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The Right-Wing Tax Scam

You might have heard that tax cuts on “savings” like reductions in the corporate, dividend or capital gains tax increase national savings and private-sector investment savings. If you haven’t heard that, you’ve heard that taxes like the corporate tax are in fact a hidden tax on America’s working class.

Well, even if you haven’t, I’m going to explain why that’s wrong. In reality the argument that taxes on the saved money of rich people harm the little guy is a right-wing lie to benefit the rich and harm the little guy.

To show this I will first present the (three) arguments that these taxes reduce investment spending and place a tax on all of us, secondly I’ll explain how studies of the Bush tax cuts of 2001 and 2003 proved this idea wrong and thirdly, I will explain how the whole idea of cutting taxes on savings to encourage savings is nonsensical.

The Arguments For Tax Cuts Reducing Investment:

There are really three arguments that taxes on savings reduce investment spending: the national savings argument, the user cost index argument and the corporate cash flow argument.

1. The User Cost Argument:

This argument uses a mathematical model which incorporates an interest rate and various taxes to find what the tax-adjusted rate of return on an investment would need to be in order to justify spending money on the investment. It assumes that potential investors are inherently rational. They are going to make the investment that earns the most money. They could choose to borrow money to make an investment and earn after tax returns (or spend money they have); but, instead, they might not borrow and forgo paying the interest rate on a loan (or lend out money and earn the interest rate on a loan). The conclusion is higher marginal tax rates or a higher interest rate will cause businesses to not invest. People use this model to argue that higher corporate taxes will reduce investment appetite.

Strulik and Trimborn 2012 was a research paper that used the User Cost Index model to find that high corporate taxes, dividend taxes and capital gains taxes were reducing private sector investment. In fact, they were reducing private sector investment so much that the government would make more money by cutting taxes. It found for instance, that a revenue-maximizing capital gain tax rate would be 445% lower than its current level. Yes, they actually argued that a negative capital gains tax rate would increase revenue.

The Cash Flow Argument:

The cash flow argument makes the case that corporate investment is really all about how much money corporations have on hand. People may use cash-flow based models to argue that a higher tax on corporations takes money away from them which lowers corporate investors. One could also argue tighter monetary conditions and higher interest rates hamper their ability to raise cash and that also hurts investment.

The National Savings Argument:

Assume that income made by all persons, businesses and our government comes from productive economic activity that produces wealth. Assume that wealth produced by our nation can be used for three things: private investment (“I”), private consumption (“C”), government spending (“G”) or the net balance of trade (“BT”). The equation which captures this idea is Y=C+G+I+BT where (“Y”) is income. Also define private savings (“S”) as income minus government taxation (“T”), minus consumption, plus government income transfers to the private sector (“Tr”): S=Y-C-T+Tr. Then we have this equation S=G-T+Tr+I+BT. Because the government deficit is the level of government spending plus income transfers minus tax revenue (Def=G+Tr-T) we have S-Def=I+BT. The overall level of public and private spending, called “national saving” is S-Def and is necessarily equal to investment minus the trade deficit. When one adopts this model, one could argue that taxes on saving lowers national savings which lower investment.

It’s important to note that this argument assumes a fixed level of Y, i.e. income. If we don’t believe in a fixed Y (income) then increasing national savings by encouraging people to save might not work. In the short term, if everyone tries to save more money, it can reduce C (private consumption) which will reduce Y and because the nation makes a lower income as it attempts to spend less, it may, on average, save the same amount.

So how can we assume a fixed Y in response to increasing or decreasing savings?

Well, you really have to believe in effective FED policy. A low Y caused by a high tendency towards saving can create high unemployment and cause inflation to undershoot the FED’s target. In response, the FED will lower interest rates which can operate through effects described in the other two models to bring up I and therefore Y and S. So, the national savings argument really only works if you already buy into some variant of the other two arguments.

Feldstein 1974 used the national savings argument to find that corporate taxes significantly reduced private-sector investment. In the long-run, it found, that meant that corporate taxes actually indirectly placed a tax on workers.

Summers 1982 (that’s former Treasury Secretary Summers) found that high taxes on savings significantly lowered national savings.

2. Bush Studies

In 2001, and then again in 2003 the George Bush administration passed tax cut legislation. In both cases the benefits fell mainly in the lap of the rich. The tax cuts reduced income taxes a lot, but there were significant reductions in the rates of taxation for things like the corporate tax and the capital gains tax.

Gale and Orszag 2005 studied the effects of the Bush Tax Cuts using the User Cost Index model. They found that the Bush tax cuts lowered tax rates, encouraging investment but raised interest rates, discouraging investment. Overall the Bush Tax Cuts actually discouraged investments.

Auerbach 2002 studied the effect of Bush’s 2001 tax cut looking for evidence of a higher level of national savings. The end result was that no matter how hard one manipulated the numbers, there was no feasible way to say that the tax cuts had a positive impact on national savings: “It is difficult to put together a combination of reasonable assumptions regarding household and government behavior under which this tax cut will increase national saving and capital formation.”

Mitchell and Castillo 2014 was a paper published in the journal Mercatus Research. This journal is managed by the libertarian-leaning university George Mason university. The paper, titled “What Went Wrong with the Bush Tax Cuts,” is unintentionally revealing. For instance, the abstract includes the quote: “In this paper we show that the Bush tax cuts had a number of problems from a market-oriented perspective: they were phased in slowly, they were set to expire within a decade, they entailed a Keynesian emphasis on stimulating aggregate demand, and—above all—they were undertaken without any effort to reduce spending,” (the underlining is mine). The article repeats this complaint many times. For instance it later reads, “The most significant problem with the Bush tax cuts was that they were not matched with spending cuts.”

Essentially the problem with most of the theoretical studies that say lower taxes on savings should increase investment is that they pair tax cuts on savings with tax hikes on worker’s income or with overall spending cuts. In reality, it is the other things which increase national savings. On it’s own, cutting taxes always lowers national savings (I’ll get to why in section 3).

The theoretical papers I covered in section 1 largely make the loaded assumption that tax cuts on the rich will be tied to something that increases national savings.

Strulik and Trimborn 2012 (the paper that found capital gains taxes should be negative) assumed that the US government would always run a balanced budget and any extra money it made from taxing the rich would immediately be transferred to citizens. Summers 1982 assumed that any revenue lost by cutting taxes on savings would be made up for by increasing taxes on labor or consumption. Of course, he found cutting taxes on savings lowered consumption. Feldstein 1974 makes a more complicated argument which I will get to in the next section.

3. Why Tax Cuts on Savings Can’t Increase Savings

A lower tax rate on savings will increase private savings. This is true because it increases private after-tax incomes (if people don’t spend all of the extra money, they must save some of it). It may be doubly true because it incentivizes people to save by taxing savings less. It also has a direct effect of reducing government savings by reducing government revenue. Feldstein 1974 argues that a lower corporate tax rate might lead to a higher national savings rate. His argument is that the incentive effect of a lower tax rate could be powerful enough to increase savings overall by more than the revenue the government loses. Hence, someone who uses a savings model will likely be a bit confused about the effect of a savings tax cut on national savings and investment.

At the same time, a person using the User Cost Index model will also be confused. Lowers tax rates on investment/saving should encourage investment according to the model. However, if a tax cut stimulates the economy, forcing the FED to raise interest rates, according to the model, this should discourage investment.

Similarly, the cash flow model presents confusion. Lower tax rates leave corporations with more cash to invest. But if the FED raises rates, this can make it harder for corporations to raise cash to invest with.

To respond to this confusion, let’s consider the following: private savings (S) is equal to Y-C-T+Tr. Meanwhile, public savings (-Def) is equal to T-Tr-G. Hence, national savings is going to be equal to Y-C-G. For the tax cut on the rich to boost investment spending through increasing national savings it must reduce consumption spending of the people benefiting from the tax cut as a share of the economy. It seems silly enough that you could give rich people a tax cut and they will spend less on consumption. The argument in favor of the notion is that higher returns on capital and (after FED action) higher after-tax returns on government debt will encourage savings. This has never been empirically demonstrated and does not seem plausible to me. Furthermore, rich people have a tendency to earn returns on private capital accumulation significantly greater than the rate of economic growth. Likely encouraging them to invest by increasing their incomes and their rates of return on investment in the long term will increase the share of the economy which goes to propping up their consumption. Given all this, I can confidently say that tax cuts on savings actually reduce national savings.

A lower tax on savings might increase investment spending but only by increasing the trade deficit to a greater extent than it decreases national savings. Remember that S-Def=I+BT, so I=(S-Def)+(0-BT) (investment equals national savings plus the trade deficit). A tax cut on savings will attract foreign investment as would higher interest rates. This flow of foreign savings would cause an appreciation in the value of the US dollar, increasing the trade deficit which might then allow for more investment spending as a result of the tax cut. This is sort of what Republicans and Joe Manchin mean when they talk about a “competitive” corporate tax rate. But, what they don’t tell you is that “competitive” means a tax rate which maintains a strong trade deficit.

However, it is important to note that, even while possible in theory, no supply-side tax cut has ever been empirically proven to boost investment spending in the long run.

Furthermore, cutting taxes to be “competitive” is a race to the bottom. Even in theory, for an investment-inducing tax cut to work, it has to lower investment in other countries. To lower America’s net trade surplus another nation’s net trade surplus has to go up. This will stimulate their economy, forcing their interest rates higher. Hence, if every country tried to boost their private investment through tax cuts, it would not be possible for it to work in every country, but it would be possible for the opposite to happen in every country. It’s possible for each country to try to be more competitive and lower their taxes causing their domestic savings and investment to fall even lower.

In Conclusion:

Cutting taxes on rich people and their savings to increase investment is a race to the bottom to achieve a goal that has only been proven possible in theory.

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