the 1980s. According to household surveys, the savings rate averaged 13.8% of income during 1981 to 1983, but fell sharply to 10% during 1987 to 1991.

Most economists, and many policymakers, believe this decline is a critical economic problem. Why? First, since they view saving as the source of capital for business investment, lower savings will mean higher interest rates, resulting in less investment and slower economic growth. Second, higher interest rates will harm consumers by making it more difficult to finance home mortgages, car loans and other purchases. Third, the current generation, by not saving enough, will face greater hardships in retirement.

While economists and policymakers of many political stripes agree that we should be deeply troubled about this situation, they don't agree on why the rate fell, or what to do about it. One political viewpoint, that of "supply side" economics, became prominent in part due to concerns during the 1980s about the falling savings rate. Among other things, supply-siders argue for redistributing income toward corporations and the wealthy, on the theory that these sectors save at higher rates. But while such a redistribution has taken place during the past 15 years, overall savings have continued to fall.

Evidence from recent decades shows that while the rich are saving more, this increase has been outweighed by dramatically lower savings from all other income groups. And the reason is that widening inequality has so harmed the incomes of moderate- and low-income households that they are unable to save, and in fact are living on borrowed money (dissaving).

Flaws in Standard Economic Assumptions
One problem with standard models (and every day folks as matter of fact) is that they assume all households, regardless of their income or wealth, make consumption decisions in similar ways. All families, the models assume, balance their current consumption needs versus the need to save for retirement, and all have reliable estimates of their future income.

These assumptions are suspect for several reasons. First, only households that have relatively stable sources of income can make long-term decisions concerning future consumption in retirement. But a large and growing number of households face great uncertainty concerning their jobs and income. Second, many households, even if they would like to save for retirement, cannot do so, because they don't have enough income to cover their current consumption needs.

Standard models also fail by assuming that households adjust their behavior similarly whether incomes rise or fall - when they rise, households consume more, and when they fall, households consume proportionally less. But the "Relative Income Hypothesis" (RIH), suggested in 1949 by economist James Duesenberry - reminiscent of eclectic economist Thorstein Veblen's earlier work dissecting the [ir]rationalities of the leisurely class (in his best known book, the Theory of the Leisurely Class, chapter 4 is on Conspicuous Consumption - a term he originated) - argues that when incomes decline (such as in a recession) households resist giving up the consumption patterns they have become accustomed to.

To maintain their previous living standards, households will either reduce their savings rates, consume out of previous savings, increase their use of debt, or raise household income by having another household member enter the labor market. This all can be summed up by what someone said to me recently: "It's amazing to see how customer care representatives at my company are driving BMWs and Lexus on a 30K a year salary." I make a bit more yet I bought a Nissan Altima in 2002, albeit souped up a bit with a V6 and spoiler but at least 10K cheaper than the former two.

In other words, the more wealthy you are on the economic continuum, the more likely you are in making more rational economic decisions that involve heightened consideration of future and present values of costs and returns of goods and assets (many with help of fine accountants everywhere), which lead in the end to a much higher rate of savings to play a large part. This trend persists through times of growth and recession over the long-run (note how static the results held over the decade-long time series). If one had time to dig the more recent '01, '02, and '03 survey data, it would show the same trend.

It would be instructive to understand given the shift in income toward the wealthy during the 1980s, what caused the decline in savings rates from 1981-83 to 1987-91? It was not a lack of savings by the richest Americans, but rather by everyone else.

The dissavings rates of the lowest two fifths rose, while the savings rates for the third and fourth fifths (perhaps approximating the middle class) fell greatly. In 1981-83 the lowest two fifths dissaved at rates of-108% and - 15% respectively, while in 1987-91 their negative saving rates grew to -122% and -28%. In addition, the third fifth went from net savers to dissavers, while the savings of the fourth fifth fell from 18% to 12% of their incomes. The savings rate of the wealthiest fifth of households also worsened slightly. But this was more than offset by their increased share of national income. As a result, this was the only income group that increased its total savings (from a 13.9 to a 14.4 percentage point contribution toward the overall savings rate, as shown in column three of the table).

...And Why Bush's Tax Cuts Don't Add Up
As such, the Bush tax cuts are not very effective given such economic realities. The problem is only worsened considering that the tax cuts are funded on borrowed money that is costly, debt-financed by our very willing co-optitors of the Far East and Europe.

Many analysts expected the overall U.S. savings rate to rise as wealthier households, with higher savings propensities, gained a greater share of the total income. And supply-side theorists continue to recommend shifting income toward the wealthy as a means of raising total savings in the United States. But the evidence demonstrates the opposite - higher savings by the rich did not make up for the severely reduced savings of the remaining 80% of households.

As some economists have argued, the bottom three fifths found it necessary to increase their dissaving in order to maintain living standards in the face of stagnating real incomes and rising costs of living, especially for housing, since the early 1970s, and now rising commodities, oil, and food prices.

In the end, the tax cuts are needed much more by the middle- and lower-income class (by middle, I mean most of you and I making less than $200,000 a year), more to buttress up the savings rate *and* to increase the consumption rate since the rich (BillG and his closest 1,000 friends) are not consuming but investing for the rest of us to consume thus completing, ideally speaking, a virtuous cycle of economic growth.

However, Bush's belief in discredited "trickle-down" supply-side economics of the 80's (whereby people making >$200K a year receive bulk of the billions in aggregate benefits of the tax cuts and save much of it, vs. just marginally speaking viewed by impact as % of their income, which fails to provide a weighted measure of the economic impact of tax cut dollars spent that stimulate aggregate demand) is a disaster for this day and age of free capital flows, debt-driven foreign-funded demand, coupled with oil and basic materials volality and price increases, political instability, and a wholesale lack of investment in education, technology and research vis-a-vis the G-8 and *China*.