As the fiscal cliff approaches, many are concerned about the impact of increased tax rates on the U.S. economy. The almost universally accepted meme today is that higher tax rates, especially on those with higher incomes, will cause a drag on economic activity. Many people also take for granted that lower tax rates result in an increase in economic activity.
The reality, however, is far more nuanced, as both higher and lower taxes may cause an increase or decrease in economic activity.
There are three principal variables to be considered when adjusting marginal income tax rates: consumption, production and tax revenue.
If economic activity is below potential, it also means that consumption, production and tax revenue are below potential. The first route taken is such an environment is typically to lower the marginal tax rates on the wealthiest. This encourages them to consume, even as it immediately lowers tax revenue to the government. It's a decision the government makes to forgo immediate revenue with the goal of increasing it in the long term.
This is the "honey" part of the "honey and vinegar" approach to fiscal policy that I discussed last year.
Consumption makes up about 70% of GDP, and about half of all retail consumption comes from the top 10% of income earners.
The argument for lowering tax rates on the wealthy is that it will cause an increase in their consumption, which will cause incomes and consumption by the 90% of income earners below them to increase. The total increase in consumption then pushes up production, job growth, GDP and net economic activity. This is what is typically referred to as trickle-down economics.
The federal budget, deficit and debt must have room to absorb an immediate decrease in tax revenue in order for this route to be politically and economically viable.
The existing income tax rates in the U.S. are at levels that were lowered temporarily by President Bush in 2001 and 2003. They were originally set to expire at the end of 2010 but were extended by the Obama administration.
In the past four years, the publicly traded sovereign debt of the U.S. has doubled, the Fed's balance sheet has tripled, and the U.S. credit rating has been downgraded for the first time ever.
At the same time, the income and net wealth of the top 10% of income and asset owners have increased at a much faster rate than the income and net wealth of the bottom 90%. This indicates wealth concentration.
Pragmatically speaking, the federal government no longer has the ability to absorb immediate lost income-tax-generated revenue in order to stimulate consumption and now must now shift toward the "vinegar" approach to tax policy.
That requires targeting production rather than consumption. This is accomplished by increasing rather than decreasing tax rates on the wealthy. Contrary to the popular meme, the primary goal in doing so is not to increase income tax revenue to the government, it is to dis-incentivize consumption and encourage investment in production.
The idea is to penalize withdrawing capital from a business and to provide tax incentives to reinvest business income back into the business by offering tax deductions for doing so, such as accelerated depreciation.
The honey approach is passive, top-down and focused on consumption as the economic driver. The vinegar approach is active, bottom-up and focused on production as the economic driver.
The resolution of the fiscal cliff as well as budget structure and tax policy for the foreseeable future will focus more on the vinegar side than on the consumption side, and the markets and economy will adjust accordingly.
It may very well do more for stimulating real economic activity and job growth than what has been tried for the past 10 years.