Government Revenue Shortfall Caused By The Middle Class?

by: Steven Hansen

A recent Chart of the Day entitled "The 5% Of American Households That The Fiscal Cliff Debate Is Really About" got me thinking - is the problem "really" that the rich are taxed too little?

"Compare the income thresholds [that were] being debated in fiscal cliff negotiations with the actual income distribution," said Justin Wolfers. The chart shows that at least 95% of American households will not be affected as Washington decides on whether to raise taxes on those with incomes higher than $250,000, $500,000, or $1 million. [the actual number was $400,000 / $450,000 married]

The Fiscal Cliff crisis is based on the perception that the government was spending too much while taxing too little - the deficit is growing unusually fast for peace time conditions. There is little question this is true.

The central Fiscal Cliff debate was about higher taxes on 5% of the population. A democracy requires a bell distribution of income, and the USA is not close. The USA has income inequality equal to some of the poorest and most corrupt countries in the world (CIA Factbook). Yes, income distribution is a problem.

The USA economy is out of balance. The balance was destroyed by a variety of dynamics. But income distribution does not necessarily have to be the cause of the imbalance - and very likely is only an effect of dynamics which are not in balance. When you prescribe medicine for an effect, and not the problem - the problem remains and likely will worsen. Taxing is a double edge sword, and when taken to an extreme makes most citizens equally poor - while the rich remain comparatively rich.

Is there anyone who believes a Robin Hood government can re-balance incomes?

The other side of the coin, government spending is discussed less in the open because neither political party knows how to cut entitlements (and have the systems operate as promised). The graph below is real inflation adjusted government spending (federal and state combined) per capita. The USA does not have a current crisis on government spending - it is the future government entitlement spending which is the problem (you can read the CBO study here). And this Fiscal Cliff resolution did nothing to mitigate. This can continues to be kicked down the road.

Inflation Adjusted Per Capita Government Spending

Inflation Adjusted Per Capita Government Tax

The current system in which fiscal policy operates requires control of the balance between income and spending. Economic theory requires government overspending to stimulate the economy. The economy has been weak since 2000, and the government did spend more than it took in - and it did again and again - and it continues to do so. No one should be thrilled with how well this has worked out in the USA (or Japan for that matter).

The Gap Between Government Expenditures and Revenue

Removing money from the private sector occurs either through government spending cutbacks and /or taxation. The growing debt is building a future problem. However, the debt buildup has almost no effect in a muddle along economy - but will act as a major headwind to economic expansion.

Catch 22 - heads you lose, tails you lose. If the USA government taxes more and / or spends less - this creates a current economic headwind. If the government continues to build debt, it builds a headwind for future growth.

The real cliff the USA is facing is not addressing the cause of growing income inequality which is resulting in loss of revenue to the government. The national debate is at an elemental level targeting symptoms and not the underlying dynamics. Why are the rich getting richer?

  • did trickle down economics made the rich disproportionately richer?
  • did Keynesian stimulus programs since 2000 make the rich disproportionately richer?
  • did consumer and environmental regulation make the rich disproportionately richer (as a small operator or mom & pop cannot enter the market leaving the markets to the rich)?
  • did monetary policy make the rich disproportionately richer? (How does the 99% benefit from the extraordinary monetary policy measures that are directed towards capital markets and Wall Street? This all seems to be a "twist" on trickle down economics - should we call it trickle down monetary policy?)

The challenge is to energize what is left of the middle class without increasing spending levels to pay for today's needs or increasing taxation. There are ways to stimulate the economy by relaxing regulations and rules only on the middle class.

The cliff we face is a declining middle class which weakens a consumption based economy.

My normal weekly economic wrap up is in my instablog.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.