Joe Biden’s Folly: Taxing The Rich Doesn’t Pay

We are used to thinking that governments raise taxes or issue bonds in order to spend. Not so. Governments use taxes to do three things: redistribute income; encourage or discourage various activities; and modulate aggregate demand. They issue bonds so as to separate monetary and fiscal functions within the government and create a check on governments’ money printing.

The problem with taxing the rich is that doing so does not garner anywhere nearly enough resources to launch or expand society-wide government programmes. Relative to the size of the economy as a whole, there are too few rich, they directly consume too few resources, and the amount of their consumption is insufficiently responsive to changes in their wealth.

Take the uber-rich, whose net worth runs into the billions if not tens of billions of dollars. It is tempting for politicians to think that if they could just get their hands on a chunk of that money they could fund such and such a programme. But it is real economic resources – labour, capital, and ingenuity – that programs need, not money per se.

The resources that will be freed up directly by taxing the very rich are minimal: they have a marginal propensity to consume of zero or close to it.

If you give short shrift to ‘trickle-down economics,’ forget about ‘soaking the rich’.

Similarly with corporations. Imposing higher taxes on corporations in a market economy will just lead firms to try to recoup some of the lost profitability by raising prices and investing less, and cause share prices to be lower. Every first-year microeconomics student learns the important distinction between who a tax is imposed on and who ends up paying it, and that taxes impose a cost on society in foregone activity (‘deadweight losses’). Again, not a great way to generate new resources.

Those who see taxing the rich as an easy way to pay for new government programmes confuse paper wealth with real resources. The top five stocks in the S&P 500 index are all Big Tech behemoths and several of their founders have reported net worth in the $100 billion or more zip-code. Most of that wealth corresponds to the stock market valuation of the companies they own. That valuation represents the present discounted of the expected future earnings of those companies, earnings that rest on the expectation of there being satisfied customers as far as the eye can see.

This wealth, while representing one of the marvels of the free enterprise capitalist system, does not represent resources that can be commandeered to produce more output today, so there is no point taxing it for that purpose.

Suppose the U.S. federal government was able to wave a magic wand and get its hands on a trillion dollars of the stock market wealth of half a dozen Big Tech entrepreneurs and, unlikely though it would be, ensured that the act of doing so did not erode that wealth.

True, the government could sell the shares and use the proceeds to hire teachers, doctors, and nurses, and fund infrastructure projects, but its ability to do so hinges on the availability of the resources not the source of the money used to acquire them.

There are reasons for society to be concerned about a small number of individuals accumulating vast financial wealth, the ability and temptation to leverage that economic and financial power for political purposes probably being at the top of the list.

If the Biden Administration wants to launch or expand a clutch of government spending programmes, there are only three ways to ‘pay for’ them.

One is to eat into the ‘economic slack’ generated by the Covid-19 slump, the current theory of the stimulus case. A second is to call forth more resources (grow the workforce by immigration and by raising the labour force participation rate) and boost productivity by promoting technological innovation and high-powered market incentives. Both processes have limits and neither is helped by raising taxes.

Which leaves the third: divert resources from existing uses. Herein lies the underappreciated role of monetary policy and the aggregate demand management part of fiscal policy. Sooner or later the economy will reach full employment and start to overheat. Then the Federal Reserve will need to raise interest rates, and the Congress and the Administration may decide to raise taxes, to rein in an overheating economy.

It is the resources that become available when tighter monetary and fiscal policy suppress economic activity across the board, that will ‘pay for’ any new permanent spending programmes, and very little of these will come from ‘the rich’.

Paul Sheard is a research fellow at Harvard Kennedy School and former chief economist at S&P Global, Nomura Securities, and Lehman Brothers.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.