In Part I of this article, I laid out some of the bare facts about the macro picture of the US economy since 1960. Specifically, I pointed out that:
A) Earnings growth in the S&P 500 index (NYSEARCA:SPY) has been very mediocre since 1960 when factors like inflation and population growth are accounted for. Earnings have just about doubled in real terms since 1960 when these factors are considered.
B) However, when we account for the great increases in economic productivity we have had as a nation since 1960, we see that earnings are flat to slightly declining - at least if a 1:1 linear relationship between productivity and earnings could be expected.
C) When we further account for the annual boost the economy has been given by various forms of deficit spending since 1960, the declining earnings pattern is slightly more pronounced.
D) The aforementioned deficit spending has built up very high levels of debt, which still look historically intimidating even in the light of inflation, population increase, and improved productivity which *could* be used to help pay them off. These high levels of debt will act as an anchor on growth until they are removed.
Why has all this been happening, and why is Obama's upper limit marginal tax rate increase bullish for the markets?
The idea occurred to me that perhaps the US tax code and growing wealth inequality in the United States were both linked to the slowly sinking adjusted earnings of the S&P 500. My reasoning for this is fairly simple. Corporate earnings are driven by corporate revenues. Corporate revenues are driven by people spending money. And it is well known that people will spend a lesser and lesser percentage of each additional dollar they receive above and beyond their mandatory expenses. Thus, more equal distribution of income must lead to short term corporate revenue increases and short term economic growth - and vice versa.
However, increasingly unequal distribution of wealth has been the rule since 1960. The chart from The Economist above illustrates the changing rate of CEO to worker compensation ratio over time. It is quite dramatic. Of course, it is not a perfect picture of increasing wealth inequality, but it is a clue.
The chart above demonstrates increasing wealth inequality from another angle, by showing increasing decoupling of median family income from productivity gains. Note here that productivity used is labor productivity for all sectors, rather than just agricultural productivity. They are roughly the same over this time period. Putting these charts together, we get a strong sense that economic gains are being funneled towards a select few, rather than spread out evenly. Why is this? Is it justified? I believe that the increasing income inequality in the United States since 1960 is largely unjustified, and that it is now acting as a severe drag on future economic growth, for a multitude of reasons. I also believe that this has been largely enabled by US tax policy, and that starting to reverse the upper marginal rate cuts is the first step towards righting the market ship and sending her on a strong course upwards.
Let's take a look at the correlation of the top US marginal tax rate to S&P 500 earnings adjusted for inflation, population, productivity increases, and debt spending. We can see that as the top marginal rate is cut, adjusted earnings for the S&P 500 go down in short order, and stay down. We can further see that when the top marginal rate is raised, as was done during the Clinton years, for example, adjusted S&P 500 earnings go up.
When we take averages of the annual earnings and plot them against top marginal tax rate (note that I have grouped some years of tax rates together and averaged the rate to get at least 6 years at each rate, for periods of time when the top rate changed every year a little) we see a clear inverse correlation between top marginal tax rate and adjusted S&P 500 earnings. It is not perfectly linear, as A) the top marginal tax rate does not capture the full progressivity of the tax code and B) My adjustments may not have accounted for every single factor of the economic cycle or the details of payroll behavior of corporations in response to specific tax cuts and increases. But the effect is obvious.
It makes sense, really. If you are a company, and you are trying to incentivize productivity through pay, but the top marginal tax rate is 91%, it is far more difficult to incentivize the CEO and other top company officials to do anything, as opposed to simply offering more pay to the lower paid workers for better and more work. If the top marginal tax rate is cut to the bone, it's much easier to pay the CEO and other top company officials more and the workers less. Is this justified? Are CEO's and other members of "the 1%" inherently 10 times more productive than ordinary workers, than they were in 1970? Or is this simply a case of marginal tax rate cuts allowing the pigs nearest the trough to gobble down more of the goodies? In other words, the idea is that those near the top of a company have more control in being able to assign their own wages than those at the bottom. They can save on expenses by doing things like cutting worker pay and benefits, refusing to hire employees but making use of temporary workers for pennies on the dollar with no benefits, and various other "cost cutting" tactics. All of these tactics ultimately have negative externalities that come back on the corporate revenues and earnings of every business in America. They are not productive at all, but anti-productive.
I don't doubt that CEOs are more productive than ordinary workers. They deserve a large multiple of ordinary worker compensation. Just not as much as it is now. The picture of adjusted S&P 500 earnings vs the top marginal tax rate tells us that, contrary to the assertions of the Republicans, tax cuts on the rich do not produce economic growth. In fact, they tend to stifle it, as the data clearly shows. Moreover, those who really are responsible for advancing productivity are often not compensated very well for it. Academic and corporate scientists and engineers tend to be responsible for most productivity increases. As a simple example, consider the Monsanto process. This has allowed acetic acid, an important industrial chemical, to be produced much more cheaply in large quantities. Who made that happen? Was that the CEO, or was that bright and motivated chemists that developed and understood the utility of the process, without ever being compensated much for it in relation to its economic utility? This is a clear example of a productivity increase, as most new and useful industrial-scale chemical reactions are. The CEOs of Monsanto and other companies have not been responsible for advancing real productivity by discovering new and obviously useful processes, but they have managed to take most of the financial credit for it. And as time has gone on, they have been taking more and more of the this credit.
This is not to say that some CEOs don't deserve their pay. Certainly, the iPhone and iPad would never have happened without Steve Jobs. He had a truly unique talent and made a unique contribution in leveraging the work of others to produce something visionary. The information age in particular has enabled CEOs and management to work more effectively. Faster access to data enables superior decisionmaking, and superior decisionmaking leads to increased productivity. This article is not meant to denigrate the contributions of executive management personnel to the economy, but to illustrate that they are in a position to more easily obtain compensation that they sometimes do not deserve, and that tax cuts to the top marginal rate make this far easier to do. Further, the article is meant to highlight that this sort of behavior has negative externalities, as the consequent failure to compensate workers fairly for their productivity increases income and wealth inequality, which reduces spending, which reduces corporate revenues and earnings, and which make the putative "productivity increases" of executive management somewhat of a moot point even in the cases where they are real.
Our nation has tried to compensate for the negative effects of lowering the top marginal tax rate, and changing the progressive structure of the tax code, in a lot of ways. They are relatively ineffective, as they have to go through massive layers of government bureaucracy. Things like government transfers, unsustainable entitlement programs, and all sorts of things like this create additional inefficiencies in the economy. They reduce the self image of people who would have been well paid workers in the 1960s and 1970s, they reduce those people's productivity, and they are inefficient at getting the financial resources through compared to what the market could provide.
Adjusting our top marginal tax rate upwards will force companies to target productivity from the ordinary workers instead of CEOs. Executive management will no longer find it as effective to take 250 times the compensation of their workers, due to tax issues, and the market will force companies to target productivity by compensating workers in a lower tax bracket more - or those companies will go out of business due to being noncompetitive. The health insurance and unsustainable entitlement issues which are creating crushing debt, the increasing and unsustainable household debt, and all of the other factors... will all go away. Not just because the government is using the increased tax revenues to pay those expenses, but because the conditions of wage privation that companies have been foisting on their workers to pay exorbitant salaries to executive management will go away, and American workers will no longer need to be reliant on government transfers. They will become unnecessary. The improved self image and compensation of the American worker will result in higher productivity and higher corporate revenues, and we will start to really grow again.
So, as an investor, I am looking forward to the inevitable victory of Obama and his Democrats over the Republicans on the issue of the top marginal tax rate. The increase in the top marginal tax rate will be bullish for S&P 500 earnings, as the historical data clearly shows, and that in turn will be bullish for equity prices in the long run. It will be bullish for the American worker, which I suspect a good number of readers are. It will be bullish for America. And that will be very good for all of us.