How Capitalism Will Save Us

by Steve Forbes

  According to Warren and Tyagi, five budget items—housing, health insurance, cars, taxes, and child care—now eat up three-quarters of the income of today’s two-income families. A generation ago, they assert, these expenses consumed only half the income of a single-earner family.

  Critics of capitalism also blame tax cuts and free trade for squeezing the middle class. It may be tempting to believe such gloom-saying during the current, especially sharp, recession. But it is not borne out by long-term statistics. In the 1980s, the net worth of U.S. households increased 110 percent; in the 1990s, it rose 108 percent. And until the financial crisis of 2007 it increased another 50 percent. In the current downturn, household net worth took a real hit because of the sharp slump in both the housing and equity markets. But this is not a permanent state of affairs. We’ve had periods in the past of decline followed by rebounds that exceeded the previous highs. The only exception, of course, was the 1930s, when, as we’ve seen, government policies hurt recovery.

  Before the financial crisis and recession the nation was, in the view of some, nearly at full employment, with unemployment rates lower than they had been throughout most of the past thirty years.

  Critics of capitalism have long insisted that Census Bureau numbers reflecting a smaller percentage of middle-income earners since 1980 suggest the decline of the middle class. Forbes columnist and author Bruce Bartlett, a former Treasury official, dismisses “the clear implication that the percentage of those defined as the ‘middle class’ has fallen because many of those who used to be considered middle class have become poor.” That idea, he claims, is essentially hogwash. “In fact, the ranks of the poor have fallen along with those of the middle class” over the past three decades.38

  The reason, he says, is that more of them are richer. Multiple studies confirm this trend, including the 2007 U.S. Treasury Department study mentioned earlier in this chapter. It reported that “roughly half of taxpayers who began in the bottom income quintile in 1996 moved up to a higher income group by 2005.”39

  Bartlett asks, “How can it not be a good thing for society that fewer people are now making low incomes and more are making high incomes?”

  But what about those people left in the middle? Aren’t they being squeezed by higher healthcare, education, and insurance costs? Yes, those things are more expensive. But it’s taxes that are causing the problem.

  Writing in the Wall Street Journal, George Mason University professor and bankruptcy expert Todd Zywicki shows how Warren and Tyagi’s study downplays the tax issue. “When a spouse enters the workforce, he or she is immediately taxed at a higher marginal rate than one worker would be alone.”40 Not only that, he says, family budgets are stretched still further by rising state and local taxes, especially property taxes.

  Mortgage payments, health insurance, and car payments have increased since the seventies. However, “the increase in tax obligations is over three times as large as the increase in the mortgage payments and almost double the increase in the mortgage and automobile payments combined. Even the new expenditure on child care is about a quarter less than the increase in taxes.”41

  Zywicki takes a closer look at the numbers in Warren and Tyagi’s comparison. He finds that the tax bill for their present-day middle-class family had increased by $13,086—an incredible 140 percent. Meanwhile, “the percentage of family income dedicated to health insurance, mortgage and automobiles actually declined between the two periods.” In other words, he says, today’s middle class families are not in a “two-income trap” but in a “two-income-tax trap.”42

  “The typical family in the 2000s,” he says, “pays substantially more in taxes than the combined expenses of their mortgage, automobile and health insurance.” Some may wonder how this can be the case in light of the tax cuts that have taken place since the 1970s. It’s because until the 1970s, most income earners were not in high tax brackets, especially after President Kennedy cut taxes in the 1960s. Then, too, Social Security and Medicare taxes were very low. In 1970 the payroll tax for FICA ate up a maximum of 6.9 percent of your income; by 1980 it was 8.1 percent; in 2009 it was 15.3 percent.

  Moreover, the real value of standard exemptions (deductions for kids and spouse) was higher in real terms in the 1950s and 1960s than afterward. When you have two income earners, especially among professionals, you fall into a very high tax bracket. People didn’t hit those brackets as often in those early days, and exemptions were richer. Add increased payroll taxes, zooming property taxes, and burgeoning state income and sales taxes, and you have yourself a heavy burden indeed. For example, New Jersey had no sales tax until the mid-1960s. Today it is 7 percent. The Garden State had no income tax until the mid-1970s, and then the maximum rate was 2.5 percent. In 2009 the highest rate was almost 11 percent.

  As for rising health and education costs, they are anything but the result of too much capitalism. As we shall see in chapter 7, healthcare costs are the result of layers of laws and regulations distorting markets for medical care. And isn’t government responsible for those substandard schools that families are economically stretching themselves to escape?

  Today’s middle-class squeeze is partly the result of another development that the gloom sayers don’t necessarily like to acknowledge: today’s higher level of material affluence and opportunity that has raised consumer expectations and standards. Yesterday’s innovations and luxuries have become today’s necessities. As personal-finance writer Laura Rowley puts it, it’s harder to live on one income today because there is “so much more stuff to say ‘no’ to.”43

  Take higher education. Spiraling college costs were not an issue decades ago when the majority of people did not go to college. But now many more do.

  Another modern convenience that was not part of life back in the 1950s: credit cards. Few people realize that they became a major factor only in the 1960s. Before, people often used personal-loan companies to borrow money for household purchases. Their rates made credit cards look like bargains. “Plastic” lowered the cost and availability of credit. You didn’t have to run to the bank to get cash. It made buying things a whole lot easier. But the downside was that you could misuse these powerful tools and incur too much consumer debt.

  The truth is that there are middle-income families that are living on one income. How do they do it? Through prudent budgeting and consumption. Living like a one-income family in the 1970s can sometimes mean scaling back consumption to something resembling 1970s standards. This sounds harsh. But those who have managed to do it insist that it isn’t. One typical post on Wise Bread, a blog for people “living large on a small budget”:

  We have had only one income for 19 years and are raising three kids. Everything we own is paid in full including our house now valued at $450,000. We take vacations every year and every two years we fly to Florida to Disney World. My husband has a blue-collar job. I don’t think it’s a status symbol to live on one income. I think it’s just the best for our family.44

  Carl, a single-income earner, opines that, in the end, family life on a single income ends up being cheaper because there aren’t the costs associated with a second job—like child care and transportation.

  We are a single-income family, saving more money than most dual-income families. I think the time when dual-income families have more money than a single-income family [is] gone. We live in a larger house and are saving more money than my brother while our income is 40% less than his dual-income …

  The idea that an average family has more money with a dual-income than a single-income is a myth. Of course there are always exceptions, but if you run the numbers with all the expenses—a single-income family actually has the edge.45

  Writes Paul, a stay-at-home dad, living on his wife’s income “allows me to garden, take care of the chickens, take care of the bees, plan and cook good meals, write poetry, walk with the kids, etc.”

  He concludes, “I have to say that I do feel, often, that the sensual enjoyment of our liv
es, the fact that we have no consumer debt and an emergency fund, and the time we can spend with our kids, raises our quality of life well above that enjoyed by most people making a little above $40,000 a year. I FEEL rich.”46

  REAL WORLD LESSON

  Progressive tax rates penalizing two-income families are the primary driver of the middle-class squeeze.

  CHAPTER FOUR

  “Aren’t Higher Taxes the Price We Pay for a Humane Society?”

  THE RAP Taxes are an investment in the common good. They are the price we pay for a humane society. Taxes are essential to funding federal, state, and local governments, which maintain social order. Not only do tax cuts deprive government of needed revenue, they mainly help the rich, who need them the least.

  THE REALITY Taxes are necessary to pay for critical government services. But excessive taxation undermines the common good. Overly high taxes keep individuals from building personal wealth and advancing in the economy. They deprive society of the capital needed to fund investment in new businesses and jobs. History shows that, time and again, tax cuts, by unleashing economic growth, have generated more—not less—money for government.

  No one doubts that we need government for essential services such as ensuring law and order, providing a national defense, providing disaster relief, and building and maintaining roads and highways, among other functions. But to pay for government, you need a healthy, growing economy. Excessive taxes defeat this objective by slapping an enormous financial penalty on work and enterprise. This penalty is even higher than most people realize. On top of what you or your business pays the government, there’s the additional cost of compliance—the thousands of dollars spent on accounting and sometimes legal fees, not to mention the hundreds of hours you spend gathering data and filling out your returns and other records—the W-2s, 1099s, and so on. In 2004, the Office of Management and Budget estimated the cost of the nation’s total tax compliance to be some $200 billion.1

  Billions of dollars in money and human resources are wasted on taxes and tax compliance that could have gone into launching or expanding business-creating jobs. Taxes also end up making economic transactions more expensive. So what happens? Fewer of them take place. That’s why high taxes sooner or later produce a stagnant economy, with fewer and poorer taxpayers who generate less money for government coffers.

  Politicians love to talk about taxes being an “investment” in society. Sometimes taxes are supposed to be a way of “protecting jobs”—as in the case of tariffs on imports. Other times they’re proposed as a way of encouraging what certain groups deem to be “desirable” behavior—for example, so-called obesity taxes discouraging consumption of sugary foods and beverages. Proponents of these taxes often don’t understand that markets are millions of people expressing their desires. Trying to control their behavior through what is basically a coercive measure usually backfires.

  No matter how they’re sold to the public, taxes rarely produce the market outcome their advocates want. As Andrew Chamberlain, Gerald Prante, and Patrick Fleenor of the Tax Foundation explain, taxes tend to produce unexpected economic effects:

  Economists teach that, in general, taxes do not stay where lawmakers put them. Instead, some portion of taxes are generally shifted onto others.2

  For this reason, taxes intended to protect the economy almost always do just the opposite—they kill jobs. The classic example, mentioned in chapter 2: the devastating Great Depression that ensued after the Smoot-Hawley Tariff slapped oppressive taxes on imports.

  Smoot-Hawley was supposed to help preserve American jobs by making a vast array of imported products more expensive. What it produced was a trade war that made countless products unaffordable. Consumers simply stopped buying. Manufacturers had to cut back on employment. Millions of jobs were destroyed. Profits shriveled and investment capital dried up, undermining banks and precipitating the economic slump. The massive tax increases enacted in 1932 in the name of balancing the budget crushed an enfeebled economy and made the Great Depression even worse.

  Taxes also helped create the infamous economic “malaise” of the 1970s. The Great Inflation of that decade pushed up salaries, forcing people into higher tax brackets. What did Congress do? It squeezed people and businesses further by, among other things, substantially boosting the capital gains tax. Would-be ventures couldn’t get financing. Productivity fell. A family making $18,000 a year in 1979 was less well off than a family that had made $7,000 in 1968.

  When tax rates are cut, however, the opposite takes place: the economy booms. Tax revenues grow. This has happened after every major tax cut in the last eighty-five years. Economist Arthur Laffer explained this continuum effect in the 1970s using what came to be known as the “Laffer curve.” Higher taxes may initially increase government revenues. But they retard economic growth.

  A classic case was the Clinton tax increases of 1993. They cut in half the 5 percent growth rate the economy had achieved by the end of 1992. This slowdown—combined with a rejection of Clinton’s proposed plan for national health care—helped defeat the Democrats in 1994. With the Republicans in charge of Congress, the capital gains tax was slashed by 29 percent. The capital gains levy on people’s primary residences was virtually eliminated; new taxes on the then-emerging Internet were barred. Welfare was also reformed and the growth of government spending was curtailed. The tax reductions, combined with slower spending, set the stage for a boom decade.

  Would-be tax hikers forget that high tax rates hinder productive work, risk taking, and capital formation. That means a slower-growing economy generating less government revenue than it otherwise would have. But when tax rates are cut, more economic activity produces more tax revenues.

  To observe the beneficial impact of tax cuts on the economy, all you have to do is look at history. In 1921, when President Warren Harding took office, the nation was in a depression, the result of the Federal Reserve raising interest rates to fight the inflation triggered by World War I. Unemployment had reached 13 percent.

  Harding’s plan for a “return to normalcy” included a major income-tax cut. After his untimely death from food poisoning, his successor, Calvin Coolidge, pushed through additional tax cuts. The result: the Roaring Twenties. The federal budget surged into surplus. Increased revenues plus spending restraints saw the national debt shrink by one third. Real GDP growth went from 2 percent to 3.4 percent.

  John F. Kennedy’s proposed income-tax cuts, enacted in 1964, had much the same effect: real income-tax revenue growth surged from 2.6 percent to 9 percent. GDP growth increased to a robust 5.1 percent. Same for the Reagan tax cuts legislated in 1981: income-tax revenue, which had been shrinking by 2.6 percent a year, grew by a robust 3.5 percent. Real GDP growth soared from 0.9 percent to 4.8 percent, ushering in an era of prosperity that lasted almost three decades.

  Not all tax cuts, however, are created equal. Some officeholders seeking political credit for cutting taxes will attempt to portray nominal rate cuts or rebates as Kennedy-or Reaganesque tax reduction. But these onetime gimmicks do not have the effects of substantial, across-the-board cuts in rates. The Bush tax cuts of 2001, for example, were largely useless. The tax rebates provided a small, one-shot boost to the economy and then fizzled, as rebates always do. The rate cuts that were enacted were phased in over so many years that their initial impact was virtually nil. The result: the economy treaded water in 2001 and 2002.

  However, the Bush administration did get it right with its second round of tax cuts in 2003. Income-tax rates were reduced by an average of 10 percent. The capital gains levy was slashed; the personal income tax on dividends was meat-axed over 60 percent, from almost 40 percent to 15 percent. Small businesses were given incentives for investment by being allowed to write off capital expenditures of up to $100,000 immediately, instead of over several years. The economy bloomed.

  The consistently salutary effects of tax cuts on the economy have been documented in a powerful study by Christina Romer, now chai
r of President Obama’s Council of Economic Advisers. She and her husband, UC Berkeley economist David Romer, studied all federal tax cuts and tax increases from 1947 to 2005. They found that tax cuts have a direct and pronounced impact on our economic output. A tax cut of 1 percent will increase GDP by about 3 percent.3

  The real issue is not whether we should have high taxes or have no taxes. It is what level of taxation is necessary to fund essential services while enabling society to grow at its full potential. A 2009 annual poll by the Tax Foundation showed that Americans, on average, believe taxes should be only around 16 percent of their income.4 Unfortunately, we’re a long way from that.

  Taxes don’t just stifle economic activity. They’re used by politicians to influence behavior that might otherwise be considered beyond the reach of government. Political debates over taxes frequently center on whether or not to impose a particular incentive—say, a tax credit for “caregiving” or for hiring American citizens. Libertarians like Yaron Brook, president of the Ayn Rand Institute, question whether the government should really be in the business of using taxes to influence what are essentially personal decisions:

  Tax policy works by attaching financial incentives to a long list of values deemed morally worthy. If you want to maximize your wealth come tax time—and who doesn’t?—you must look at the world through tax-colored glasses, “voluntarily” adjusting your behavior to suit social norms and thereby qualify for tax breaks. In this way, the social engineers of tax policy preserve the impression that you’re exercising free choice, while they’re actually dispensing with your reason and your judgment.

  [T]here’s nothing wrong with caring for grandparents, hiring local people or spending on R&D—if a rational thought process leads you to conclude that those choices actually serve the self-interest of you or your company.5

  Taxes also let policy makers dispense political favors. How did the the sale of lumber by the timber industry come to be taxed—and stay taxed—at the capital gains rate instead of the normal tax rate? One factor: Weyerhaeuser Company, a leading forest products company, had huge properties in Washington State, represented in the 1950s and ’60s by powerful senators Henry “Scoop” Jackson and Warren Magnuson.