WASHINGTON, January 5, 2016 — Both Democratic candidates for president continue to claim our economic system is broken. They say it is rigged to favor the rich. They note that the majority of new income created during the Obama administration has gone to the top 1% of income earners and proclaim that this situation, which started more than 40 years ago, needs to be changed.
The candidates claim this situation has led to an increase in income inequality, as the rich appear to get richer while everyone else’s wages stagnate. The remedy, they say, is to raise the tax rate on the highest income earners from the current level of about 40% to 70%, 80% or even 90%.
Then they would use the increased tax revenue to created more income transfer programs which will result in the middle class and lower class receiving things like free college tuition, student loan debt relief, and increases in programs like welfare and food stamps. They say that by taking income away from top income earners and giving it to lower income earners, the income inequality problem would be minimized.
In reality, however, their policies would make income inequality worse not better. Isn’t this exactly what president Obama has done for the last seven years? Hasn’t income inequality worsened?
Recall, Obama raised the top tax rate on high income earners by 10% and raised the capital gains tax rate by more than 50%. At the same time, he increased welfare payments and food stamp payments, the latter to record levels.
The free market system, when not burdened by an over regulating government, will seek a natural equilibrium where individuals are paid according to the value of their contribution. The simple reason why there is an increase in income inequality is that the system is trying to create more capital for expansion and growth. But capital is created by high income earners. This trend started years ago.
After World War II, the American economy transitioned from producing wartime goods to producing consumer goods. This led to new an avalanche of consumer products being developed in the 1950s and 1960s. Virtually all new production was labor intensive, meaning the products were made using workers rather than using capital goods like heavy machinery.
Then in the late 1960s, labor unions, seeing how profitable their employers and companies were, joined together and flexed their collective muscles. This resulted in rapidly increasing wages for union workers. To afford them, companies had to raise the prices of the finished goods while still maintaining enough profitability to attract capital needed for growth.
In the 1970s, rapid increases in consumer prices led to a severe inflation problem, so much so that by the end of the decade the annual U.S. inflation rate exceeded 13%. The free market’s response to this was to encourage the creation of capital goods (like sophisticated machinery) that could be used to replace expensive labor and reduce the cost of production.
Beginning with the dramatic recovery of the severe 1981 recession, wealth began to be transferred from overpriced labor to higher income earners who create capital. This capital creation is what led to a 25-year American economic expansion that continued (except for brief economic hiccups in 1991 and 2001) from 1982 to 2007.
Today capital creation is more important than at any point in the history of the U.S. That’s because the American economy is shifting from a manufacturing economy to a service-oriented economy. Currently, about 70% of U.S. GDP comes from the service sector.
The only way our manufacturing sector can compete in a global economy — where free trade should be encouraged because it benefits the vast majority of people — is to produce goods that can be made at a competitive cost. Since labor wage rates in many countries are 90% lower than they are in the U.S., Americans must manufacture goods using machines rather than people.
That’s why products like automobiles are manufactured with robots on the assembly line instead of workers that cost auto manufacturers as much as $60 per hour in 2016 dollars. This reduces the costs and allows American manufacturers to be competitive in many markets.
Today, with the labor force participation rate stubbornly sitting at record lows, the input from capital is critical if this country is to grow its economy at a rate that provides opportunity for all Americans. Capital for expansion is created by those high income earners, who, after paying current high tax rates, still have large amounts of capital to invest. By taking away their investment capital through ever higher tax rates, the Federal government assures that less capital is being created, inevitably resulting in slower growth.
We should be thanking the 1%. Not over-taxing them.
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