Monthly Archives: September 2011

Another Reason to Like Rich People

They don’t just create jobs…

One of the most common complaints of a free market system comes from consumers who, while desiring a nascent product, are too in-affluent to buy it. I frequently see this sentiment emerge while reading the various technology and automotive blogs across the internet, where new products are introduced several times each day. Experienced bloggers and commentators are adept at shrugging off their disappointment in these situations; they know that consumers need only wait, and the product will eventually become affordable. Many people, however, don’t seem to understand how this occurs, and their bewilderment too often turns to impatience. To alleviate this problem, let me attempt an explanation of how a good or service becomes affordable.

First, an entrepreneur/producer has an idea for a product, either to create a new one or to improve upon an existing one. Because the product is relatively new and strange, the cost of building it is high. It requires lots of investment, research, time, and labor to create. The high cost of production necessarily translates into a high sale price.

Because the initial sale price of the new product is so high, relatively few people will be able to buy it outright—this small group of people consists of the most affluent among us. However, if the rich buy enough of the product, potential producers will interpret this as evidence of growing demand, and they will enter the market to capitalize on it. The subsequent combination of increased product supply from numerous competing firms, and streamlined production lines, causes prices to fall until profit margins can no longer support a growing number of producers. At this point, the market has reached the equilibrium of supply and demand, and the product is now affordable for the greatest number people.

Rich people are incessantly demonized by the envious and the despotic, but consider how our economy would be different if they were suddenly absent. Without rich people, new and expensive products would never be purchased. This would send a signal to potential entrepreneurs and producers that there is little likelihood for a return on their investments, which would seriously hamper the research and development of new products. It is difficult to imagine a world in which the shelves of our stores aren’t constantly being stocked with new products—a world where a better life is just out of reach—but such a world is possible when affluence is erased.

New products are risky. There’s a substantial chance that a new product will fail upon reaching the market. It is thanks to entrepreneurs and producers, who risk their time and resources on ideas, that we have an abundance of ever-improving tools and technology. However, we also owe thanks to the most affluent consumers who help determine if a product is viable. Because they’re willing to take a risk in buying a new product, the rest of us are eventually able to afford a higher standard of living.

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Understanding ’80s Economics

With the resurgence of American conservatism and the advent of the Tea Parties, politics in the United States has become increasingly polarized. Often cited as evidence of superior fiscal/economic policies is the economic record of Ronald Reagan. Ronald Reagan has become a quasi-religious icon of the American conservative movement and on some practical levels he appeals to politicians of all ideologies. Even Barack Obama, considering himself to be like Reagan in manner and appeal, has invoked Reagan in order to garner support for his leftist policies. Nevertheless, Reagan’s popularity makes him a common target for criticism by the left. Unfortunately, too much of that criticism seems to go unanswered, and pundits on the right seem to take the soundness of Reagan’s policies for granted. I hope to give some support to conservative economic policies by providing some simple answers to questions and comments I’ve heard about our 40th president.

Question: Ronald Reagan is often lauded as a staunch fiscal conservative, but is he not responsible for an increase in U.S. debt by two trillion dollars?

It is true that the debt rose by $1.86 trillion under the Reagan administration, and it is also true that the debt ceiling was raised more often under the Reagan administration than under any administration in U.S. history.[1][2]

How was all this debt accrued? Wouldn’t a lack of budgetary restraint of this magnitude suggest fiscal liberalism, not conservatism?

It might suggest that, if we only look at total spending; but not all spending is created equal, and it is necessary to examine the components of federal spending as well. Federal outlays increased by $466 billion during the Reagan years—from $678 billion in 1981 to $1.1 trillion in 1989.[3] “Human Resources” spending (which includes spending for Social Security, Medicare, Medicaid, and other entitlement programs) accounted for 44 percent of the increase; defense spending accounted for another 31 percent; and every other form of spending (infrastructure, government payroll, general operations, etc.) took up the remaining 21 percent.[4] As we can see, entitlement spending was the primary driver of all federal outlays (a trend consistent with previous presidencies). Spending on the largest entitlement programs is not discretionary, meaning such spending is not affected by the government’s annual budgets, and fundamentally reforming these programs is extremely difficult without a unified government, something America did not have during any years of the Reagan presidency.[5][6] Ultimately, Reagan’s credentials as a conservative will be determined by your view on the effectiveness and necessity of the military buildup which he advanced. We should not lose our sense of perspective, however: Even if defense spending had remained at 1980 levels throughout Reagan’s presidency, the country would still have been running a $6.6 billion deficit in 1989 due to the increase in entitlement spending, something over which Reagan had minuscule control.[7]

Question: Setting aside the country’s fiscal status, what were the economic outcomes of the 1980s?

Under the Reagan administration, the United States began the longest sustained peacetime economic expansion in its history, and the second-longest during either peace or war. Real GDP grew by 33 percent from 1981 to 1989, averaging 4.13 percent annual growth.[8] Real per capita income grew by 22 percent over the same period.[9] There was a net gain of 16.2 million jobs, slashing the unemployment rate from 7.5 percent in January of 1981, to 5.4 percent in January of 1989.[10] The rate of inflation was cut from 11.82 percent in 1981 to 4.67 percent in 1989.[11] Private sector savings increased by $85 billion, and domestic private investment surged by a magnitude of $369 billion.[12] In short, Americans were working more, producing more, earning more, and benefiting from monetary appreciation, all at a faster rate than any other peaceful time in U.S. history.

How was all of this brought about?

From 1981 to 1989, Ronald Reagan signed a series of bills that lowered taxes overall and simplified the tax code. These bills, known collectively as the “Reagan Tax Cuts”, lowered the marginal rate on all income tax brackets—including a drop in the top marginal rate from 70 percent to 28 percent—reduced the capital gains tax from 28 percent to 20 percent, and indexed for inflation marginal tax rates at every income level.[14] They also reduced the Alternative Minimum Tax rate from 25 percent to 21 percent, and they repealed the Add-On Minimum Income Tax altogether.[15] Lastly, they cut the number of income tax brackets from fifteen to four, expanded personal exemptions, and limited deductions to make the tax code flatter and more fair.[16][17] In addition to the significant changes in the tax code, Ronald Reagan also heavily curbed the regulatory reach of the federal bureaucracy. Since its creation in 1936, the Federal Register—which annually chronicles the publication of all new federal regulations—has grown by thousands of pages. These executive edicts, which carry the force of law, saddle Uncle Sam with tens of billions of dollars per year in administrative costs alone, and they produce manifestly detrimental effects for the economy.[18] Up until 1980 this growth was exponential, but under Ronald Reagan the Federal Registry actually shrank from almost 90,000 pages to about 50,000 pages.[19] Although the steep upward trend resumed after Reagan left office, the vast combination of tax cuts and regulatory relief produced an economic climate of unprecedented strength throughout the decade.

Question: It seems that tax cuts of this magnitude would bankrupt the U.S. Treasury. Are these the policies that contributed to the huge amount of added U.S. debt accrued during the Reagan years?

No, in fact, the opposite is true: total federal tax receipts grew drastically, from $599 billion in 1981 to $991 billion in 1989.[20] If the economic growth of the 1980s hadn’t occurred as rapidly or persistently as it did, it’s safe to say that the debt would have been much greater than it was.

Question: How do we know that the economic growth is not attributable to well-timed monetary policy along the Keynesian vein of economics, rather than broad-based tax cuts?

Some have argued that Paul Volcker, Chairman of the Federal Reserve from 1979-1987, is chiefly responsible for the economic boom of the 1980s because of his monetary policies: Specifically, they claim that Volcker’s raising of the Federal Funds rate in the late 1970s reduced inflation, and although this policy caused a recession in 1981 and 1982, the eventual lowering of interest rates in 1982 allowed the economy to take off in 1983. While it is true that Volcker’s actions, which were actually endorsed by Reagan in 1979, greatly helped to curb inflation and the cycle of stagflation characteristic of the 1970s, it is incredible to say that these monetary policies caused the post-1982 boom. Interest rates actually fell twice between the summer of 1979 and the implementation of any of Reagan’s fiscal policies, but contrary to what Keynesian monetary theory would suggest, employment and gross private investment never rebounded to above-1979 levels until 1983 when the Economic Recovery Tax Act had almost been fully implemented (inflation never rebounded to 1979 levels during Reagan’s presidency, which also contradicts Keynesian economic theory because the increased demand should have caused inflation).[21][22][23][24] While it’s safe to say that Volcker’s monetary policies facilitated the economic growth of the 1980s, it’s erroneous to conclude that those policies spurred the growth.

Question: One of the most significant of the Reagan Tax Cuts was the Tax Reform Act of 1986, which decreased the marginal income tax rate for the highest income bracket and increased the rate for the lowest income bracket. Did the subsequent tax relief and economic growth only benefit the rich?

No. If anything, the poor benefited more than the rich. Between 1981 and 1989, the second-lowest and lowest income quintiles saw a drop in effective tax rates by 39.6 percent and 420 percent respectively.[25] This is only possible due to a doubling of personal exemptions and a tripling of the earned-income tax credit, which would have been impossible without the vast new revenue generated by economic growth. These changes effectively abrogated the tax liability of over 4 million low-income taxpayers. Conversely, the middle, second-highest, and top income quintiles saw more modest drops in their effective tax rates of 27.7 percent, 25.2 percent, and 6.3 percent respectively.[26]

We see similar trends when we look at the distribution of the federal income tax burden over the period. In 1981, the bottom 50 percent of income earners paid 7.45 percent of all federal income taxes, but in 1989, they paid only 5.83 percent.[27] By contrast, the top 1 percent of income earners paid 17.58 percent of federal income taxes in 1981, but by 1989 they paid 25.24 percent.[28] Clearly, the poor benefited demonstrably more than the rich in terms of tax liability.

Question: The change in the distribution of the federal income tax burden seems to outright contradict the change in nominal and effective income tax rates. How is this possible?

There are only two ways such a change in tax liabilities could occur after the aforementioned tax acts of 1981 and 1986: one way is if there were more people within the highest group of income earners in 1989 than 1981; the other is if the people in that group were making more money in 1989 than in 1981. The fact is that both occurred: from 1979 to 1986, the real average family income of the bottom income quintile rose 77 percent, 37 percent for the second-lowest quintile, 20 percent for the middle, 10 percent for the second-highest, and 5 percent for the highest.[29] In addition to the benefits of rising real incomes, individuals also benefited from huge amounts of economic mobility: according to a 1992 U.S. Treasury study, 86 percent of individual income tax filers in the lowest income quintile in 1979 had moved to a higher quintile by 1988, and 15 percent of them had moved to the top quintile. For the second-lowest quintile in 1979, 61 percent moved up, and 11 percent moved to the top. For the middle quintile, 47 percent moved up, and a little less than one-third of them moved to the top. For the second-highest quintile, 35 percent moved to the top, and in the top quintile, 65 percent of earners remained there after the 10-year stretch.[30]

Conclusion

The data would seem to confirm what we’d theoretically expect: Reducing the growth of government, cutting taxes, reducing regulation, and limiting inflation with sound monetary policy does in fact lead to economic growth. In a time today when the country is torn about how to get the economy moving again, we may want to look on the 1980s and the accomplishments of Ronald Reagan with a favorable light.

References
1. U.S. Department of the Treasury. Bureau of the Public Debt. Historical Debt Outstanding – Annual 1950 – 1999. Treasury Direct. Accessed 3 Aug. 2011. http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo4.htm

2. U.S. Office of Management and Budget. Statutory Limits on Federal Debt: 1940-Current. Table 7.3. Accessed 2 Aug. 2011. http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/hist07z3.xls

3. U.S. Office of Management and Budget. Fiscal Year 2014 Historical Tables: Budget of the U.S. Government. Table 1.1, p. 23, Apr. 2013. Accessed 7 Feb. 2014. http://www.whitehouse.gov/sites/default/files/omb/budget/fy2014/assets/hist.pdf

4. Ibid. Table 3.1, p. 55-56

5. U.S. House of Representatives. Office of the Clerk. House History. Accessed 12 Aug. 2011. http://artandhistory.house.gov/house_history/

6. U.S. Senate. Senate Historical Office. Party Division in the Senate, 1789-Present. Accessed 12 Aug. 2011. http://www.senate.gov/pagelayout/history/one_item_and_teasers/partydiv.htm 

7. OMB. Historical Tables. op cit. Table 1.1, p 23. Table 3.1, p. 55-56. 

8. U.S. Department of Commerce. Bureau of Economic Analysis. National Income and Product Account Tables. Table 1.1.6, 29 Jul. 2011. Accessed 13 Aug. 2011. http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1

9. U.S. Department of Commerce. Bureau of the Census. Current Population Survey: Income: Total CPS Population and Per Capita Income. Table P-1. Accessed 13 Aug. 2011. http://www.census.gov/hhes/www/income/data/historical/people/

10. U.S. Department of Labor. Bureau of Labor Statistics.  Labor Force Statistics from the Current Population Survey. Accessed 14 Aug. 2011. http://www.bls.gov/data/

11. U.S. Department of Labor. Bureau of Labor Statistics. Consumer Price Index. Accessed 14 Aug. 2011. http://www.bls.gov/cpi/

12. Bureau of Economic Analysis. Account Tables. op cit. Table 1.1.6.

13. Freddie Mac. Monthly Average Commitment Rate and Points on 30-Year Fixed-Rate Mortgages Since 1971. Accessed 15 Aug. 2011. http://www.freddiemac.com/pmms/pmms30.htm

14. Board of Governors of the Federal Reserve System. Selected Interest Rates (Daily) – H.15: Historical Data. Accessed 15 Aug 2011. http://www.federalreserve.gov/releases/h15/data.htm

15. The Library of Congress, Thomas. Bill Summaries and Status. 97th Congress (1981-1982). H.R. 4242. Accessed 4 Aug. 2011. http://thomas.loc.gov/cgi-bin/bdquery/z?d097:HR04242:|TOM:/bss/d097query.html

16. The Library of Congress, Thomas. Bill Summaries and Status. 97th Congress (1981-1982). H.R. 4961. Accessed 4 Aug. 2011. http://thomas.loc.gov/cgi-bin/bdquery/z?d097:H.R.4961:

17. The Library of Congress, Thomas. Bill Summaries and Status. 99th Congress (1985-1986) H.R. 3838. Accessed 20 Aug. 2011. http://thomas.loc.gov/cgi-bin/bdquery/z?d099:H.R.3838:

18. Tax Foundation. Federal Individual Income Tax Rates History: Income Years 1913-2009. Accessed 4 Aug. 2011. http://taxfoundation.org/sites/taxfoundation.org/files/docs/fed_individual_rate_history_nominal%26adjusted-20110909.pdf

19. Dudley, Susan, and Melinda Warren. 2006. “Moderating Regulatory Growth: An Analysis of the U.S. Budget for Fiscal Years 2006 and 2007.” Weidenbaum Center on the Economy, Government, and Public Policy 28. Figure 1, p. 7. Accessed 16 Aug. 2011. http://wc.wustl.edu/files/wc/2007RegReport.pdf

20. Ibid. Figure 3, p. 9.

21. OMB. Historical Tables.  op. cit. Table 1.1, p. 22.

22.  Board of Governors. op cit.

23. U.S. Department of Labor. Bureau of Labor Statistics. Labor Force Statistics from the Current Population Survey. Accessed 14 Aug. 2001. http://www.bls.gov/data/

24. U.S. Department of Commerce. Bureau of Economic Analysis. op cit.

25. U.S. Department of Labor. Bureau of Labor Statistics. Consumer Price Index. Accessed 14 Aug. 2011. http://www.bls.gov/cpi/

26. U.S. Congress. Congressional Budget Office. Historical Effective Tax Rates, 1979 to 2005: Supplement with Additional Data on Sources of Income and High-Income Households. Table 1, p. 7. Accessed 24 Aug. 2011.

27. Ibid.

28. Heritage Foundation. 2011 Budget Chart Book. Percentage of Federal Income Taxes (2008). Accessed 3 Aug. 2011. http://www.heritage.org/BudgetChartBook/top10-percent-income-earners

29. Ibid.

30. Hubbard, R.G., J. Nunns, and W. Randolph. Household Income Changes over Time: Some Basic Questions and Facts. 1992. U.S. Department of the Treasury, Office of Tax Analysis. Table 6. Accessed 10 Jul. 2010. http://www0.gsb.columbia.edu/faculty/ghubbard/Articles%20for%20Web%20Site/Household%20Income%20Changes%20Over%20Time_Some%20Basic%20Questions%20and%20Facts.pdf

31. Ibid. Table 1.