The American Dream. The Land of Opportunity. Pulling yourself up by your own bootstraps.
These phrases often bring to mind thoughts of love and patriotism. They altogether represent the American fondness of its own economic system: capitalism. Regardless of increasing criticisms of capitalism, Americans still love it far more than other economic systems (1).
So why all the love?
History tells the tale. Most Americans would probably tell of a historical America when people fought all the odds to create new and better lives for themselves. Heck, the colonists of the 18th century fought the world’s largest empire and won just to have freedom. Americans often look back into the past and see an America where almost everyone was once an immigrant with no job security, no money, and no certain place to live. Additionally, some of those immigrants were later the ones who fought to keep the country together during the Civil War. Fast forward, Americans then fought nobly in defense of freedom and self rule in the first and second World Wars. Some of these same Americans were the ones who struggled through the Great Depression to come out of it on top. Later, Americans went to the moon, invented vaccines that prevent polio and other diseases, and capitalized on the Industrial Revolution to reach technological feats that were never thought possible.
This sounds like one incredibly impressive past as a nation. Americans will often say that it is through these struggles that America became the greatest and richest country in the world. And the system that enabled such success is capitalism.
After all, the theory of capitalism is too enticing not to adopt. Capitalism describes an environment where anyone who has a brilliant idea and the will to make it a reality can get ahead. Anyone who is willing to work for his or her success will have that opportunity. The incentive to one day be rich and powerful drives innovation and invention. Someone who knows that hard work will be rewarded with proportionate benefit will be willing to give everything for it. The thrill of inventing something while turning a profit drives economic success.
This is the beauty of capitalism.
After all, capitalism has delivered amazing economic growth for the United States; just look at the growth in gross domestic product per capita over the past half century (2). GDP per capita is used often to depict a population’s wealth as it measures the total value of output created by the country divided by the population size.
Since 1947, real GDP per capita has increased from $13,513 to $50,953 in 2015. This value is measured in what is known as “real” dollars, which ties the dollar value to a certain year (here 2009) in order to account for inflation. In nominal dollars, of course GDP per capita should increase over time. What is important for growth is for that value to keep up with and overcome the weight of inflation, thus, creating positive real growth.
This economic prosperity is especially impressive when compared to some of the United State’s competitor nations (3).
Based on this data, a sensible person would argue that capitalism delivers far greater prosperity than the controlled economies of communism in China and the former Soviet Union. The logical next question is what spurs such economic growth?
For one, we can look at the number of patents for inventions issued. This can indicate just how much innovation is occurring in a country. Sadly the data is only from the past decade, yet it does still demonstrate a trend.
In 2011, the United States had 339.4 patents per million people issued, whereas both China and Russia had less than two each (4). The difference in invention is staggering.
Other important factors in measuring the strength of a country is overall living standards. First, the most telling indicator of health is life expectancy.
The United States is still ahead here as well with an average life expectancy of 78.84 years (5).
Health wise and prosperity wise, it seems that the United States via capitalism has delivered great success compared to Russia and China. Those analyses take care of the comparison of capitalism to present–or in the case of Russia newly deceased–command economies.
But there is another mainstream way of operating an economy: socialism. Socialism by definition is “a way of organizing a society in which major industries are owned and controlled by the government rather than by individual people and companies” (6). Now we must be careful about extrapolating from definitions. Countries in reality have a mixture of economies, where a few industries or services may be controlled by the government. This is the case in most of the United State’s peer European countries and even to a certain extent in the United States itself. Many of those countries will often be in charge of their education and health sectors but not much else. Therefore, to be clear the countries that will next be compared are not completely socialist. However, it is still possible to compare a semi-socialist country to the United State’s which has freer markets.
Again, we look at gross domestic product per capita to examine the wealth of the population in each country.
Looking at the Scandinavian countries, which are known as the socialist nations of the world, we see a much different story than previously (7). Denmark, Sweden, and Norway all have greater GDP per capita than the United States. Norway actually has almost double with $97,307.43 per person compared to $54,629.5 per person in the United States.
What is going on here? Capitalism was theorized to be the greater deliverer of wealth, yet these socialist countries are beating the U.S. out. Is the U.S. not the breeding ground of innovation as previously thought?
Nope, that’s not it. The United States has far and above more patents issued per year than the Scandinavian countries (8). Thus, if the United States has greater innovation, why doesn’t it have the wealth that the socialist countries do?
Well, let’s be clear: the United States continues to have the largest and most valuable economy in the entire world. The socialist countries do not even compare (9).
Now there are many reasons to explain this fact. The United States simply has more people, vastly greater land size, and a greater diversity of resources. Nevertheless the United States is the commanding force in the world economy. However, as shown previously, when that value is divided by the population size, the Scandinavian countries come out above the United States. How do we explain this reality?
We can measure how strongly and quickly these economies are growing compared to the United States. This can demonstrate if these socialist countries have more robust growth than the capitalistic United States, which would allow for greater wealth to be created in the same amount of time.
It turns out that at most times throughout the past half century, the Scandinavian countries have indeed been growing quicker than the United States. Therefore, they would be able to create more value that would outpace population growth at a greater rate creating more wealth for the population. In fact, the only time the U.S. has had stronger growth than all these socialist countries was in the mid 1960’s, the late 1970’s, the mid 1980’s, and 2011 through present day. American growth achieved #1 status at least once per decade for thirty years; then after the mid 1980’s that status disappeared until present day. It is indeed odd that such a status was missing for thirty years.
The socialist countries even beat the U.S. out in life expectancy (9). Therefore, not only have they been growing faster but they deliver better health results to their people as well.
Now we may ask: How can these countries be growing faster much more often than the U.S. if they have government controlling their industries, and how are they achieving better health standards than the U.S.? Did certain government actions stunt U.S. growth? Can there be something inherently wrong with capitalism? We begin to see some possible conclusions when we throw our fellow capitalistic peers into the data as well.
When we put Japan, Germany, Italy, and the United Kingdom into the mix, we obtain roughly the same results: the socialist countries often grow faster than the capitalist countries (9). The graph is interactive online allowing for precise comparisons at specific time periods.
The results are even more grim for capitalism when we examine real GDP per capita (10).
Knowing these data, we may begin to ask how socialism can possibly produce stronger growth and more growth per citizen than capitalism.
Well, it turns out that the United States used to experience higher GDP per capita growth rates.
When we examine the data, we see peaks of 4-6% growth in GDP per capita until the last peak year in 1984. After that peak, the peaks tend to be around 2-3% growth. Even with a peak of just over 3% in the late 1990’s, that still does not compare to the robust growth of 4-6% in past decades. Additionally, that peak was an outlier rather than the rule for the years from 1984 to present day.
Now to be clear, emerging economies typically have very robust growth and then once an economy stabilizes, growth will still be positive but at a slower rate. However, the United States was already almost 200 years old at the time this data set begins. This reality does not seem to answer for the slowdown. A respectable counter argument, though, is that the 1940’s through 1960’s were in a way America’s second Industrial Revolution due to the mass production of consumer home goods. This was in fact a robust driver of economic growth. However, that growth was still strong into the early 1980’s; therefore, maybe there is more at play here.
Our next logical question then is: What changed around the 1980’s when high growth seemed to peek for the last time?
Admittedly, economics is one of the most difficult social sciences to ever completely understand due to so many variables having an effect on the world. Anything from war to taxes to innovation can affect an economy. When we begin looking through the data, though, we see a trend that did noticeably begin around the 1980’s.
This graph displays the total share of U.S. income held by the top 1% of earners in a given year (11). From around 1935 to about 1975, the top 1%’s share of the total income generally decreased from about 19% to 9%. Then, from 1975 to 2013, the 1%’s share generally increased from 9% to 21.2%. Undoubtedly, 1% of the income earners having over double the share of income means that there is less income for the bottom 99% to share. The income is concentrated at the very top; this means that the top 1% owns one fifth of total U.S. income.
This is a graph of the GINI Index (12). GINI measures the income inequality of a country. Income inequality is defined as how concentrated or evenly distributed the total wealth is in a country. When the index is 0.00, all citizens own exactly the same amount of wealth–in a sense, theoretical socialism. When the index is 1.00, exactly one person contains all the wealth.
Regarding income inequality in the U.S., the lowest inequality came in 1968 with an index of under 0.39. Today income inequality stands at about 0.47–a change of .08 over 48 years. The level of inequality has almost returned to the same level as just before the Great Depression, and our inequality is worse than almost every single peer country–socialist and capitalist. The only developed country with higher inequality is Chile, which can hardly be considered a peer nation (13).
How did this increase occur after such a decrease in the 1940’s? Let’s examine when the increases began to occur and when they rose quickest. From 1968 to 1982, the index rose 0.02–a period of 14 years. From 1982 to 1996 (14 years), the index rose around 0.05–over double the rate of the previous 14 years. From 1996 to 2010 (another 14 years), the index rose about 0.01–slower than the previous 28 years. Therefore, it seems that something caused income inequality to rise between 1982 and 1996–with a 0.02 increase happening between 1982 and 1989, another 0.02 increase just between 1991 and 1992, and then 0.01 between 1992 and 1996. Therefore, most of the increases took place throughout the 1980’s and very first years of the 1990’s.
Now that we have pinpointed a time frame for this change in income inequality, we can begin to hypothesize what could have caused this change. What could have driven income from being shared across the income brackets to being so concentrated at the top? Additionally, could this income inequality be to blame for the slowdown in GDP per capita growth?
Intuitively, we can conclude that people earning less income could result from lower wages. These wages could still increase over time, but inflation can negatively affect their purchasing power.
When we look at the growth in hourly compensation over time compared to 1948, we see a stark change (11). From 1948 until about 1972, hourly compensation was virtually tied to productivity, which means the output per hour of workers. Thus, workers were being proportionately awarded for their efforts on increasing efficiency. Since 1972, we see that hourly compensation growth has essentially flatlined; workers are no longer benefitting from increased productivity. Now, it is widely known that the U.S. suffered a major economic recession during the 1970’s due to hyper-inflation and a global oil supply shortage. However, wage growth then should have picked up again as the economy expanded in the late 1970’s.
We begin to ask: how did these wages for American workers stop growing so quickly?
One possible explanation could be the decline in labor union membership. About 25% of all workers belonged to labor unions in 1980; today that rate stands around 11% (11). Unions offer workers the ability to organize, bargain, and have the ability to strike in order to gain higher wages and greater benefits. Without unions, workers simply no longer have the leverage against employers. The drop in unions can be at least partially attributed to anti-union laws passed by state governments. For example, what are known as right-to-work laws “prohibit union security agreements, or agreements between labor unions and employers, that govern the extent to which an established union can require employees’ membership, payment of union dues, or fees as a condition of employment, either before or after hiring.” Twenty-six states currently have such laws,and nineteen of those states adopted the laws between the mid-1940’s and the mid-1960’s (14). This correlation is awfully peculiar as after that period of time, union membership began to fall quickly with a fairly consistent rate of 10% every twenty-five years. Therefore, according to this data, we do not notice any smoking gun in the 1980’s, but surely this consistent dropping in union membership over the past fifty years could have contributed to lackluster wage growth starting in the 1970’s. Wages seemed to stop growing very soon after these nineteen states had implemented these laws. However, correlation is not causation, especially since a majority of states did not have such laws until recently.
A common addition to this wage stagnation story is the increase in globalization. Some people argue that due to the fact that global trade is now easier because of transportation and communication, this has led to the outsourcing of American jobs, which lowers wages. This is indeed true of the manufacturing industry, which saves much money by employing foreign workers for lower wage. However, this globalization does not explain the wage growth stagnation of all jobs, including ones that cannot really be outsourced to other countries.
Perhaps there is more to the wage slowdown story than the decline in union membership and globalization. Our vision becomes a little clearer when we consider the difference in income growth for the top 1% of income earners compared to the bottom 20% (11).
This graph demonstrates where all the income is going. In the 1970’s, the growth of the two groups was almost identical. Then, the paths of the two lines began to differ sharply. While the top 1% now earns 174.5% more than it did in 1979, the bottom 20% only earns 39.7% more. The difference in growth is stark.
Now, we can throw taxes into this in order to determine on whom the tax burden is falling and how that affects these income growth percentages (11).
We now see that the top 1% actually earned 200.2% more after-tax income compared to 1979. Comparing this to 174.5% in the previous before-tax income graph, this means that the tax burden on the top 1% actually decreased throughout these years causing those earners to gain around 25% more income. When we view the bottom 20%’s growth, we see that after taxes, the growth was 48.2% compared to 39.7% before taxes. This means that the bottom 20% earned 8.5% more income from having to pay less in taxes. This means that the 1% experienced three times more income growth due to a decreased tax burden compared to the bottom 20%. The graph also displays the bottom 99%’s growth in after-tax income. Even the top 18% of income earner only gained 67.4% more income than in 1979. Therefore, it is quite clear where all the income is growing. Since income is measured not by individual but by household, it is important to note that there are 125 million households in the U.S. (15). The top 1% then is just 1.25 million households. All the income growth, then, is disproportionately going to a tiny sliver of all the households in the U.S.
It is worthy to note the average annual incomes of these income brackets since they have been our markers on growth thus far.
The top 1% includes American households that earn over $400,00 per year.
The top 10%: over $150,000 per year.
The top 20%: over $106,000 per year.
The top 40%: over $65,000 per year.
The bottom 40%: under $41,000 per year.
The bottom 20%: under $22,500 per year.
The median income is $52,000 per year (16).
Typically workers who make over $400,000 per year are CEOs and other high-level executives of businesses. Therefore, it is worthy to note the difference in growth between the average worker’s pay and CEO pay.
As the graph shows, CEOs used to make $42 for every $1 earned by the average workers in 1980. Now, that ratio is $373 for every $1 (11). We see that the most drastic changes came between 1980-1994 (100x more), 1994-2000 (383x more), 2001-2004 (150x more), and 2009-2011 (approximately 90x more). Growth in CEO pay seems to be closely linked to the health of the stock market, which essentially means that as a company’s value increases, awards for success tend to shift more to the CEO rather than the company’s workers.
Examining the change in worker pay from 1965-2013, we measure a 32% total increase in pay, whereas CEO pay increased a total of 1,752% (17). Specifically, this change has occurred even while corporate profits have risen, effective corporate tax rate have fallen, and the stock market has grown.
These data demonstrate a peculiar trend. While after-tax corporate profits have almost doubled as a percentage of GDP since 1981, employee compensation has dropped over 2% as a percentage of GDP even while the effective corporate tax rate dropped over 10%. Even if we exclude the Great Recession, corporate profits still rose 2% since 1981 and the effective corporate tax rate fell almost 6% while employee compensation dropped 0.6% (18). It seems that even while profits have grown and tax rates have fallen, corporations have rewarded their CEOs rather than their workers. Interestingly, when corporate tax rate were highest under President Truman (47.3%), workers were making more (53.6%) than today (53.2%) when corporate tax rates are the lowest (20.5%) since President Hoover (14.7%).
Moving beyond CEOs and corporations, it may be noteworthy to see how taxes on the various income groups of America citizens have changed over time. If we can see on whom the tax burden is falling, maybe that will provide us with an answer on why we are seeing rising income inequality and also slower GDP per capita growth than in the middle of the 20th century and compared to socialist countries presently.
Important to note is the fact that many corporations have avoided paying the corporate tax rates that were discussed above via shift to what are known as pass-through businesses, where the profits are paid by each executive at the individual tax rate (19). Therefore, it may be even more pertinent to analyze how tax rates on individuals have changed over time.
For this analysis, inflation-adjusted income will be used so that we are able to compare how much someone would pay in taxes with the same relative income but at different points through U.S. history. The U.S. income tax system is progressive meaning that certain income ranges pay certain tax rates. Therefore, what is known as an individual’s effective tax rate is the total percentage of money owed in taxes–after calculating through all the applicable income brackets–compared to his or her pre-tax income.
To demonstrate differences in taxes paid throughout history, I will calculate the amount of money owed in taxes for an individual making the median income of $52,000 per year and for an individual making $400,000 per year (the top 1% of income earners). Do note that these calculations do not include any reductions, loopholes, or other forms of taxes (like consumption or payroll). This is merely the tax burden dictated by the income tax brackets. Calculations are also done in the last year of a president’s term in order to show any potential effect the president may have had on the tax code.
2015 (Barack Obama)
The Median’s Tax Burden: $8,793.75 (16.9% of pre-tax income)
The Top 1%’s Tax Burden: $115,605.25 (28.9% of pre-tax income)
*Following adjusted using 2010 constant dollars*
2008 (George W. Bush)
The Median’s Tax Burden: $9,297 (17.9% of pre-tax income)
The Top 1%’s Tax Burden: $118,324 (29.6% of pre-tax income)
2000 (Bill Clinton)
The Median’s Tax Burden: $10,239 (19.7% of pre-tax income)
The Top 1%’s Tax Burden: $130,125 (32.5% of pre-tax income)
1992 (George H.W. Bush)
The Median’s Tax Burden: $10,226 (19.7% of pre-tax income)
The Top 1%’s Tax Burden: $117,247 (29.3%% of pre-tax income)
1988 (Ronald Reagan)
The Median’s Tax Burden: $10,283 (19.8% of pre-tax income)
The Top 1%’s Tax Burden: $112,001 (28% of pre-tax income)
1980 (Jimmy Carter)
The Median’s Tax Burden: $10,741 (20.7% of pre-tax income)
The Top 1%’s Tax Burden: $226,781 (56.7% of pre-tax income)
1976 (Gerald Ford)
The Median’s Tax Burden: $11,825 (22.7% of pre-tax income)
The Top 1%’s Tax Burden: $215,206 (53.8% of pre-tax income)
1972 (Richard Nixon)
The Median’s Tax Burden: $11,379 (21.9% of pre-tax income)
The Top 1%’s Tax Burden: $206,573 (51.6% of pre-tax income)
1968 (Lyndon B. Johnson)
The Median’s Tax Burden: $10,739 (20.7% of pre-tax income)
The Top 1%’s Tax Burden: $195,792 (48.9% of pre-tax income)
1963* (John F. Kennedy)
The Median’s Tax Burden: $12,465 (24% of pre-tax income)
The Top 1%’s Tax Burden: $223,902 (56% of pre-tax income)
*JFK assassinated before finishing his term.
1960 (Dwight D. Eisenhower)
The Median’s Tax Burden: $12,359 (23.8% of pre-tax income)
The Top 1%’s Tax Burden: $221,331 (55% of pre-tax income)
1952 (Harry S. Truman)
The Median’s Tax Burden: $13,369 (25.7% of pre-tax income)
The Top 1%’s Tax Burden: $229,374 (57% of pre-tax income)
1945* (Franklin D. Roosevelt)
The Median’s Tax Burden: $12,658 (24% of pre-tax income)
The Top 1%’s Tax Burden: $195,202 (48.8% of pre-tax income)
*Data from 1944 not available.
Analyzing these data, we can compare the change in the tax burden from the time of lowest income inequality (1968) to today. The median income earner is paying $1946 less in income tax–an 18% decrease. The top 1% income earner is paying $80,186 less in income tax–a 41% decrease. While income inequality has increased, the top 1% of income earners have seen their taxes cut by double the cut for the median income earner. The richest 1% simply has gotten to save much more of its income compared to the median earner.
Furthermore, when looking at GDP per capita growth since 1968, we begin to see trends related to the change in taxation. Tax rates on the top 1% dropped sharpest during the administration of Ronald Reagan. Their tax burden went from 56.7% in 1980 to 28% by 1988–a virtually exact halving. When looking at the time frame from 1968 to 1984, GDP per capita growth peaks hovered around 3.5-6.25%. Never again since those massive tax cuts for the top 1% were implemented has GDP per capita growth ever again hit above 3.5%. Possibly conclusions can be made here. Admittedly, correlation does not mean causation, but surely taxation could have an effect on income inequality and GDP per capita growth.
Let me explain how.
As we have seen, both corporate and individual income tax rates have fallen over the past many decades. Corporate taxes are now over 10% lower than in the 1980’s, and individual tax rates on the top 1% are now 50% lower than before the 1980’s. As discussed previously, many businesses now operate as pass-through corporations, which are taxed at the individual rates. This is one of the reasons corporate taxation as a percentage of federal revenue has fallen from 30.5% in the 1953 to just 10.6% in 2015 (19). More businesses are simply using the individual rates due to the fact that at times throughout the past few decades, the individual rate has been lower than the corporate rate.
Furthermore, while American workers are paying around 15-20% of their incomes, corporations often manage to pay $0 in federal income tax. “They were merely taking advantage of major corporate tax loopholes and provisions long part of the fabric of the U.S. tax code.” Some corporations have even gotten money paid to them by the government through rebates and loopholes (22).
It is reasonable to question at this point: So what if the richest have seen their taxes cut so much? How could this possibly affect income inequality and GDP per capita growth?
As we know, most people attempt to pay as little as possible in taxes, and this practice is usually not illegal. People naturally take advantage of rebates, loopholes, and deductions. The critical point here is when a company must pay a high tax rate, that incentivizes the company to “write off” as much in expenses as possible to deduct from its taxes. When a company must pay a lower tax rate, it does not have to deduct as much. Deductions can be any expense that is “ordinary and necessary” for the businesses’ operation. These deductions can be almost anything that is helpful for the business (23).
This may be counter-intuitive, but when a business must pay a higher tax rate, it is then incentivized to reinvest all the money possible back into the business itself. These reinvestments may come through research & development, increasing employee wages, offering retirement plans for employees, etc. Now that corporations pay far lower tax rates, they are not deducting as much through reinvestment in the businesses themselves. It can rather pay its low tax rate–possibly even nothing in taxes through loopholes–and then have massive amounts of profit with which to reward high-level executives.
Therefore, we see that high tax rates are not simply about businesses having to pay more in taxes. The high rates encourage business reinvestment rather than high profits for executives to enjoy. The reinvestment would certainly cause more economic growth through research & development and also through higher wages and benefits for employees. This may indeed be the reason wages have stagnated for decades now even while productivity and corporate profits have increased. This then drives income inequality directly.
The effect also has a negative feedback loop explaining how lower wages for employees via lower tax rates on corporations has caused slower-than-normal GDP per capita growth. The explanation becomes clear through the study of basic economic theory.
As we discussed previously, capitalism encourages businesses to desire the greatest amount of profit possible. Profit is a great incentive for innovation. However, profit comes through cutting as many costs as possible. Intuitively businesses do not want any excess in cost whatsoever. They seek to operate with as much revenue as possible while having the lowest costs possible. One of the major areas that compose businesses’ costs is employee pay and benefits. A business wants as few employees possible that will operate the business most efficiently. This is known as the law of diminishing returns; each employee added after the greatest efficiency point will cause only marginally greater return or even possibly a lower return. Therefore, businesses want only the fewest amount of employees needed.
We may then ask: What would cause a business to hire then?
The answer becomes clear when we imagine a scenario. If supermarket A has only two cashiers, those two employees can perfectly manage the ten customers that are waiting to pay. But let’s say that the supermarket now has twenty customers waiting to pay. With a line of ten people at each register, customers may eventually get impatient and aggravated causing them to shop at supermarket B in the future that has more employees to reduce wait times. Supermarket A does not want to lose that second batch of ten customers; therefore, it is incentivized to hire two more employees that can efficiently ring up those customers, and supermarket A will then gain that revenue.
The pressure on a business to hire then is customer demand. When consumers demand more products and are shopping more often, a business feels the pressure to hire more workers in order to meet that demand. Without the demand present, supermarket A would have no purpose in having four cashiers.
The lesson here then is that economic growth comes from consumer demand. There is a healthy feedback loop from this reality. When consumers are empowered to spend at businesses, those businesses feel the demand and hire more employees. Those new employees then have more money in their pockets than previously and will then have greater demand for consumption. This demand then puts pressure on more businesses to hire more employees. And so on and so forth. This is the churning of economic growth.
We may then ask: how can we put money in those first consumers’ pockets in order to start the churning? Well, first we have to decide who those customers would be and, therefore, where to focus our efforts.
Consumption rides a concave curve increasing as income grows but with diminishing effect.
A poor person spends almost 100% of his or her income. Someone in the bottom 20% of income earners only makes at most $22,500 per year. Almost all of that income then must go toward rent, health care, groceries, and education. There will be almost no money left over after all expenses are paid. Therefore, such a person has a 100% marginal propensity to consume. That means every additional dollar he or she may earn will certainly be spent. That is because the person can then more easily afford a better home, more groceries, or better health care.
On the other side of the spectrum, an extremely rich person spends a much lower percentage of his or her income. That is because one person can only consume so much. Of course, someone in the top 1% can buy another yacht or another home, but there is a lower likelihood of spending all that money. Excluding those high-price items, a rich person can only buy so many groceries, durables, or other household items. One example I have heard is that a rich person can only buy so many pillows.
The rich person would have a higher propensity to save money since he or she does not have expenses that equal his or her total income. The additional money then will sit in a bank or be invested on the stock market. Of course, investment in the stock market gives companies more cash on hand in order to invest in the companies. However, consumer demand must first be present in order to give companies the ability to grow and the reason to invest.
Therefore, when income inequality is high, there is more money in the bank accounts of the rich that is not being spent to consume and, therefore, not churning the economy. If average American workers had more income, they could buy that additional pillow. They could afford more groceries, more education, or more health care.
Thus, our efforts on increasing incomes should be on the lower and middle classes. Those Americans are more likely to spend all their income, which spurs economic growth via increased consumer demand. Additionally, the best way to increase wages for workers is to lower the size of the labor pool. That is due to the fact that when there are fewer available workers needing jobs, employers have to compete for those workers. Those workers are then worth more, which means their wages will be higher. In order to reduce the size of the labor pool, we need to ensure that consumers have income to spend putting demand pressure on businesses to hire more people. That will then lower unemployment and drive up wages. Therefore, tax cuts on the lower and middle classes are much more effective on spurring economic growth. Consumer spending will spike instantly due to such tax cuts, and consumption will resume due to the increased employment and wages that will come as a result. Tax cuts on the top income levels will not have such an effect on consumption and, therefore, will not increase employment and wages.
Some businesses have realized that focusing on long-term growth through the empowerment of employees is much wiser than constantly cutting costs in order to have the greatest short-term profits. However, it is difficult to fight this natural tendency of capitalism, especially when cutting the bottom line in the short term seems like the best route to profit. That is why it is so challenging for a company to voluntarily increase benefits or pay. However, some companies push back on this notion because they realize that putting more money in the pockets of employees will not only increase consumer demand but will also increase worker satisfaction and productivity. People who are paid well and treated well are naturally better at their jobs. For example, Starbucks Coffee Company and Costco Wholesale pay workers above minimum wage and also offer extensive benefits, such as one-for-one matching of 401(k)’s, vacation pay, and college education funding. These companies experience some of the lowest turnover ratings in their industries due to the fact that employees are happy with their company. Additionally, the increased pay encourages those employees to then spend more at their workplace driving up profits and churning the economy. This method may be counter-intuitive in the short term, but in the long term it delivers record profits and worker satisfaction. It is sad that short-term profits discourage companies from behaving this way often. Most companies are too fearful of making long-term investment when profit can be made in the present quarter, which keeps wages and benefits down for workers and will hurt long-term growth. Additionally, when companies keep pay so low, they force employees to turn to government assistance in the form of food stamps or Medicaid. Therefore, the natural tendencies of loving short-term profit are preventing economic growth and are increasing government debt.
When in an economic recession, we may wonder how to jumpstart consumer demand in order to encourage businesses to hire again. When businesses do not have a reason to expand, the only force that can spend money in order to start the economic engine once again is government. Government has the ability to take on costs and even debt without closing down unlike a business. That is why businesses will not be the ones to be the first actors in jumpstarting economic growth. Government must go out on that limb.
In order to affect economic growth, government has two options: increase spending or cut taxes. As discussed previously, tax cuts will be most effective on Americans who have the highest propensity to consume–the lower and middle classes. That is why 28% of the American Recovery and Reinvestment Act passed by President Obama in 2009 consisted of tax cuts (24). The other side of the governmental options for spurring growth is increased spending. If government can prop up business projects, it can then create job openings for Americans. That is why the stimulus package included many projects, such as infrastructure jobs. Those jobs were created by the government in order to put Americans back to work, putting money in their pockets, which they could then spend at businesses, which would put demand pressure on businesses to begin hiring again.
This crucial function of government in times of economic peril is exactly why balanced budget amendments for the Constitution are misguided. It is absolutely wise to have a balanced budget at most times. However, when the economy suffers an enormous shock, the government must be free to step in and spend in order to spur growth. Additionally, when taxes are cut on the top income earners, the government has less revenue to be able to finance such economic recoveries. Of course, government has other areas where it frivolously spends money. Those endeavors need to be cut, but the government must have a fair share of revenue coming from all income earners. The tax code used to be much more progressive in that there were many increasing income brackets to account for the change in marginal propensities to consume and save as income increases.
For example this was the tax code in 1968:
Then in 1988:
Then in 2013:
This gutting of the progressive tax code is the main contributor of why the top 1% of income earners have seen their tax burden slashed in half while the median income earner’s tax burden has largely not changed since 1968. Also important to note, other main forms of taxation are consumption and payroll. Payroll taxes pay for social programs like Social Security; they are applied with an equal rate for all income groups. The same goes for consumption tax, which is applied to all consumer goods. When a tax is instituted without progression for increasing income, the tax adversely affects lower-income Americans since that tax then makes up a great percentage of their income.
As the data show, the bottom 20% of income earners essentially paid 2.1% of their income to sales tax while the top 1% paid just 0.3% (25). It seems that the highest income earners have enjoyed a decrease in their tax burden disproportionately to the percentage in sales tax that the median and lower income earners must pay.
Examining the U.S.’s history of taxation, we begin to make some conclusions about the effects on income inequality and GDP per capita growth. Lower taxes on businesses encourage less business reinvestment, which means lower wage growth for workers, which means slower economic growth and higher income inequality. The cycle seems to continue on loop then.
On the other hand, the socialist countries like Norway institute a much more progressive tax code akin to the U.S. before the 1980’s.
As seen in the graph, Norwegians can end up paying almost 40% of total income (26). Because of this high rate of taxation, more business reinvestment is encouraged. Therefore, the rate of income inequality is much lower in the Scandinavian socialist countries compared to the U.S.
Unfortunately, the GINI indexes of the Scandinavian countries have not been measured for very long, but it is still apparent that income inequality is much lower in them than in the U.S. (27).
In addition to progressive taxation combatting income inequality, it also allows for more tax revenue to be able to counteract some of the inherent flaws of capitalism. As we stated previously, capitalism allows for businesses to cut costs as much as possible in order to gain the most profit possible. That is a very smart and efficient notion. However, as we have already discussed, cutting costs can also mean cutting wages and jobs. When the government has enough revenue, it can finance programs that combat the natural tendencies of businesses to cut at the expense of workers’ jobs and pay. In 1980, the 1.25 million household in the top 1% would be paying a total of $283,476,250,000 in income taxes. Today, those same 1.25 million households pay a total of $144,506,562,500 in income taxes. That is a total difference of $138,969,687,500 in income taxes that the government does not collect from the top 1% anymore or that does not get written off as reinvestment in businesses as wage or benefit growth for workers. We know that government actions can have an effect on union membership, which may affect pay and benefits for workers because of the power that unions can leverage against businesses. Furthermore, government can institute laws like a higher minimum wage for government workers, mandated health care provided by employers, social security, unemployment insurance, etc. These programs can help counteract the natural tendency of businesses to cut pay and benefits while ensuring that American workers have the capacity to continue consuming, which affects demand pressure on businesses and encourages those businesses to increase employment and pay.
Knowing these data and these theories, it may be time to blend the benefits of capitalism and socialism together. We do not want to stunt innovation with ungodly taxation, but we can return to the taxation of a few decades ago, which accompanied lower income inequality, lower government debt, and higher GDP per capita growth. We want to ensure the ability of businesses to innovate while protecting American workers from the natural tendencies to cut wages and benefits. This can indeed be achieved through thoughtful policy that can put more money in the pockets of America workers to drive consumer demand, which will encourage higher employment and more economic growth.
If we put more money in the pockets of those that will certainly spend it, the economy will be fueled giving those same Americans a greater chance of moving up the economic ladder. As of right now, the chances of moving up that ladder are quite low–especially for someone who is born into the lowest income brackets.
Most children born into the bottom 10% of income earners will likely stay in the same income region, and children born into the top 10% of income earners will likely stay in the same rich income region (28).
The U.S. actually ranks second to last compared to the above countries in social mobility. “The four countries with the lowest ‘intergenerational income elasticity,’ i.e. the highest social mobility, were Denmark, Norway, Finland, and Canada with less than 20% of advantages of having a high income parent passed on to their children” (29). This means that children born rich do not have some special advantage over poorer children at becoming rich. In other words, the Nordic Dream is three times as powerful as the American Dream.
If we want to instill equal opportunity for all in this country–where you can get ahead as long as you are willing to work for it–we need to reevaluate the American Dream and just how fair, or unfair, it is depending on one’s birth status. If we do not wish to be a land of nobility, we ought to instill economic policies that level the playing field. We do not want to favor the wealthy so much that we then disable the economic ladder for anyone not born into the wealthy class to one day reach it. We do not wish for equal results or complete income equality, but we do not wish for such inequality that it makes it impossible for a driven, hard-working poor person to one day reach the top 1%. Economic policy should not be about ensuring income equality as much as it should be about instilling fairness and opportunity for all people. That is true freedom. That is the American Dream. We need to work to ensure that the Dream remains a reality.