Quarterly Commentary

Tax Cuts: Whom Do They Actually Help?

 

I’ve had the opportunity to meet some amazing people over my 36-year career. One of the great privileges I’ve had is to be visited by a number of state representatives, U.S. congressmen, U.S. senators, and even one Virginia Governor. The conversation usually begins with a sentence that goes something like this:  “Joe, I need to have a better understanding of economics so I don’t embarrass myself in public while answering questions. So, can you give me a crash course on the basics?”  “Of course I can,” I tell them. “In fact, I can tell you everything you need to know in one sentence. And if you just remember this one thing, everything else will fall into place.” They usually expect me to explain one of the two most popular economic theories, Supply Side Economics or Keynesian Economics (also known as Demand Side).   I then proceed to tell them the foundational principal of my very own economic theory. I like to call it, “Monaconomics.”

“People tend to do what they get paid to do” is the foundation for Monaconomics. It’s the reason why people go into the coal mines every day, why kids borrow money to go to college, why the illegal drug trade survives the “war on drugs” and why employees at Wells Fargo opened unauthorized accounts. They didn’t do it because they are altruistic, they did it because, at least in their belief, they got paid to do it.  And so to understand why the new tax policy will be written the way it will, you need to keep this question at the forefront of your mind: “What is this legislation paying people to do?”

Do tax cuts raise or lower the deficit?

The main debate about tax cuts is: “Do taxes collected increase or decrease after the tax cut?” The two largest tax cuts in recent American history occurred in 1982 under Republican President Ronald Reagan and in 1964 under Democratic President John F. Kennedy (JFK’s tax cuts were actually passed by congress after his assassination in 1963). Both sides passionately opine about the effects, and loosely throw out conflicting statistics while making their arguments. Therefore, I decided to go to the source for the facts. The Federal Reserve Board keeps detailed track of economic statistics. Below I have posted a chart from the Federal Reserve’s economic data website, www.stlouisfed.org.

FRED Taxes Collected

During the six years following the 1982 tax cuts by the Reagan administration, tax receipts collected by the federal government rose from $387 billon to $623 billion, but. . .

 

According to the Federal Reserve, during the six years after the Reagan tax cuts, federal tax receipts rose from $387 billion to $623 billion. That means tax receipts collected by the federal government rose by $236 billion, or in other words by 61% in only six years. Although space limitations prohibit me from also posting the results of the JFK tax cuts, if you look it up for yourself you will find that a similar result occurred in the 1960s. Therefore, a careful study of major “across the board” tax cuts refutes the idea that they necessarily reduce tax income to the government.

. . . during those same six years of 1982—1988, federal spending rose from $783 billion to $1,199 billion.
$783 billion to $1,199 billion

 

Indeed, one would have to conclude that such tax cuts actually tend to increase government tax receipts. This then begs the question: “Why do we always hear that federal deficits exploded during the Reagan years?” The answer to that question can be found in the second rule of Monaconomics:

The advantage of having spent time with politicians of both parties is getting to know how they think, what their core beliefs are. I can assure you that contrary to the rhetoric we see in the news, both parties are staffed with people who want to solve our nation’s issues. Both see poverty and injustice and both want to solve it. The strategy of how to solve these issues differs between the parties, but the tool they use is the same.

For example, if you’re having marital problems and go to your pastor, he will probably say the issue is spiritual. Your psychologist will say it stems from your childhood. Your financial advisor will say it’s your spending. This is due to rule # 2 of Monaconomics, “To a man with a hammer, every problem looks like a nail.” In other words, we see all problems through the lens of whatever tool we have to solve them. Congress has not been able to control their spending because they see problems and the only tool congress has to solve problems is money. So if education is a problem, throw money at it. If it’s hunger. . .spend money. Poverty? Spend money. Security? Spend money.

Given that there are seemingly endless problems and issues we face, whenever congress gets more money their tendency isn’t to reduce the deficit, their inclination is to spend it on the additional problems.   Look at Chart 2 and you will see that the reason federal deficits rose in the ’80s was that although tax revenues increased by 61%, government spending increased by 97%.   Therefore, tax cuts don’t cause deficits, compassion causes deficits.

The amount of money someone borrows is irrelevant. What matters is the amount they borrow in context to what they make. The above chart from the Federal Reserve shows the deficit in relation to GDP (total business activity in the USA). When the blue line is above the horizontal black line the government is running a budget surplus, when it is below the black line the government is running a deficit.

 

 

So Then, Who Should Get Their Taxes Cut?

All this begs the question, “Is the tax cut proposed by the Republicans fair?” Well, all the way back in 1962 the following Q&A occurred between White House correspondent Helen Thomas and Democratic President John F. Kennedy:

Thomas: “Mr. President, many people say that your proposed tax cut isn’t fair. What would you say to those critics?”

JFK:   “Life’s not fair.”

President Kennedy said this because the purpose of effective tax cuts isn’t to be fair, but rather to create a desired outcome. Let me explain:  If the problem is not enough spending, then tax cuts should be given to the poor and not the wealthy. If you give $1,000 to a single mother of three, she will likely quickly spend that money. Maybe on shoes, coats, food, or slurpees. . .it doesn’t matter, it’s going to be spent quickly.

On the other hand, if the problem is there is not enough money available for borrowing and investment then the tax cuts need to be given to the wealthy and not the poor. A wealthy person already has bought whatever he wants, so he will take that tax savings and look for the most advantageous and efficient investment for his capital.  Lastly, if the desired outcome is to grow employment and wages by expanding the nation’s business environment, then the tax cuts should go to business.

You might have noticed that I haven’t mentioned the middle class. This is because historically middle class tax cuts have the smallest affect on changing national economic outcomes. They don’t spend all of the money like the poor do, nor do the middle class spend it as quickly. And while unlike the poor, the middle class will invest some of the tax savings, unlike the rich they will not invest all of it. So you tend to get a little bit of spending and a little bit of investment. The biggest thing you get with a middle class tax cut is votes, so you can rest assured that whatever and whenever the tax cut is passed, it will include a middle class cut.

The logic of creating a new tax schedule is based around the desired outcome. Today our nation’s biggest problem is our non-competiveness with foreign nations. On any income above about $50,000 U.S. corporations pay taxes at a 35% rate. The average tax rate of other developed countries is approximately 15%. So it behooves U.S. companies to make most of their money elsewhere. This is why you hear things like, “The average tax rate of U.S. companies is much less than 35%.” They’re combining the 15% overseas rate with the 35% U.S. rate. The other problem is if U.S. companies bring back any of those profits to spend in the U.S., the IRS slaps them with that extra 20% (the difference between 15% and 35%) tax as soon as the money hits our shore.

Going back to Monaconomics Rule 1, since people do what they get paid to do, if people get to keep the extra 20% if they leave the money overseas helping out foreign workers, that’s exactly what they will do.

People tend to do what they get paid to do. Intuitively Kennedy understood this and Reagan understood this. Their tax cuts weren’t aimed at being fair, they were aimed at causing a specific outcome. When assessing the proposed tax cuts, don’t evaluate them through the prism of “what’s fair.” Evaluate them through the outcome they will create.

 

Joe Monaco

Ph.D. (economics)

President—Monaco Capital Management, LLC

Registered Principal—RJFS

 

Securities offered through Raymond James Financial Services, Inc., Member FINRA/SIPC. Monaco Capital Management, LLC is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment advisory services offered through Monaco Capital Management, LLC.   Information contained in this report does not purport to be a complete description of the developments refered to in this material. This information has been obtained from sources deemed to be reliable but its accuracy and completeness cannot but guaranteed. Opinions expressed are those of Joseph A. Monaco, PhD. Registered Principal, RJFS, and are not necessarily those of Raymond James.