WASHINGTON, July 13, 2015 − In a July 13 speech, Hillary Clinton stated that her economic policy would focus on “growth and fairness.” She hinted that the fairest way to grow the economy is to increase middle-class incomes and raise the capital gains tax rate. But her policy of “growth” and her definition of “fairness” will inevitably lead to stagflation, which results in neither growth nor fairness.
To reach her twin goals, she apparently plans to change tax policy. Her intention is lower tax rates for middle class income earners and raise the tax rate on capital gains to pay for those tax cuts. Her logic is that if middle class income earners have their taxes reduced, they will have more disposable income, which will lead to more consumption (spending).
Since consumption accounts for about 70% of total GDP, the tax cut for the middle class should lead to a growing economy. Hillary’s assumption is that when total demand in the economy increases, business will produce more output to meet the demand and the economy will grow.
Hillary further argues that this action is fair and will tend to reduce income inequality. She claims her tax policy will increase income for the middle class and reduce income for an upper class that earns most of its income through capital gains. This redistributes income away from the top earners and towards the middle class which reduces income inequality, according to Clinton.
The reality is that her tax policy will have exactly the opposite effect, and will tend to make income inequality worse, not better. The reason for this is easy to see.
It is true that a middle class tax cut will lead to an increase in demand. The fallacy Hillary’s logic occurs when we try to determine how business will respond to the increase in demand. There are two options:
Let’s say a business can produce 10 units of output per day. Due to the Great Recession of 2008-2009 and the almost non-existent recovery that’s taken place over the last six years, this business is currently producing only 9 units per day, since that’s all they can sell.
Hillary cuts the tax rate for the middle class, consumers have more to spend so the business finds it can now sell 10 units per day. The increase in production leads to growth in the economy, just as Hillary wants.
Then, demand continues to grow so the business finds it can sell 12 units per day. Since they are only making 10 units they now want to expand. In order to do that, the business needs two basic inputs: labor and capital. Because the number of out-of-work Americans is very high, it is easy to find labor. But it is not so easy to raise capital.
Since Hillary will raise the capital gains tax rate, less capital will be created for investment purposes. In fact, if she raises the capital gains tax rate high enough to cover the middle class tax cut, a huge sum of capital will be unavailable to business. Without sufficient capital and without the ability to borrow funds − because Dodd-Frank legislation has severely reduced banks’ ability to make many loans − the firm cannot expand.
The only other way to react when 12 people wish to purchase 10 units, is to raise the price to the point where two people, potential customers, drop out of the market. Then there are 10 people left to buy the 10 units. What we end up with is what we had throughout much of the 1970s: stagflation. That’s defined as a stagnant economy that can’t grow due to capital shortages created by raising the capital gain tax rate and resulting high inflation due to firms raising prices in response to the increase in demand rather than increasing output.
Stagflation increases income inequality since the higher prices and poorer opportunities result in reductions in real income especially for the middle classes and below. At the same time inflation increases the price (and the profit when sold) of capital goods held primarily by upper income earners.
Stagflation was a serious problem in the 1970s. But the situation was fully resolved in the 1980s and later by choosing a different option. Tax rates were lowered for all Americans, especially the capital-creating high income earners. This finally encouraged an increase in demand from consumers and a concurrent increase in supply, because the lower tax rates for the highest income earners provided capital for expansion.
Building on earlier efforts for individual taxpayers, in 1997 President Bill Clinton and Congress lowered the capital gain tax rate from 28 to 20 percent. This action resulted in anaccelerating the economy, leading to budget surpluses, higher growth, low unemployment and low inflation. In 2008 Hillary said she would not raise the rate above 20 percent whereas President Obama has raised it. Now she may want to raise it higher.
Her latest policy shift would surely lead to a fresh round of stagflation. As a result, Americans will end up with less growth and less fairness from her policy, exactly the opposite of what she claims she wants.
*Cartoon by Branco. Reprinted by permission and arrangement with LegalInsurrection.