|Economic Growth, Social Security
and Capital Gains:
A Supply-side Fable of
Grasshoppers and Ants
January 29, 1990
Executive Summary: Most of Washington's policymakers learned their basic theory of public finance from childhood fables, the grasshopper and the ant being a popular favorite. Senator Moynihan's Social Security proposal has reopened debate around the bookkeeping issues of saving and spending, surpluses and deficits, supply-side capital gains tax cuts, and a fascination at the White House with the national savings rate. Yet more savings means more debt! Nobel Laureate James Tobin of Yale, chief theorist of the liberal Democrats, insists that the nation "desperately" needs higher taxes to add to the nation's wealth, and that both rich ants and blue-collar grasshoppers should pay. Very few opponents or supporters of a capgains cut understand the dynamics of growth involved, but still see it in terms of the fable. We suggest a tree as a metaphor, with a tax structure that serves both incipient enterprise and mature corporations, the root system and the crown. Alan Reynolds observes that the capital gains tax is currently the highest in U.S. history, for most Americans, and a cut to a flat 15% is to be preferred over ending double taxing of dividends. The Bush Administration, mesmerized by the fable, dilutes the proposal to encourage ants over 'hoppers, threatening robust growh in the '90s. OMB's Richard Darman is still the best hope to break out of the confines of conservative Keynesianism and refocus on growth, not savings or debt.
Economic Growth, Social Security and Capital Gains:
A Supply-side Fable of Grasshoppers and Ants
The debate Senator Moynihan sparket with his proposal to cut Social Security taxes moved The Wall Street Journal to remind its readers that the issue is about economic growth. There is no way for the workers to "put away" part of their current production and pull it out in 20 years. The concept of "savings" as it exists inside the heads of most grownups, including those in the Bush White House and Treasury, is a childish one: Consumption is bad; savings is good. Do not eat the seed corn. Be an ant, not a grasshopper.
Most professional economisgts, including many in the White House and Treasury, also have this childish view of the way the world works. It rarely if ever occurs to grownups that all production is consumed soon after it is fashioned. Even squirrels eat their nuts soon after they are stored! Except for the national petroleum reserve, no production is saved. In fact, it is all produced with the explicit hope that it will be consumed as soon as possible! All banking and bookkeeping, public and private finance, all the elaborate financial markets, are devices to remind us of the status of IOUs, our simple promises to do future work sufficient to pay back what we have borrowed.
It does not occur to most grownups, including almost all politicians, that if savings is good, debt must be just as good! For every dollar saved, someone, somewhere, must increas his or her idebtedness by a dollar, or it can't be saved. Treasury Secretary Nicholas Brady wants all families to save up to $5,000 more annually. Does it occur to him that this can only happen if foreigners are willing to borrow all this money? The OMB wants to eliminate the national public debt of $3 trillion, but this can only happen if it can find enough people to save $3 trillion less. Or, it must find enough households and businessess willing to take on $3 trillion of private debt, which is exactly the opposite of what Secretary Brady wants to achieve. Fed Chairman Alan Greenspan has termed the nation's low savings rate "the most important long-term issue that has to be addressed by policymakers."
If there is anyone in Washington who believes himself to be a true believer in free markets it is Alan Greenspan. But for Greenspan to believe the savings rate is something for "policymakers" to worry about is an absolute denial of the free market. If Adam Smith's invisible hand does not work in a household, the smallest economic unit, it can't work in the largest. Milton Friedman is exactly right when he says the national savings rate is simply the addition of all household savings decisions, free individuals freely deciding in their own best interest how much to save, how much to consume, of their after-tax income.
This precise discussion took place during sessions at Camp David last April, which I attended with several others at the invitation of President Bush to discuss economic policy. Former CEA Chairman Martin Feldstein made a presentation bemoaning the U.S. savings rate, and I challenged him, pointing out that Italy has a much higher savings rate than the U.S., and that the Soviet Union has the highest savings rate in the world -- there being little to consume with monetary wages. I also promised to increase my savings rate if I knew Feldstein would be unsuccessful in his attempt to get the administration to devalue the dollar, which would mean I would suffer a capital loss on my dollar savings. Of those present, only Richard Rahn, chief economist at the U.S. Chamber of Commerce, and Beryl Sprinkel, former Chairman of the CEA, argued along with me tthat the savings rate issue was a bugaboo. The other participants were silent or sided with Feldstein.
Ironically, these grasshopper-and-ant ideas behind the savings issue flow from the original Keynesian model of the 1930s that argued that the Great Depression was the result of too many ants and not enough grasshoppers. Lord Keynes argued there was too much savings and not enough debt! Rich people were the problem, he and his followers argued, because they already had all that money could buy, and were squirrelling their excess cash away instead of buying more goods. Their propensity to save was higher than their propensity to buy. The solution: Tax away the excess savings fo the rich, or have the government borrow it from them, and spend it on the output of the working class or welfare of the poor.
Most of the participants of the current debate in Washington over Social Security, the national debt, and the capital gains tax learned much of what they know about public finance from their childhood fables. Conservative Republicans believe that after 60 years of liberal Keynesianism, ants have been overtaxed, and the government has borrowed too much of ant savings. They want to cut the capital gains tax and keep tax rates high on the payrolls of blue-collar grasshoppers. Most liberal Democrats believe ants are richer than ever, that grasshoppers have their backs to the wall, and that the very idea of cutting the capital gains tax is an obscenity. But the liberals are divided on whether to cut payroll taxes for the blue-collar grasshoppers, or to keep taxes high for all working ants and grasshoppers, in order to pile up wealth for the future.
In this last category is the leading grasshopper theoretician of our time, James Tobin of Yale, a Nobel Laureate in economic science, a lifelong Democrat, and chief architect of the idea that high taxes and cheap money will increase the national wealth. In The Washington Post of January 21, Tobin emerges from a long silence to complain bitterly that ants are getting richer than grasshoppers: "Inequalities of income and wealth have increased dramatically over the last 10 years. Nothing could be a more legitimate concern in a democracy. Who have been the redistributors? Not the liberals, but the supply-siders. They have engineered a redistribution, a regressive redistribution. To oppose more of the same is scarcely the socialist heresy that conservative ideologists allege."
Tobin's solution: "The country desperately needs to raise taxes." He is furious that President Bush "gives first legislative priority to cutting capital gains taxes," but he also denounces Senator Moynihan's proposal as a "fiscal disaster -- as Moynihan, who understands the need for deficit reduction to promote national investment without endless borrowing abroad well knows." In a rousing appeal for grasshoppers and ants to save like crazy, Professor Tobin then says of Moynihan: "He is right that payroll taxes are too high relative to other taxes, but the answer is to raise those other taxes while letting Social Security surpluses truly add to the nation's real wealth instead of financing chronic and growing budget deficits." (Emphasis added)
With everyone at home saving like crazy, we have to find people abroad to borrow like crazy. When Professor Tobin's proteges -- Fred Bergsten and Richard Cooper -- were last in a position to promote his ideas, in the Carter administration, the system was flooded with cheap money. But taxes were so high at home that investment opportunities were limited. Yes, S&Ls could borrow like crazy and invest, because depositors are federally insured. And a lot of the crazy borrowing took place abroad, in the Third World, with U.S. banks eager to get rid of Tobin's cheap money. A second-generation Tobin protege, Charles Dallara, is not Assistant Secretary of the Treasury for International Affairs, helping to bail out Third World debtors from the same pool of tax dollars that is bailing out the S&Ls. "The country desperately needs to raise taxes," Professor Tobin confidently writes in the Post.
The Journal's editorial, "Thinking about Social Security," January 25, sees through this Keynesian fog. The nation's wealth is not its savings, pieces of paper called stocks and bonds, but the productivity of its capital stock. "The more the economy grows between now and 2010, the more goods and services will be available to split between retirees and producers. The issue is a a macroeconomic one: What level and type of taxation, and what level and type of expenditure, will yield the fastest growth?"
A century ago, it would have seemed incredible that in the year 1990, for the country as a whole, three workers putting in a mere 35 hours per week could support their families plus a retiree in a separate household, and at the standard of living we now enjoy. The notion that it will take two workers doing the same in 20 years seems not only plausible but a piece of cake. Indeed, it will not be long before we are productive enough to lower the retirement age, not raise it, amidst warnings that robotics and computerization there isn't enough work for humans.
But not if we destroy the efficiency of our economic machinery with Professor Tobin's high taxes on capital and labor and cheap money. And not if we adopt the grasshopper-and-ant scheme cooked up by the Bush Administration to tax blue-collar grasshoppers to pay off the national debt. The most important things we could do this year to give us the Life of Riley in 2010 are to 1) lower the capital gains tax to 15% and 2) fix the dollar's value to real goods, preferably gold, in a way that guarantees it will be worth the same in 2010.
Most Democrats, being advised by economists who represent grasshoppers, have been led to believe that a cut in the capital gains tax will for the most part redistribute wealth to ants. Most Republicans -- including those who support a lower capgains rate, also believe this will shift wealth to ants, whom they think will make more productive use of it. Neither understand the dynamics of economic growth, which is why the level of enthusiasm on behalf of a lower rate is not especially high. A senior member of the White House staff asked me last fall: "Are you sure a cut in capital gains is all that important?" A Fed governor asked me earlier this month, "Wouldn't you really rather have an end to the double taxing of dividends?" No, I wouldn't. I said I'd love to see an end to the double taxing of dividends, for the same reason I'd want to see a 15% capgains tax, to increase the efficiency of capital. Prior to the 1986 tax reform I would have preferred ending the double tax on dividends. But at the moment, I'd take a lower capgains rate first, partly because the President already has a mandate for it, which makes it easier to acheive.
In my mind, most of the growth effects of capital gains taxation occur beneath the surface of the economy. Much of the effect of a high rate is to prevent the formation of new enterprise.
I asked the Fed governor to imagine a tree. Not a curve, which Art Laffer imagined to illustrate the law of diminishing returns in public finance. But a tree, to illustrate the growth effects of the Laffer Curve. A tree has a vast underground root system in order to collect nutrients and moisture and provide it foundation. If there is no moisture or nutrients to collect, the tree dies. It also dies if there are ample nutrients and moisture, but no sunshine, which it also needs for growth. If it is cut off from the process of photosynthesis, it also dies.
The leaves and blossoms that crown the tree are small in number compared to the myriad fingers of the root system. Think of this crown as mature corporate America. Think of the root system underground as entrepreneurial America. Not just the publicly-held NASDAQ companies, but the vast network of privately-held businesses where all growth begins. If the root system is overtaxed while the crown is not, the tree dies. If the crown is overtaxed while the roots are not, the tree also shrivels and dies. The process in either case is not always easy to see in its early stages. An end to the double-taxation of dividends would be a good thing, I explained to the Fed governor, but only insofar as it casts more sunshine on the crown of the tree. Dividends flow from mature enterprise, which benefitted relatively more than incipient and new enterprise from the tax reform of 1986. Tax rates on existing corporate and individual income went down, while tax rates on capital gains went up. The tree got more sunshine and less moisture.
Ending double taxation of dividends would have marvelous effects on the efficiency of capital, we must hasten to add. If dividends were tax free to shareholders, after profits passed through the corporate tax gate, management would be forced to pay out all profits in dividends, then go to the market with new issues to finance new initiatives. As it is, corporate elites are able to play around with profits without subjecting their capital investment decisions to the discipline of the markets. Instead of paying out dividends, it makes more sense of the corporate elites to pay themselves bigger salaries and perks, and borrow heavily through banks and bonds to finance leveraged buyouts, with interest payments on the debt single-taxed. This tax deductibility of interest rates produces many awkward distortions in the system, but the gains to be had by balancing it with tax deductibility of dividends are not as great as lowering the capgains tax. The least risky corporations wouild benefit the most, utilities, for example, while fast-growing, high-tech enterprises would benefit least.
The capital gains tax is most imporant to economic growth at the roots of the system, although it is not hard to find economies with zero capgains tax that do not grow. The answer invariably is that the personal income-tax rate on labor is prohibitive. In his Washington Post essay, Professor Tobin argues that if Congress is so foolish as to give the President a capgains cut, it should only be on new investment, because lowering the rate on past investment provides no incentive effects and would thus be a windfall. "Windfalls are not incentives," he writes. But think again of our tree, trying to grow, having both sunshine and moisture, but the moisture is frozen in the ground. What the 1986 tax reform did in raising the capital gains tax by more than 50% for most people, to 33% from 20%, was to freeze this capital, locking it into existing assets. In the same way that double taxation of dividends decreases the liquidity of capital, the high capital gains tax rate discourages individuals from releasing capital assets to potentially higher and better uses. In other words, capital is prevented from finding its way by Adam Smith's invisible hand to the most promising investments. This lock-in effect, after all, is an important argument the administration is using to drum up support for the capgains cut, in that the lower rate will invite asset sales that produce federal revenues. The administration has been less active in pointing out that state and local revenues would expand as well.
For most people, the capital gains tax is now the highest it has been in the history of the United States, Alan Reynolds points out. The top rate is 33%, with another few points tacked on at state levels. The top rate has been as high as 48%, as recently as 1978, and it was 45% going into 1964. This top rate of 45% resulted from the 50% exclusion on the 90% rate that remained after World War II. It was not terrible burden to the root system, though, because it did not effect many people.
This was prior to the great inflation, remember, when the price of gold was $35 an ounce and skilled workers earned $6,000 a year. The broad middle class was in the low-income tax brackets, where a 50% exclusion on capital gains usually meant a tax of 6 or 7%, and where small businessmen and professionals would pay 10%. The high-income classes did not pay capital gains taxes at all, because they did not invest in the stock market or other assets that might yield high incomes facing the top rate. They invested in tax-free municipals, oil wells, mink ranches and other shelters.
The boom in the stock market was especially pronounced in low-capitalization stocks in the late 1960s, when the Kennedy tax cuts dropped the top capgains rate to 35% from 45%, with proportional reductions down the line. The end of the boom in low-cap stocks coincided with President Nixon's increas in the capgains tax to 48% in 1969. The crown of the tree -- the high cap stocks -- held up well enough until 1974. But by then real rates of income tax were swelling with the bracket creep of the previous three years. Nixon had also followed the cheap money advice of Tobin and his followers by removing the dollar's gold link in 1971 and devaluing the dollar sharply. The stock market's real value crumbled from 1974 to 1978, while the tree's root system dried up completely. New issues of low-cap stock disappeared.
A new surge in growth activity at this level surfaced only after the late Rep. William Steiger wrung a cut in the capgains rate to 28% during the Carter Administration, with the help of high-tech Democrats in Congress. All this occurred, though, while dollar devaluation was continuing to push the broad middle class into the upper income tax brackets. The effective capgains rate in this income band crept up as well. Interest growth in new low-cap stocks slowed even further as soon as the higher effective tax rate took effect in 1987.
I've recently been quoted in Forbes January 22 issue, to the effect that one reason for Japan's competitiveness in the last generation has been its relatively low capgains rate. In the February 5 issue, M.S. Forbes picks up on this argument, in an editorial comment, "How to Get the Dow to 37,000."
In arguing for a cut in [capgains], Jude Wanniski of Polyconomics makes the eye-popping point that a $1 investment that doubles annually and is sold every year will be worth $1 million after 20 years; but if that dollar is taxed at 35% every year, it will be worth only $22,000 over the same period.
That computation is not academic. In early 1966, the Dow Jones Industrial Average briefly pierced 1000. The equivalent Tokyo index was nearly at the same level. The capital gains tax is virtually zero in Japan, while in the U.S. over that time it has averaged over 30%. The Dow Jones now stands at around 2700; the Nikkei Dow Jones at 37,000.
Even this incredible divergence underestimates the real value of the two Dow Jones indices. The price of gold in dollars has gone up by 12 times since 1966, and by only 3 times in yen. The Dow at 2700 is that much more inflated! A growth path for the Dow in dollars over the next decade would be dramatically different with the enactment of a capgains differential. For this reason alone it seems reasonable to equate much of the volatility of the markets to the fate of the legislation on Capitol Hill, as well as in the administration.
Because Secretary Brady especially has a fascination with savings and long-term horizons for businessmen, the administration continues to water down the original Bush proposal of a flat 15% capital gains rate. Brady began diluting the Bush proposal almost as soon as the election was over, essentially negotiating with himself over the holding period. The reported proposal now is to phase in a more modest differential over a three-year holding period, bringing the rate down to 23% for those in the 33% bracket.
Conservative Keynesians generally believe that longer holding periods before gains are cashed are good for the economy. Brady and Feldstein and Greenspan imagine an investor who would like to convert a capgain in cash in order to spend it! By forcing the investor to pay a high tax rate to cash in, they will thus discourge spending. They believe this is good. This is more grasshopper fable. What they are really doing is freezing the capital liquidity under our tree. Little droplets of capital hat would otherwise be available to the start-up enterprise at the earliest stage, long before a firm is mature enough to go public, are frozen out of its grasp. (Polyconomics was founded in 1978 with $20,000 in capital, my personal treasure of securities cashed.)
Almost every feature of the Keynesian demand-management model is reversed when analyzing the dynamics of a lower capital gains tax. Where a lower rate is supposed to primarily benefit the rich, it is of far greater relative benefit to the young who would like to become rich. Those who have the least access to capital, African-Americans and Hispanic-Americans, benefit most of all, as the lower rate tips white risk capital towards their shallow pools. White capital can do this indirectly, simply by bidding up the value of assets held by blacks, including stocks and real property, until they have enough capital to cash to start an enterprise.
Rich people, unlike those who have accumulated less wealth, never have to sell their stocks, bonds or homes in order to start a business, retire or put their children through school. When the tax on capital gains is too high, it mainly affects those who are not wealthy enough to avoid selling their assets, including many in financial distress. Moreover, thos with modest incomes are likely to be pushed out of the stock market, even though growth stocks would leave them with a larger nest egg if, like the rich, they could safely afford to lock up their funds for years. Families with modest ability to save are not likely to feel comfortable about investing in the sheer hope of capital gains when such gains will be taxed just as heavily as the certain and immediate income from a money market fund.
President Bush and his economic team have a fairly good grasp of these dynamics, some more than others. Their hang-up over the savings issue is another matter and conventional wisdom dies hard. The most likely convert is OMB's Richard Darman, who is the least wedded to grasshopper-and-ant analytics and who, at 46, is still young enough to shift his thinking. He already has on tax policy. At his confirmation hearings last year, he was asked about his opposition to the 1981 Reagan tax cuts, when he and David Stockman were in league to postpone them:
I was not initially among the supply-side advocates of the rate cut. But the more I think I learned about the subject, and the further I got into the theory of tax reform, the more positively I became disposed toward the value of substantial across-the-board marginal rate reductions. So, now I am an enthusiast for that which I was not so much back there in 1981.
It was Darman's OMB that came up with the scheme to pay off the national debt with Social Security surpluses, but one he supposes he may have done purely in response to the Moynihan threat, the way one would grab the nearest piece of furniture to hold off a wild animal. He was definitely not an enthusiast of Brady's Family Savings Plan. And while he still prefers ants to grasshoppers, his conversion to supply-side tax theory indicates he can make it into the rest of the framework in time to take over the Treasury job if and when Brady departs. At Polyconomics, we prefer grasshopping, but with so much work to do, we just haven't had the time.
* * * * *