Obama's Economic Solutions Are Contractionary

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"The man, that lives upon the production of other people, originates no demand for those productions; he merely puts himself in the place of the producer, to the great injury of production.” - Jean-Baptiste Say, A Treatise On Political Economy

With President Barack Obama now in control in Washington, it’s time to ask how his economic plan might affect the real economy.

Obama has stated that “We are in one of those periods in American history where we don’t have Republican or Democratic problems, we have American problems.” Obama and his economic team have released a broad outline of the way they intend to fix an economy that some say is on the verge of falling into a second Great Depression. But Obama’s solutions meant to aid the economy—at least on paper—won’t fix anything. Indeed, if implemented it’s easy to see how they might actually cause the economy harm.

Eager to attract support from the Republican side of the aisle, Obama has expressed a high degree of willingness to include tax cuts in his post-inauguration legislation. At first blush, tax cuts sound appealing and speak positively about a politician who’s been up front with his belief that a “monopoly on good ideas does not belong to a single party.”

Good political theater for sure, but we might add that neither party has a monopoly on bad ideas either. Reading the fine print, we see that the definition of a tax cut in Washington is far more nuanced than what we might be used to. The tax cuts Obama has in mind might attract votes, but they have very little to do with economic growth.

First up are income credits described as tax cuts. The latter are meant for low-income families, and as the Wall Street Journal described them, they will allow “more families that earn too little to pay income taxes to claim at least some of the $1,000-per-child tax credit.” At present, a household must have income of $12,500 per year to be eligible for tax credits, but under the Obama plan, the cutoff will be reduced to $3,000.

So what Obama and his advisors call a tax cut is really only a transfer payment from one set of hands to another. Such redistribution fosters no new production, and with that, no subsequent demand.

For at least two reasons, the credit will be an economic retardant. Productive workers will see more of their earnings taxed or borrowed in order to stimulate immediate consumption. When we consider that all profits in society result from past parsimony, we can see that the productive economy will be weakened if this form of alleged stimulus is put in place.

Most important, Obama should not run from the basic truth that economic growth is always and everywhere the result of productive work effort. To the extent that low-income families are plied with yet another form of welfare, this will reduce the individual incentives within impoverished households to engage in more work.

Put simply, the tax credits masked as cuts will reduce the work incentives for those redistributed from, all the while making real work less necessary for the alleged beneficiaries of the credit.

On the taxation front for top earners, the story gets worse. The late Warren Brookes once wrote that “We are all blessed by the genius of the relatively few.” What Brookes meant was that thanks to the frequently innovative and entrepreneurial efforts of a vital few in this country, all Americans are able to enjoy better jobs and better products.

That is far from Obama’s mind. He has made plain that he intends to return the tax rate on top earners to the Clinton-era level of 39.6 percent, and the capital gains rate on investment success will move from 15 to 20 percent. Higher tax rates in the Obama model are meant to pay for the aforementioned credits, along with yet another stimulus package.

Assuming Obama’s plan to soak the rich works, it has to be said that increased revenues for the federal government will reduce the amount of capital available for the business sector to fund the wages of the poor. Whether the government is borrowing or taxing in order to redistribute, capital is being removed from the private pool of available funds meant to create new industries, new companies, and new jobs.

And when it comes to Brookes’s vital few, the poor and the middle class alike will be made worse off if the successful among us choose to remove their skills from the productive economy due to higher penalties on work.

Jean-Baptiste Say once noted that the heavily taxed “are seldom regular in their payments,” but it seems he actually downplayed the negatives that come with penalizing the successful. If they were merely irregular in their payments to the tax man the economy would be fine, but the real threat is perhaps the unseen. Indeed, it’s tax distortions which cause the rich to be irregular in their work and investment habits that lead to economic degradation.

With regard to corporate taxation, according to another Wall Street Journal account, a key provision of Obama’s plan is to “allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years.” Translated, failing companies will write their losses off on the backs of successful individuals and companies alike.

When we consider what actually causes economies to grow, the corporate tax provision is creating incentives for something quite the opposite. In his Theory of Economic Development, Joseph Schumpeter wrote that “development consists primarily in employing existing resources in a different way.” But if failing companies are kept alive not by a simple reduction in the tax rate on their profits, but rather thanks to a bailout of the non-financial variety, entrepreneurs waiting in the wings to redeploy mismanaged physical and human capital will be hampered in their efforts to bring the economy out of its slump.

In the end, entrepreneurs can only innovate to the extent that they’re able to purchase the assets of failed business combinations with visions of more profitable future combinations. So when governments prop up failed or dying businesses, far from saving the economy, they only hurt it by delaying the process whereby people and capital are managed productively.

All of which brings us to the jobs portion of the Obama corporate tax plan. For the companies that make new hires or forgo layoffs, the Obama administration is set to offer a one-year tax credit in return. Once again, the incentives here are backwards, and if heeded, will surely stimulate the opposite of growth. Indeed, if there’s one certain rule when it comes to business success, it has to do with producing as much as possible with as little labor as possible. Far from a job killer, when companies do more with less they free up the very capital that allows them to expand into other potentially profitable areas previously out of reach due to a lack of funds.

To the extent that businesses keep workers employed for non-productive reasons, the economy will surely be rendered poorer in time. Workers are like capital. When either labor or capital is wasted, the end result is less growth.

The tax portion of the Obama package includes write-offs for business expenditures, and it’s safe to assume here that companies producing business equipment will be the beneficiaries of this new rule. Equipment write-offs recall a frequent Wainwright theme over the years that when the Federal Reserve moves around its target interest rate, it merely reschedules economic growth, as opposed to fostering new economic activity. Write-offs should be viewed in much the same way. Businesses will simply move up equipment purchases in the near-term; those purchases will detract from capital spending over the long-term.

It’s also important to remember that as a mature economy, U.S. economic growth has very little to do with spending on capital equipment, but quite a lot to do with spending on human capital. Using Google as an example, its growth over the years has been the result of heavy investment in the best minds, as opposed to the best equipment. Equipment write-offs at best address a past version of the U.S. economy that most Americans would no longer recognize.

Sadly, the tax portion of Obama’s recovery plan was only put in place to give Republicans the political cover necessary to vote for the various spending initiatives that the new administration envisions. This is the alleged “stimulus” part of Obama’s economic package, and as Wainwright publications have emphasized over the years, government spending can in no way stimulate economic growth.

Beyond the negative work incentives created by wealth redistribution, the basic reality is that no one—least of all government—can profit from the same transaction twice. That’s the assumption the government is making when it claims it can grow the economy through the transfer of wealth already created. In a sense, the very notion of stimulus turns routine economics on its head.

But to address arguably the worst aspect of Obama’s proposed $775 billion spending package, we must once again bring in the notion of the entrepreneur waiting in the wings. It’s tautological to say that entrepreneurs cannot innovate without capital. When the federal government is borrowing at relatively low rates from the private sector, there’s necessarily less capital at higher rates for entrepreneurs to access in order to utilize human and physical capital more effectively.

At its core, Barack Obama’s economic recovery plan is anti-entrepreneur, and as such, anti-growth. So while we should expect to read quite a lot about how “change” in Washington will enhance our economic wellbeing, we shouldn’t be fooled. The new administration plans to engage in feverish activity. It may be meant to make us better off, but it would be charitably naïve to mistake it for any real prescription for economic recovery.

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