Friday, December 10, 2010

Deficits and Investment

Earlier this week President Obama announced a compromise - using that word loosely - with Republicans for a tax and spending bill. Obama agreed to allow temporary tax rates instituted at the beginning of George W. Bush’s administration to remain in force for at least another two years. This includes the temporary reduction in capital gains, dividends and estate taxes. For this extraordinary concession he got an extension of unemployment benefits for workers for another thirteen months, a holiday on payroll taxes, and a continuation of tuition tax credits among other credits.

My immediate reaction - and the reason I am compelled to write at length today - is the complete abandonment of any effort to reign in deficit spending. The provisions leave an estimated $860 billion in the U.S. economy and there is very little effort to reduce the federal budget. You might wonder why I am getting so bothered. After all deficit spending along with devaluing the currency are the favored means to counter depression. We are suffering from a steep unemployment rate and job creation is so very slow.

Deficit Spending

I will concede that deficit spending can work to cure depression. Japan in the 1930s is an example. Of course times were different then. The Japanese government enlarged their deficit by buying munitions in preparation for going to war in the 1940s! Few of us have the stomach for another world war, so let’s not go here.

The U.S. would be hard pressed to create the same effect in the 21st Century anyway. Over three-quarters of the U.S. economy is services these days. Unfortunately, productivity in the services sector - that is output for the number of hours worked - is lower than in the manufacturing sector. Productivity is after all what lifts an economy out of what ails it, increasing profits for future investment in new technology and ultimately new jobs. It is what raises our living standards without driving up inflation.

The U.S. debt is estimated to top $15 trillion in 2011, representing approximately 98% of the U.S. Gross Domestic Product. Just how much of an impact can deficit spending really have at this point?

Taxing the Wealthy and Investment
I will leave that question for later. Instead let’s take a look at how Obama with his new Republican buddies expect to infuse money into the economy. The continued low personal tax rate schedule is one source. The Republicans argue that the wealthy should be allowed to retain more of their income and investment dollars through continuation and even permanent adoption of tax cuts sponsored by President Bush in 2001 and 2003. The premise is that when the wealthy get an incremental dollar in their pocket that they invest, thereby creating new jobs.

That might have been a likely outcome a few decades ago, but is it the case now? Modern capital markets are more fluid than ever, leaving very few structural barriers to investment. Accordingly, there is no guarantee that an incremental dollar in the pocket of a wealthy person in the U.S. will end up invested in the U.S. where new jobs are needed. It is quite possible and most likely that the incremental dollar will end up in China or India where rates of return on investments are currently higher than in the U.S.

The fact that the lower tax rates have been in force for nine years and that we are suffering from substantial unemployment suggests that fortifying wealthy taxpayers in the U.S. with tax breaks is pretty lousy approach to creating jobs. That said, I note that job creation rose dramatically in 2004 after the Bush tax cuts went into effect, peaking at 350,000 new jobs in the month of March 2004. Unfortunately, by the end of 2005, some economists were arguing that the so-called Bush tax cuts had no discernable impact on employment. Approximately 2.6 million new jobs were created in 2004 and 2005 even though an estimated 4.0 million jobs were expected without the tax cuts.

Perhaps a more important question is what would a wealthy tax payer do if higher taxes led to one LESS dollar in their pocket? Most wealthy people would concede that their personal consumption would not decrease, suggesting that there would be little impact on the services sector making up three-quarters of our economy.

The next impact might, indeed, be that feared reduction in investment by the wealthy. However, it is important to figure out where that reduction might occur. Most likely it would also lead to a shift in investment allocation from foreign investment or derivative investment to tax advantaged investments in the U.S. In other words, an increase in taxes on the most wealthy could increase the amount of capital directed toward local government bonds or U.S. treasuries.

Thus for an estimated increase in tax collections by a return to a progressive tax rate schedule of 15%, 28%, 31%, 36% and 39.5% (from a slightly lower rate schedule of 10%, 25%, 33% and 35%), Congress might be able to encourage a return to U.S. investment alternatives. Gee, then maybe local governments could invest in highways and schools, opening up new construction jobs. There is a novel concept!

Unemployment Benefits
Obama did get the Republicans to agree to a continuation of unemployment benefits. In my view, this is not much more than a life saver thrown over the bow of a listing ship. The money will end up consumed in essentials such as rent, food, gas and pay-down of credit card debt. The value of the move probably does not end there. Unfortunately, it is challenging to quantify the opportunity cost represented by the social upheaval that occurs when the unemployed are evicted, fail to take care of their health, neglect their children or turn to crime. Remember the 1970s when we used to regularly see muggings in Mid-town Manhattan?

With no definitive conclusion in financial terms, the question of whether to extend unemployment benefits is largely one answered on moral terms. If we bailed out the big banks, why are we so reluctant to extend a hand to the least among us? Republicans postulate that the unemployed are simply slackers and must be compelled by poverty to return to work. This is an argument that holds water only when we are faced with little more than frictional employment (the normal course of transitioning to new jobs), which is usually around 3%. Today we have a considerable level of structural (job skills of unemployed do not match available jobs) and cyclical unemployment (occurs when there is persistent low aggregate demand).

Of the 9.8% unemployment we have today, how much of it do you really think is frictional and therefore going to be resolved by simply forcing people into a corner? The idea is just a bit repugnant that eliminating the extended benefits for the unemployed is going to reduce unemployment in the current economy. This is one where the Republicans and their wealthy cronies really need to return to the economic text books.
 Payroll Taxes
Obama was able to win - at least in the proposed legislation - a concession on payroll taxes that would reduce payroll tax collections to 4.2% (from 6.2%) for the next year. Benefits from the reduction go to the employee’s portion rather than the employer’s portion. This provision leaves more dollars in the economy, which will likely go to paying bills. The result is something like putting a band-aid over a cut. The cut will heal but it would probably have healed without the cover anyway. Obama needs to address the regressive character of payroll taxes, which are capped at an amount equal to 7.65% of total wage or salary income.

Business Tax Write-off
This post has become quite lengthy and we are just now getting to a provision of Obama’s proposed compromise with Republicans that might really have a meaningful, immediate impact on investment and the economy. Under the proposal, for the next two years businesses will be able to immediately write-off 100% of costs related to new equipment purchases. This reduces the tax bill for businesses in the near-term and could encourage cash-strapped businesses to take the plunge on capacity expansion. Then they might hire someone to run the machine. I can live with this!

#Inflation #Taxes #Obama

1 comment:

wsm said...

I'll take these in reverse order:

Business tax writeoff - I agree, this a strong point of the proposed agreement.

Payroll taxes - The most idiotic portion of this proposal is being overlooked. Namely, the fact the the employER's portion is unaffected, which fails to add any incentive for actual hiring.

Unemployment benefits - I disagree with your characterization of what the "Republicans postulate". Though, I probably do think that the extension of the benefits was the right call given where we are.

Taxing the Wealthy and Investment - "The fact that the lower tax rates have been in force for nine years and that we are suffering from substantial unemployment suggests that fortifying wealthy taxpayers in the U.S. with tax breaks is pretty lousy approach to creating jobs." This is actually a pretty clever non-sequitur. But if we go ahead and finish out the logical progression of that statement, it follows that unemployment would actually be even worse than it already is, if not for the stimulative tax cuts.