Financial FAQs

The stimulus debate over what form government aid should take to the recovery is only over for the moment. The headlines tell us both the rich and poorer among us will receive various tax breaks under the Democratic-Republican Party compromise, while businesses will have their research and development (R&D) tax credits extended. This is bound to lead to more hiring, say most of the pundits.

What was the debate about? A hint was the House Democratic majority’s unsuccessful attempt to cut the inheritance tax exemption from $5m to $3.5 million. If the goal is over what gives the most bang for the buck, then it is important to know who will benefit. Economic growth is already back to its pre-recession level (See my Popular Economics Weekly column of this week.).

So the real debate yet to be settled is who will receive most of the benefits of the recovery. The Bush II recovery was fueled by tax cuts for the wealthiest, which brought us a wealth distribution that matched 1928 before the Great Depression. The theory being was that the investor class was in the best position to boost growth.

Alas, that didn’t happen, as just 5 million jobs were created from 2000-08 after the Bush II tax breaks, the lowest since WWII, vs. 22 million jobs created during the Clinton Administration (when tax rates were higher). Why? Incomes were much more eqalitarian then, creating much more demand from the income brackets that do most of the spending.

The solution really isn’t such a puzzle; more like common sense. The wealthiest tend to spend less of their incomes, whereas the middle and lower brackets spend almost all of their incomes. So simple math tells us the more income that flows to the lower income brackets, the more of it gets spent. And it is overall spending that fuels growth in our 70 percent consumer-driven economy.

What do the top income brackets do with their wealth, other than conspicuous consumption? They invest it, in part by lending it back to the rest of us. That happened from 2000-08. The record low interest rates engineered by Chairman Greenspan’s Fed created easy money that allowed the 90 percent income earners to borrow from the wealthiest 10 percent in record amounts. But, as Roosevelt’s Fed Chairman Marriner Eccles said during the Depression, the game ended once those players ran out of borrowed chips.

Though leaving the Bush tax cuts in place for those earning more than $250,000 per year benefits the highest income earners most, the other 90 percent also benefits somewhat with the temporary payroll tax reduction. Adding the 2 percent payroll tax cut lowers revenues to social security, however. The maximum tax drops to 12.2 percent from 14.2 percent, shared equally by employer and employee for salaried workers.

It is basically above the $500,000 annual income level that the Democratic and Republican Parties’ tax proposals differ. Preserving all the Bush II tax cuts boosts tax savings of the $500k to $1million incomes from $6,701 to $17,467 and for $1 million plus incomes from $6,309 to $103,835, a huge jump.

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So the tax cut compromise doesn’t give as much bang for the buck as we would like. The strong retail sales report for November points to consumers feeling wealthier in certain areas, however. The latest (October) Federal Reserve consumer credit report showed consumer credit expanded $3.4 billion in October, following a $1.2 billion rise in September.  Outstanding credit has not risen for two consecutive months since mid-2008.  The latest rise was led by a $9.0 billion boost in non-revolving credit, following a $10.1 billion jump in September.  Both months reflect healthy motor vehicle sales.

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Revolving credit, a category centered in credit cards, continues to contract, down $5.6 billion in October following September’s $8.8 billion drop. The decrease in revolving credit means consumers are not pulling out the plastic for purchases—disappointing news for retailers.   It also likely is due to continued charge offs by banks of bad loans, conjectures Econoday. 

Basically, consumers are still cautious about spending, maintaining a relatively high saving rate.  With so many of the tax benefits still going to the wealthiest, this means only a moderate pickup in overall consumer spending is sustainable. So it looks like the U.S. public will have to wait longer for a more egalitarian tax structure that both benefits most Americans, and pays our bills.

Harlan Green © 2010