Monday, 22 September 2008

Why the poor need tax-cuts for rich people, too

There has been a lot of (welcome) talk recently about the Liberal Democrats’ pledge to cut taxes for low- and middle-income earners. This has been broadly welcomed in the party, though many have only accepted it as long as it is accompanied by a promise that the overall tax-take will remain the same, and that richer people should shoulder more of the tax burden.
This kind of “redistributionist” approach is always very popular, as most people are in the poorer rather than the richer category. It is easy to take from the minority to give to the majority, and there is no minority less sympathetic than the rich.

A counter argument might be that the only fair thing to do (and “fairness is something that the Liberal Democrats claim to take very seriously) would be to cut taxes for everybody if we are cutting them for some. But that kind of fairness - that everybody be treated equally no matter how wealthy they are - generally only cuts one way.

However, economists such as George Reisman make a far more startling claim: that it is tax cuts for rich business people and for corporations that are in the long-term interests of low and middle income wage earners; more so, in fact, than tax cuts aimed directly at the poor themselves.

Reisman’s initial point is a simple one, but one that is too often forgotten: that human society enables one to benefit from other people’s success. “The view of redistributionists…” he explains, “is that the only wealth from which an individual can benefit is his own…” The redistributionists are mistaken, however: “in order to benefit from privately owned means of production, one does not have to be an owner of the means of production… one benefits from other people’s means of production – [not only] every time one buys the products of those means of production [but] also as a seller of labor (sic.).” Capitalists invest in improving the efficiency of production so that they can enhance their profits, but in the process they make the goods we buy cheaper and make our labour more productive, so increasing real wages.

The reason that redistribution looks so attractive is because one tends to think of redistribution in terms of individual sums being transferred from a rich person to a poor person; and there can be little doubt that £1,000 is more valuable to a poor person than a rich person. But it does not follow that £100 billion is worth more in the hands of poor people overall than in the hands of rich people overall.

The problem is that “most people tend to think of themselves as members of the class of wage earners rather than separate individual wages earners, and to think of their interests as indistinguishable from the interests of other wage earners.”

In fact, while it is more in my interests that I have £1,000 than that Richard Branson does, it is no more valuable to me that a poor man in Liverpool has that £1,000 than Mr. Branson. And it is far more likely to serve my interests that a few rich people have £100 billion than huge numbers of poor people, even if £1,000 of that £100 billion ends up in my hands. The reason for this is that poor people spend a greater proportion of their money on consumption, and are more likely to consume than to invest additional sums. As Nick Clegg said in a recent interview with The Times, "give tax cuts to the better off [and] they will just save them. You have to give [tax cuts] to people on lower incomes who will transfer them into consumption on food and fuel.”

This is ceertainly true and is entirely predictable: those on the breadline would be happy for the opportunity to buy new shoes, while those who already own a yacht are free to invest extra money in their business. This is especially true for businesses themselves: business taxes leach away the money that would either be invested in improving productivity or would be paid out in the profits that attract further investment.

There is a point here that Reisman does not fully draw out, but which we can recognise today after a decade of Labour economic mismanagement. Money in the hands of the poor would create greater wealth in the short term, as a result of a consumer boom. But these consumer booms are unsustainable: buying more clothes and electronic goods does not make their production significantly more efficient. Investment makes them more productive, but this requires an investment boom. In fact, during the past decade the consumer boom has been accompanied by a dangerously low and shrinking savings rate: the West has saved almost nothing. Consequently, productivity has not risen as it should have done, which is one reason why real wages for less skilled workers (which are set by their productivity and thus by the investment in them and in the tools that they use) has not risen. Simply taking the money that would be invested in businesses and giving it to others to consume is “eating the seed corn.”

By comparison, “A tax reduction on businessmen and capitalists will promote capital accumulation, far, far more than a tax reduction on the mass of the individual wage earner's fellow wage earners. The average businessman and capitalist will save and invest the taxes he no longer has to pay, in far greater proportion than would the average wage earner, [and the businessman] will be induced to introduce more improvements in products and methods of production, which are also a major cause of capital accumulation…” In addition, “cutting the taxes of businessmen and capitalists [will] significantly … raise the demand for labor and … reduce or eliminate unemployment”. The result of increased innovation will be to enhance “the ability of upstart new firms to grow rapidly and thus to challenge old, established firms.”

Overall, “The effect of this combination is … a continually rising productivity of labor… and thus prices of consumers' goods that are progressively lower relative to the wages of labor, which means progressively rising real wage rates, so that in not too many years the average wage earner is far ahead of where he would have been on the strength of a cut in his own taxes.”

So ironically, it seems that cutting taxes for the labourers makes capitalists rich in the short term, whereas cutting taxes for the capitalists makes labourers rich in the long term.

The reason that Reisman’s argument is so challenging is that it seems to suggest that tax cuts for the poor are not in their own best interests. This isn’t mere sophistry. If productivity does not rise, real wages cannot rise. All “labour” can do is fight with “capital” and “land” for the share of wealth. This seems to be the be-all-and-end-all solution for redistributionists, who argue that the poor can only benefit at the expense of the rich. This would be true in a static economic system. But they forget that economies are (or at least should be) dynamic. The route to prosperity is through economic growth: “The average standard of living would double in a single generation if economic progress at a rate of just 3 percent a year could be achieved. Such economic progress would also mean a halving of the average wage earner's tax burden in the same period of time — if government spending per capita in real terms were held fixed.”

Consequently, the long-term prosperity of the average worker is best served by capitalists who invest for their own benefit. In seeking to further increase their own profits, capitalists invest extra money in improving productivity, which they do by buying new and better plant machinery, "upskilling" their staff and employing new and better business systems. Improvements to productivity in turn push up real wages and so benefit labourers far more than tax cuts on their own wages would. If Government can avoid the urge to “share the proceeds of growth” then wage earners will see their taxes fall anyway – not in absolute terms, but as a proportion of their rising incomes.

If there is a problem in Reisman's plan, it is that in advocating this policy of easing taxes on business and high incomes first, he overlooks the political economy of the 21st Century. No matter how correct he may be about the long term economic effects, it would be impossible to implement such tax cuts in the face of the vast majority of voters who will understandably ask why their taxes are not being cut while those of £billion businesses and rich oligarchs are. What is needed, therefore, is a sort of liberal realism that recognises that lowly paid workers, who form the bulk of the electorate, will want to see some of the short-term gain that their richer peers will enjoy as they wait for the longer term growth-benefits to kick in. One might suggest that a little honey today will keep them sweet until tomorrow’s jam arrives.

Thus if the Liberal Democrats really want to improve living standards for those on low incomes, we need to look not just to redistribution but to cutting the overall level of taxation in the economy. And we must do this by reducing taxes on businesses and among those wealthy enough to invest as well as those who will feel the benefits most in the short term. This is not about larding the rich for their own sake; it is about recognising a fundamental lesson of liberalism – that we all benefit from one another’s success – while also understanding that it is investment, not consumption, that makes future prosperity possible.

Reisman concludes that

Of course, in a further display of their ignorance and blindness, members of the Left will undoubtedly characterize the line of argument I've presented in this article as the "trickle-down theory." There is nothing trickle-down about it. There is only the fact that capital accumulation and economic progress depend on saving and innovation and that these in turn depend on the freedom to make high profits and accumulate great wealth. The only alternative to improvement for all, through economic progress achieved in this way, is the futile attempt of some men to gain at the expense of others by means of looting and plundering. This, the loot-and-plunder theory, is the alternative advocated by the redistributionist critics…. It is time to supplant it with ... sound economic theory….

14 comments:

Jennie said...

isn't this exactly what has got us into the situation we are in now? Tax cuts for rich corporations?

BTW, I'm all for fairness when it comes to individual taxation - I think the rich and the poor should pay the same proportion of their income in tax. Currently, this is nothing like even approaching the case.

Tom Papworth said...

Thanks, Jennie. I agree with you on the tax issue.

However, I don't think that tax cuts for rich corporations can be blamed for our current woes.

Actually, there are two culprits. One is the result of what economists call the "Principle:Agent problem" - the owners of companies had too little control over their employees, whose interests were not the same as the owners. The employees had too much to gain from high-risk get-rich-quick manoeuvres.

It is worth noting that Hedge Funds, which are generally actively run by those whose money is at stake, have not been going to the wall or seeking bailouts in the way that Investment Banks have.

The other is Government. Excessive regulation is part of the problem. In America, banks were forced to lend to people with poor credit records by regulators, thus forcing the sub-prime market.

Meanwhile, investment managers sought out ever more convoluted ways of sloughing off the regulatory straightjacket that was preventing them from generating capital.

Personally, I favour less regulation in the first place and no bail-outs when they screw up. Nothing will make the markets more cautious and sensible than a few healthy bankruptcies.

Jennie said...

"Personally, I favour less regulation in the first place and no bail-outs when they screw up. Nothing will make the markets more cautious and sensible than a few healthy bankruptcies."

That sounds eminently sensible to me.

Joe Otten said...

Tom,

Actually I suspect that the opposite is largely true. Tax cuts for the poor will produce more trickle-up than tax cuts for the rich will produce trickle-down. Or maybe it is the same amount, in which case tax cuts for the poor are still preferable.

The consumption/investment contrast is somewhat artificial. Global capital markets mean that investment will be found wherever there is a profit to be had. And greater spending power for anybody will mean there is a profit to be had.

Kit said...

One point must be stressed:

Corporations DON'T pay tax.

They only collect it on behalf of the government. The corporation tax burden falls on the shareholder, employees, and customers. For instance, taxes paid by the supermarkets particularly hurt low-skilled workers and the poor.

Costigan Quist said...

Tom,

You've laid out the theory of trickle-down economics well. The problem is that the theory's been tried, in the '80s, and simply didn't work as designed. The rich got much richer and the poor saw very little benefit at all.

http://en.wikipedia.org/wiki/Trickle-down_economics

Liberal Neil said...

This would be a very compelling argument if all the available evidence didn't point the other way.

Technomist said...

"It is worth noting that Hedge Funds, which are generally actively run by those whose money is at stake, have not been going to the wall or seeking bailouts in the way that Investment Banks have."

Erm, except that's not actually the case, is it? They have been quietly going out of business: at least 50 of them so far. We just haven't noticed because everyone hates a hedge fund - it helps people we don't know manage risk we don't understand. And aren't are all fat, evil, wear top hats and smoke cigars?

See: 'Hedge funds suffer mass redemptions' in today's Independent,
by Nick Clark

http://www.independent.co.uk/news/business/news/hedge-funds-suffer-mass-redemptions-938959.html

Tom Papworth said...

Joe,

Those global capital markets do rather rely on wealthy individuals with money to invest, though. It's not going to come from making it easier for somebody to pay their gas bill.

That may be a worthy goal in the short term, but in the long term real wages will only rise if investment can be gained either from shareholders directly or via those captial markets.


Costigan Quist,

I refer you back to the last paragraph. This isn't "Trickle Down". It's the only means of raising real wages, which is to improve productivity through the application of capital.


Neil,

If you could cite any of the "available evidence" that suggests that consumption-booms were sustainable whereas investment booms were not I would be grateful to see it.

Any examples?


Techonomist,

As the Independent article makes clear, the problem for Hedge Funds is Government intervention, not the market. Since the Government stepped in to prevent the perfectly reasonable process of Short Selling, a main plank of their business model has been removed.

It's a bit like saying Starbucks is suffering from the Credit Crunch after the Government bans coffee!

Alex S said...

I second Kit's point about tax incidence: companies are legal fictions and when their taxes are increased, that increased burden is borne by some combination of investors (in the form of lower returns), customers (in the form of higher prices) and workers (in the form of lower wages).

So raising corporation tax is not some 'painless' way of extracting money from business and diverting it to recipients who are deemed more worthy, but futile gesture politics.

Rather than raising the rate, I would like to see the phasing out of industrial subsidies, elimination of most tax reliefs and exemptions and a big cut in the rate.

This could be revenue-neutral given the parlous state of the public finances - although there is some evidence (notably from Ireland) that cutting corporation taxes produces 'dynamic' benefits and might lead to a higher yield. (I am not arguing that this is the case for all taxes, or for a naive faith in the Laffer curve, but there clearly can be supply-side benefits to cutting tax rates.)

Jennie: It's true that the top 20% of the income distribution pay a (slightly) lower share of their income in tax than the bottom 20%, a situation that is clearly unfair.

This is true despite the fact that our income tax system, in and of itself, is highly progressive - because other taxes like National Insurance, VAT, council tax, tobacco duty, some green taxes etc are borne disproportionately by the poor.

Overall, then, the tax system is regressive and, by itself, actually worsens income inequality. The reason this is the case is not just because of specific iniquities, but because the state is too large, requiring low/middle earners to be heavily taxed.

Much of the tax and benefits systems, and Brown's edifice of tax credits, consists of taking money from people on modest incomes and recycling (some of) it back to them after it's gone through a big state bureaucracy. Vince Cable made this point very well in his second speech in the tax debate at conference.

Tom: I agree that investment booms rather than consumer booms are the catalyst for productivity improvements and long-run GDP growth.

But I think Nick Clegg's point is about macroeconomics, not microeconomics: if the aim is to boost the faltering economy in a counter-cyclical way, then it makes more sense to cut taxes on people who are more likely to spend rather than save.

(The elephant in the room in our internal debate seems to be the ballooning budget deficit, which is going to be a millstone round the neck of future taxpayers - but that's another debate!)

As a party we're moving in an encouraging direction on cutting personal taxes; I'm not sure I can say the same about our approach to corporate and capital taxes, which are at least as important to wealth creation as you suggest.

Ideally we should be aiming to cut income AND capital taxes, introduce a land value tax and reduce the overall burden as you say.

I'm interested to know what you think of Vince's case that we should reinstate the old Nigel Lawson system whereby income and capital are taxed at the same rate.

That sounds sensible in theory, but I'm not sure increasing CGT from 18% to 40% is the way to go (even if he would soften the impact of this by reinstating indexation). What may have made sense in the 1980s (a 40% CGT rate) does not necessarily make sense today.

Tom Papworth said...

Alex,

I largely agree, but I'm not sure I'd let Nick off the hook that easily. Our tax policy is much older than the current economic slowdown and this Conference was the first time I heard it explained in macroeconomic (stabalisation) terms. In the past it has been purely about redistribution and in that sense it is flawed.

I am also sceptical about the degree to which Governments should manage economic cycles. I tend to think that sound money and the rule of law should be just about the limits of a Government’s economic policy.

I agree that CGT should be taxed at the same rate as income. In fact, I think the distinctions should be eliminated – it is income, in a real (rather than technical) sense, though derived from investment, not labour. I am drawn towards the idea of taxing all forms and all levels of income at a flat rate, but removing all the allowances and loopholes that result in “higher rate” taxpayers actually being able to offset most of those taxes against various “expenses”. If nothing else, this would allow us to reallocated a lot of (human) resources at HMRC and in accounting firms to more efficient and thus profitable use.

Then of course there is the question of double taxation. I don’t understand why my investments are taxed once when a profit is declared and a second time when it is sent to me. But one battle at a time, eh? :o)

dreamingspire said...

Equally I don't see why the state old age pension should be taxed. And more efficiency in the public sector (and in the lower paid employment areas, particularly part timers) could result if the personal allowance can be significantly raised.

Beth said...

Tax cuts are only half of the solution. In other writings of Dr. Reisman's, he points out that tax cuts without decreasing government spending and government debt really can't work. It's why in the era of tax cuts, government debt soars. Government spending both deprives the private sector of needed resources, and prompts the central bank to increase the supply of money (read: inflation, i.e. loss of purchasing power for the currency).
You need both tax cuts and spending cuts get the burden of government off the back of the producers and allow the economy to flourish.

Thanks for a nice summary of a great article.

Tom Papworth said...

Beth,

I utterly agree that tax cuts need to be balanced with spending cuts.

But one battle at a time... :o)