US Tax Reform: “Voodoo Economics”

“Today we have a similar debate over this. Anyone know what this is? Class? Anyone? Anyone? Anyone seen this before? The Laffer Curve. Anyone know what this says? It says that at this point on the revenue curve, you will get exactly the same amount of revenue as at this point. This is very controversial. Does anyone know what Vice President Bush called this in 1980? Anyone? Something d-o-o economics. ‘Voodoo’ economics.” — Teacher in Ferris Bueller’s Day Off

While I have some sympathy for the proposals coming out of the White House and US Congress to cut corporate taxes despite the potentially negative long-term effects, I am less sanguine about their efforts to eliminate or reduce estate and individual income taxes. These measures seem like yet another attempt to implement classic, Laffer Curve–inspired supply-side economics.

The basic premise behind this theory is that cutting taxes for society’s wealthiest individuals incentivizes them to spend more money and thus create new jobs for the middle and working class. Income tax breaks for the rich “trickle down” to those lower in the economic pecking order and eventually benefit everyone. The growth created leads to more tax revenue and thus offsets the cost, in depleted government coffers, of the initial tax cuts. Everybody wins.

Zombie economics roams the country — again.

But like other examples of magical thinking — day trading is profitable, Japanese equities are in a long-term bull market, hedge-fund managers represent the “smart money” — trickle-down economics sounds great even if it doesn’t work.

Still, a lack of supporting evidence hasn’t kept supply-side proponents from resurrecting the Laffer Curve-powered zombie every few years.

The latest proposed experiment in “voodoo economics” would indeed create additional tax revenue: $471 billion over the next 10 years, according to estimates from the Tax Policy Center. But not because of any trickle-down effects.

The cuts in personal income taxes and the abolition of the alternative minimum tax (AMT), plus greater allowances for standard tax deductions, would cost the federal government about $2.4 trillion in tax revenue between now and 2027. The plan compensates for that loss by broadening the tax base. Eliminating personal exemptions would generate about $1.6 trillion in new revenue, and the repeal of state and local tax deductions would bring in another $1.3 trillion.

The proposed tax cuts, and especially the repeal of the AMT, are structured so that those with the highest incomes see the greatest benefits.

By 2027, the households with the lowest incomes — the bottom 20% of the income distribution — would save about 0.2% in federal taxes, or about $50 per year, according to the Tax Policy Center. In comparison, the top 1% would see an annual income tax reduction of 5.8% — about $207,000 dollars. The top 0.1% would receive a tax cut of 6.4%, or roughly $1 million per year, giving this cohort a lower average tax rate than the top 1%. And households in the top 20% but outside the top 5% — those in the 80% to 95% range — would actually have a higher tax rate under the plan than they do today.

Everybody is equal but some are more equal than others.

The effects of these tax cuts could be accentuated by the proposed repeal of the estate tax. Currently, an estate tax of 40% is levied when a person dies and their assets are not bequeathed to their spouse. But the first $5.49 million of an estate’s assets is exempt from the tax, so only the richest 0.2% of US households have to pay the tax anyway. A repeal of the estate tax would cost the federal government an estimated $239 billion over the next 10 years, according to the Tax Policy Center.

The United States is already one of the most unequal countries in the industrialized world as measured by the GINI coefficient of income inequality. This wasn’t always the case. In the 1950s and 1960s, income inequality wasn’t just lower than today, it was on the decline. Top income tax rates were in the 70%–90% range and ubiquitous labor unions helped ensure that workers had decent wages and pay raises that compensated for inflation and then some.

Runaway inflation, the decline of unions, competition from emerging markets with cheaper labor, and last but not least, a steady reduction in income tax rates for the rich have led to rising income inequality since the 1970s. Over the last couple of years, the top 1% of US households has earned more than 20% of all income — a share last seen in the 1920s, in the run-up to the Great Depression.

US Inequality and the Top Marginal Income Tax Rate

Source: Stone Center on Socio-Economic Inequality (Branko Milanovic), Tax Policy Center

There is at least a weak connection between income inequality and the level of taxation in a country. The chart below shows the top income tax burden, including social security and other taxes, in different industrialized countries together with the most recent data on income inequality. Sweden, Finland, and Belgium have more equal societies and high taxes, while the United States, South Korea, and New Zealand tend to have lower taxes but more inequality.

But the chart demonstrates that the United States is an outlier, which suggests that tax policy is not the sole cause of the imbalance.

Income Inequality and Top Income Tax Rates by Country

Source: Stone Center on Socio-Economic Inequality (Branko Milanovic), OECD

Is there a link between inequality and economic growth?

Higher social inequality might not be a bad thing. After all, the more unequal a society, the more incentive for those at the bottom of the economic ladder to commit themselves to climbing higher. But there is increasing evidence that the so-called “Great Gatsby Curve” is real. That is, as income inequality increases, the rungs on the ladder grow farther apart, making it harder to ascend.

If trickle-down economics worked, a more unequal society would see a more intense growth spurt from tax cuts for the rich. The many studies exploring the link between inequality and economic growth provide conflicting data.

In a recent analysis of 12 developed nations between 1905 and 2000, Dan Andrews, Christopher Jencks, and Andrew Leigh do not find a systematic relationship between income inequality and economic growth. Since the 1960s, they do find higher inequality has a small positive effect on economic growth. A 1% increase in the income of the top 10% leads to 0.12% additional economic growth the following year. But the researchers cannot say if this effect is large enough to make the bottom 90% better off in the long run. In fact, their estimates suggest that it could take 13 years for the beneficial effect of faster growth on the average incomes of the bottom 90% to counteract the drawbacks of reducing their overall share of total income.

Furthermore, other studies indicate that increased inequality between middle- and low-income households may be detrimental to economic growth while greater inequality between middle- and high-income households may be beneficial. Since the proposed individual tax reforms would increase inequality on all levels, it is hard to estimate how it would affect economic growth.

Voodoo economics take a non-economic toll.

While the economic outcome remains uncertain, the evidence suggests that greater income inequality has detrimental social costs, contributing to increased political polarization and tensions between the haves and have-nots.

Politicians become more responsive to their wealthy donors than to the general public. Policies enacted by and for the rich often take aim at public education and the social safety net, which in turn lead to lower economic growth both in the short and long run.

As social mobility decreases, inequality perpetuates itself, creating more polarization. And democracies start to resemble plutocracies run by and for the wealthy.

We have seen this before, and not in a John Hughes film. And I don’t think it’s what anyone wants today.

For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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