Raise Taxes to Cure the Recession

Political debate in the United States is currently strangled by the failure of anyone to advocate raising taxes, however strong the arguments in favor. This is presumably the ultimate tribute to the genius of Grover Norquist, who has made it political suicide to even mention the possibility. The likely result is economic catastrophe, but that is of no consequence to the low-tax brigade.

In the long term, the consequence of a refusal to raise taxes will be to present the American people with a choice between the preservation of such elements of a welfare state (notably social security) as it has in the past built and continuing increases in the national debt. The CBO projects government spending on present trends at just over 22% of GDP in the first half of the 2020s and the tax take as slightly over 18% of GDP.

Insofar as growth occurs, one can run a secular deficit without an increase in the debt/GDP ratio, but that allows only for at most a 2% real gap. There is no way that discretionary expenditures can be cut enough (even if one is prepared to ignore the case for increasing some of them), since they are projected to amount to only about 5.5% of GDP (including defense). A reduction in mandatory expenditure (such as social security expenditure) would be needed, despite the increase in the number of claimants that is in prospect.

There is a second baleful long-term consequence of the refusal to consider tax increases. This is the need to achieve equality between debt and equity. At present debt is subsidized by being tax-free, with the result that corporations and banks (like governments) have far too much debt and far too little equity. Since we cannot afford yet more give-aways of tax revenue, the only way to square the circle is to tax debt. Logically tax reform, if it ever happens, should include the abolition of mortgage interest relief. But these reforms are also precluded by a refusal to raise taxes.

In the short term, I have long held that a switch in the composition of taxes could be helpful, but this also is precluded by the slogan of no new taxes. The particular switch that seems to me called for is to institute progressively a heavy tax on conventional energy, in return for a progressive reduction in taxes on things that we want to encourage, like income. The reason for believing that it could be helpful in the present situation in that it would provide a concrete incentive to undertake investment in the new energy industries; if it were done so as to be fiscally neutral, there would be no adverse impact on aggregate demand. The idea of a “carbon tax” has been around for many years, and was indeed considered (and rejected) by Congress at the start of the Clinton Administration. Politically, opponents of the carbon tax presented it as implying a tax increase; if instead it were presented as the price of an income tax reduction, it might be less unpopular with the general public. Of course, there is no hope of persuading Grover Norquist or the Exxons of this world.

What is new, at least to me, is an additional short-term case. This arises from an argument persuasively advanced by Andrew Smithers[1]: that the shift in managerial compensation from salary to bonus distorts management incentives in such a way as to bias managerial incentives toward the short-term. The argument is that managers are now largely compensated by bonuses, that most bonuses depend on recorded profit per share being higher than in the preceding period, and that it is therefore in their personal interest to risk the long-term future of the firm where there is a conflict with its short-term interest. 

Where do such conflicts arise? In regard to investment, where long-term a firm may need to expand its capacity by investing more, while in the short term it can make do with its existing facilities. And with regard to its price mark-up; short-term profits can typically be increased by charging more than is good for the firm in the long run. So one has an explanation of why firms are sitting on oodles of cash instead of investing as past experience suggests they can be expected to. Similarly, we suffer from more inflation than past experience would lead us to expect, given the extreme weakness of demand.

Changing these outcomes is essential to achieving a real recovery. The most straightforward way I can see of achieving this is to reverse the fact that managerial returns now come overwhelmingly from bonuses. And how to achieve that? How about using the tax system? Ideally one would want to impose a tax rate of about 98% on bonuses, as opposed to the present top rate of 39.6% plus state taxes, so that bonuses cease to be worthwhile.

A good approximation would be to raise the income tax rate on incomes over (say) $1 million to a rate of about 90%, which (combined with state taxes) would typically give a marginal rate of about 98% for those with incomes of over a million dollars a year. We were sold tax reductions with the argument that they are good for incentives, and there are high-earning individuals for whom this is surely true. But they earn over $1 million? The only persons who earn in that range are those with large assets and company CEOs on bonuses; the former do not need incentivizing and for the latter we have just argued that the incentives have a perverse outcome.

So it would be easy to design a program that would both promise to end the recession and improve the fiscal outlook. Of course, it won’t happen. For that we have to thank Grover Norquist and the low-tax brigade. 

[1] The Road to Recovery, Wiley, Chichester (UK), 2013.

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