Tax Reform: Worst Policy Since The Great Depression

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Includes: SPY
by: John Early

Summary

The last 30 years growing at 2.5% is the weakest 30 year period since 1939.

The three times the top marginal tax rate was cut below 38% were all followed by below average growth.

An income tax schedule needs two features to encourage prosperous growth. A low top marginal rate fulfills one at the expense of the other.

The best 30-year period growing at 5.2% had much higher tax brackets than in recent history.

The key to widespread prosperity is to have the wealthy take less income, pay less tax, and grow the value of their businesses more.

Do you understand why both of the following facts are true? President Reagan cutting the top rate from 70% to 50% was followed by growth improving. The 1986 tax reform act that lowered the top rate to 28% launched the weakest 30 year period since the Great Depression. If your view of tax policy doesn’t explain both these facts, you may want to consider one that does.

A Low Top Tax Rate Hurts Growth

Let’s clear up the common misconception that a low top marginal tax rate encourages growth. While pundits and ideologues can cherry pick periods to claim anything they want. The last 100 years in the US has no support for the idea of a low top rate encouraging growth.

The 22 years the top tax rate was below 38 percent had an average growth of 1.5 percent. History suggests the top tax rate one year has its biggest influence on growth two years later. So, the top rate of 35 percent in place from 2003 through 2012 would have influenced growth for the years 2005 through 2014. Those 10 years grew at a 1.5 percent pace. Using this two-year lead time the 22 years influenced by the low top rates averaged 0.3 percent growth. A low top rate has no success stories in the U.S. in the last century.

Two Requirements for Prosperity

Widespread sustainable prosperity requires two features from income tax policy. We can think of these as two pockets. The taxable income drawn from the business is the small pocket. The big pocket is the value of the business. Business owners must be able to draw out of their businesses a large enough income at a low enough average tax rate that our wealthy and talented have sufficient incentive to run businesses. This is the small pocket incentive, and it must be balanced with the big pocket incentive to grow the business. The higher the marginal tax rate a business owner faces the more incentive there is to avoid taxes by growing the business, rather than taking more personal income.

A low top marginal tax provides the needed small pocket incentive but encourages pulling revenue out of the business and short circuits growth in the big pocket. We need to remember that paying personal income tax is optional for someone running a business. If a business owner plows all the revenue into wages, marketing, equipment, research, training, and other deductible or depreciable expenses that grow the business and the economy, she will owe no income tax. The growth in the value of her business can accumulate income tax-free.

If a business owner is in the 25 percent bracket, he has a marginal rate of 25 percent, but his average rate might be 15 percent. The first few thousand dollars of income will be tax-free after personal exemptions and either the standard deduction or itemized deductions. Then the next few thousand dollars are taxed at 10 percent. Several thousand after that are taxed at 15 percent, and the remaining income is taxed at the 25 percent rate. If there were an additional $100 of income, it would increase his tax $25.

An adequate small pocket incentive does not require a low top tax rate. A better way uses a favorable combination of low marginal tax rates and dollar levels for the bottom five or ten tax brackets. The small pocket incentive should encourage both workers and running a business.

The marginal tax rate on business owners influence how much revenue they pull out as income or plow into growing the business. If the marginal rate is too low at high levels of income, more revenue gets pulled out as income resulting in slower growth for businesses and the economy. The higher the marginal tax rate the more attractive plowing revenue into the big pocket becomes, since taxes can be postponed indefinitely.

The 30-Year Growth Rate

The strongest 30 year growth rate, 1934-1963 growing at 5.2% had an average top tax rate of 85.8%. The top bracket averaged 1,780 times GDP per person. Today, that would be about $99 million. So, on average, only the portion of a couple’s income above the equivalent of $99 million would have been taxed at the 85.8% rate. In practice, almost no one paid any tax at that rate; they plowed money into growing their businesses and the economy instead.

The weak period ending in 1974 had marginal tax rates that were way too high for the dollar level of their brackets, or you could also say the brackets were way too low for the rates. Even with this imbalance, the economy still managed to grow at almost 3%. The 83.1% average top rate was not as destructive to growth as a low top marginal tax rate. The weakest period since the Great Depression, 1987-2016, had the lowest average top tax rate since 1936. Of course, leading into the Great Depression the top rate had been cut to 25% and the capital gains rate to 12.5%.

Growth Goes Up and Down with Tax Rates

The strongest year of growth in the last 65 years was 1984 which was influenced by a 50% top tax rate and a 28% capital gains tax rate. Earlier, we noted that the top rate influences growth two years later. The capital gains tax rate has its strongest influence on growth five years later, or at least the 5-year lead time gives the most robust correlation with growth. So, the capital gains rate of 28% in 1979 and the top rate of 50% in 1982 influenced the 7.3% growth in 1984.

Prior to this, the top rate had been 70%, and the capital gains rate had been 39%; both of those tax rates were way too high for the tax brackets. Carter cutting the capital gains rate and Reagan cutting the top rate both benefited growth. These are the last two cuts of marginal tax rates that were followed by stronger growth. Since 1982, the top racket has been less than 10 times GDP per person. With these low brackets, the 50% top rate and 28% capital gains rate are pretty close to the growth optimizing tax rates.

The chart above shows how the top tax rate and the capital gains tax rate have influenced growth since 1984. The green and blue lines for the two tax rates are pushed forward by their respective lead times. The green axis for the top rate, and blue axis for the capital gains rate are scaled according to their influence on growth. The red line is a model of the two tax rates' influence on growth.

The two years influenced by the top rate of 50% and capital gains rate of 28% grew at 5.7%. Tax rates were cut and growth weakened: the two years corresponding with a top rate of 28% and a capital gains rate of 20% grew at 0.9%. Tax rates went up growth improved: the seven years lining up with a 39.6% top rate and 28% capital gain rate grew at 3.6% although the model estimated 4.1%. Taxes were cut, growth faltered: the seven years influenced by a top rate of 35% and a capital gains rate of 15% grew at 1.0% slightly below the estimate.

Increasing the top rate to 39.6% and the capital gains rate to 23.8% (with the Medicare surtax) suggests growth will rise to 3.3% for 2018 and 2019. It should be noted the model does not predict annual fluctuations in growth or recessions, but appears to be reasonably good at estimating growth over a period of years.

President Carter aided growth under President Reagan by cutting the capital gains rate closer to its growth optimizing rate. Reagan helped growth under President Clinton by raising it back near the optimal rate. President Obama likely will have aided growth under President Trump by raising the capital gains rate toward the growth optimizing rate.

The key to widespread prosperity is to have the wealthy take less income, pay less tax, and grow the value of their businesses more. To encourage that will take higher marginal tax rates at very high levels of income, but with the lower brackets allowing plenty of incentive to work and run businesses.

Goldilocks Tax Rates

At a given level of income, there appears to be a growth optimizing marginal tax rate. Growth benefits when the tax rate is neither too high nor too low. The level of the bracket and the marginal rate should make a balance between the small pocket and big pocket incentives. The higher the bracket is the higher the marginal tax rate it takes to make the balance.

When the top tax bracket was cut from $400,000 to $200,000 in 1965, the bracket went from 119 times GDP per person to 56 times. Prior to 1965, the top bracket had never been below 100 times GDP per person and had been as high as 8,751 times. Since 1965, it has never been above 56 times.

The chart above shows the data influenced by the period when the top bracket has been at or below 56 times GDP per person. Using the two year lead time, the data in the chart starts in 1967. I refer to this as the low bracket era. The best-fit curvilinear line in the scatter plot suggests the growth optimizing tax rate is 54.5%.

The best fit line also shows that the 70% top rate had comparable growth to the 39.6% top rate. The best growth in the period was influenced by the 5 years President Reagan had the top rate at 50%. This helps explain why Reagan cutting the top rate to 50% improved growth, while cutting it to 28% harmed growth.

When Reagan had the top rate at 50%, its bracket was around 10 times GDP per person. I estimate the growth optimizing bracket for the 50% rate would be about 31.5 times, which would be about $1.8 million in 2017.

My analysis suggests the top tax bracket in the tax schedule that would create the most robust growth and restore the middle class would have a marginal rate of 66% on income above $431 million (7,500 times GDP per person).

The analysis and details behind this schedule along with the optimal way to tax capital gains are in my new book. If you want to learn more, there is a promotional price on the eBook of free ($0.00) on December 1 and 2; you can download PUT MONEY IN YOUR POCKET from Amazon.

The ideas above are almost certainly new to you. I would love to get your feedback in comments below or in a review of the book.

Corporate Income Taxes

The corporate income tax rate appears to have little effect on growth. Only about 1% of the variation in the growth rate appears to be explained by the level of the corporate tax rate. The chart shows a concurrent correlation. When I tested lead times, the relationship got even weaker with a one-year lead time, two-year lead time etcetera.

Growth averaged being stronger when the corporate income tax rate was around 50% and weaker than it has been recently when the tax rate was between 10% and 15%. So history doesn’t suggest we will get any big surge in growth from cutting this tax rate.

As with individuals, the corporate tax rate only applies to the revenue that is not spent running and growing the business such as wages, marketing, research, equipment, and the like.

The interesting question that economists don’t agree on is who bears the burden of the corporate tax. From an accounting standpoint, cutting the corporate rate will boost after-tax profits and benefit corporate shareholders. From an economic standpoint, this is not clear. In theory, much - or even most - of the burden of paying the corporate tax may be passed on to workers in lower wages and/or to consumers in higher prices, while the level of after-tax profits is determined by the amount of competition a corporation faces. If we get a corporate tax cut, it should be interesting to analyze whether the supposed extra profit is competed away and who actually gets the benefit.

Reigning in Trump’s Tax Cut

Congress will likely rein in much of the potential of Trump’s tax cut to harm the economy. The 25% tax rate Trump wanted on passthrough businesses could have given more incentive for billionaires to draw revenue out of businesses instead of growing them than any time since we were plummeting to the bottom of the Great Depression. Remember, the 25% top rate led us into the depression. The bill that passed the house has a 70/30 rule where only 30% of income an owner pulls from a pass-through business will get the 25% rate, 70% will count as salary or wages. So instead of diluting the 39.6% top rate to 25%, it will in effect be 35.2%. Proposals in the Senate limit the income level available for the 25% rate. So, it could still apply to small business, but not the Trump family 500 plus pass through businesses.

Trump wanted to eliminate the Medicare surtax on capital gains which was part of Obama Care. This would have lowered the tax rate further below its growth optimizing level. Congress could not come together to repeal Obamacare. Apparently, neither the House nor Senate is proposing to cut the capital gains rate.

At today’s dollar level of the top bracket, the growth optimizing top tax rate is probably around the 50% rate President Reagan had for 5 years. Trump wanted a 35% top rate. The bill passing the House kept the 39.6% rate but more than doubled the top bracket to a million dollars. In dollar terms, this would be the highest top bracket since 1941. In GDP per person terms, the highest since 1981. Cutting taxes by raising brackets rather than cutting rates should be pro growth. It enhances the small pocket incentive we talked about earlier without hurting the large pocket incentive to grow businesses.

Likely proposals in the Senate would cut the top rate less than Trump proposed. While no one knows if the Senate will pass a tax bill or what might come out of the conference committee between the House and Senate, the tax cut if it comes should not harm long-term growth much.

Bubbles and Tax Rates

President Coolidge cut the top tax bracket from 46% on income above $500,000 to 25% on income above $100,000 in 1925. In four years, the number of people pulling million dollar plus incomes out of businesses went up almost seven-fold. A low top tax rate creates almost the definition of a bubble. Lots of revenue gets pulled out of businesses weakening intrinsic value inside businesses, while the money pulled out cycles through the financial markets bidding up the price of businesses. The result was a huge bubble then, an 85% drop in stock prices.

As mentioned above, we have had the lowest average top tax rate for 30 year periods since 1936 and the weakest economic growth since the depression as well. Meanwhile, stock prices head to valuation levels rarely seen. The CAPM valuation measure the last 20 years has averaged about twice what it did the prior hundred years.

With record debt ratios in government, business, and households, the next recession could be a disaster for stock prices. However, the economy should not suffer as much as in the great recession. Going into the last recession, the expected growth rate from the tax policy model was only 1.3%. The expected growth rate for 2018 and 2019 is 3.3%. When growth is fluctuating around 1.3%, recessions should be much worse than when growth fluctuates around 3.3%.

The tax cut passing or not passing could be a catalyst for a change in sentiment, and therefore, a change in the direction of stocks prices, but what appears to be on the table should not have much effect on the long-term growth rate of the economy.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.