It’s Time to Update Your Economics

Kansas is proof that Laffer has failed.

From Kuznets to Piketty

A lot of economists and politicians have been following a failed prescription: That if you cut taxes on the rich, they’ll have more money in their pockets that they’ll unleash upon the economy as new businesses and new jobs. Exactly the opposite has happened. But it’s an understandable mistake.

The Invention of The Economy

In 1934, Congress asked economists to look at what was going on with the economy. “The Economy” hadn’t really been invented yet — or more specifically, no one had ever tried to do the ambitious work of summing up everything a nation produced and assigning a number to it. Simon Kuznets answered the call, by inventing GDP — Gross Domestic Product.

GDP was used in 1934 to answer the question of what happened in 1929 (The Great Depression). And Kuznets’ GDP was called on again by FDR in 1941, to decide whether the US could afford to enter WW2. FDR did what politicians do and dismissed Kuznets’ response. But the question caused Kuznets to look even more carefully at the shape of the US economy, and its allies: the UK and France.

And he kept at it. In 1961 he published his data in a book, Capital in the American Economy. In 1973, he added another decade of data: Population, Capital & Growth. He summarized his economic data, 1940–1970, with the “Kuznets Curve,” which says if you can just grow the economy forever, economic inequality will fall. Although he didn’t coin the term, people refer to Kuznets all the time when they say “A rising tide lifts all boats,” or argue that cutting taxes on the rich will cause that wealth to trickle down.

Kuznets’ Following

Kuznets was brilliant and boring, by all accounts. It’s no surprise he had a major impact on economists; in some ways, he invented macroeconomics.

Economists like Arthur Laffer have extended this premise into the modern era, and they’ve got politicians’ ear. They propose, in their “Supply-side economics,” that if you just cut taxes on the rich enough, you’ll see explosive economic growth, crashing economic inequality as the poor work their way to being rich. The American Dream.

An economist named Tyler Cowen recently declared that Americans are lazy, and that’s what’s wrong with the economy — resting on the “rising tide” hypothesis.

At the core of the Laffer/Kuznets model, lies the belief that it’s possible to have permanent growth rates of 4–10%.

In the Kuznets model, as long as economic growth exceeds 4%, the Middle Class’s contribution to GDP in terms of wages outpaces the Capital Gains of the Upper Class, creating a sort of hidden Wealth Tax on the rich — if the Upper Class don’t work hard, the Middle Class will outpace them and replace them. The growth of the economy occurs so quickly that all the property the Upper Class rests on are devalued faster than they can collect interest and rent.

Piketty Refutes Kuznets’ Work — by Extending It

A more recent economist, Thomas Piketty, expanded on Kuznets’ work from 3 countries and 40 years to 27 countries and 100 years. He finds the big growth rates US, UK, France saw post-WW2 unique to Developing economies. Piketty finds you can categorize economies as Developing, and Developed. Developing ones are either seeing their entrance to the developed world (like China), or they were recently destroyed (like post-WW2 US, UK, and France). The initial entrance into the Developed world, or the race to rebuild, ask for big 4–10% growth rates. And sure enough growth in the US was big from 1940–1980, then tapered off. Same with UK and France.

By being asked to look so intensely at the US and its allies, Kuznets accidentally cherry-picked the data. China had 30 years of 10% growth and now, it’s tapering off. Kuznets believers are panicking about it.

Normal growth rates in a developed economy, Piketty finds, are between 0 and 3%. Sure enough that’s what the US has seen since 1980, and most of the world over the past 100 years. The economy’s been built already; it doesn’t need huge growth. It can’t support it.

In a Developed economy with these lower growth rates, the Middle Class can never catch the Upper Class, unless you do something about it. The hidden Wealth Tax goes away — on average, each year, the Upper Class’ holdings make them more money than Middle Class wages — the return of Capital Gains exceeds wages every year by about 5%. This compound interest creates runaway Economic Inequality burying the middle class further and further underneath the rich.

Piketty catalogues this all in his book, Capital in the 21st Century. And he open sourced the data, wid.world. It’s the most comprehensive, peer-reviewed gathering of economic data of all time.

It’s too bad economists like Tyler Cowen haven’t read it. If they even looked at the data, they’d notice that the share of Capital in the Middle Class is falling and continues to fall, just as Piketty’s numbers predict. When he noticed Americans are starting fewer businesses, he might’ve realized it’s not because Americans are lazy, but because they lack the capital to get one started.

And it’s too bad Arthur Laffer hasn’t read it.

A Failed Prescription

Arthur Laffer was relied on heavily for Kansas Governor Sam Brownback’s ambitious tax cut plan. Laffer’s numbers made it clear: cut taxes to 0 on business, and explosive growth will pave over any state budget losses as other revenues soar.

Brownback and the Kansas State Legislature made the cuts. Laffer predicted an “immediate and lasting boost” to the state’s economy. It was a big moment. Conservative thinktanks and Republican politicians had been recommending this approach for years. Finally, a test.

It has not gone well. Kansas passed the tax cuts in 2013, when the US was amidst a full national recovery. If Laffer was right, much of the windfall of the US recovery would arrive in Kansas. Instead, precisely the opposite occurred: Kansas Unemployment trailed the national; it also fell more slowly. Job growth in Kansas was half the national rate. State Domestic Product grew just 4.8% while GDP grew 11.9%. And most damning of all, Kansas share of businesses in the US didn’t grow — it didn’t even level out. It fell.

Unsurprisingly, all of this doom and gloom did not bode well for the Kansas state budget. In 2017, Kansas’ deficits are setting records, breaking the records they’d only set the year prior. The Kansas state legislature has turned on Brownback, and rather than admit defeat, Brownback is trying to portray resignation as a victory exit, lobbying for a role in the Trump Administration.

It’s clear Laffer sold a false bill of goods to Brownback, and the Republican movement in general. But what exactly went wrong?

Taxes Don’t Do What You Think

At the heart of this failure is tax cuts on the rich. In his book, Piketty finds that increasing taxes on the rich have the surprising effect of increasing jobs. Likewise, decreasing taxes on the rich get you, well, Kansas: It reduces jobs. This upsets the narrative that putting more money in the pockets of the richest will cause them to hire more. So, why?

Piketty finds that the richest tend to have a lot of influence on not just jobs, but how businesses in the economy spend their money. They tend to own them, and often are CEOs or other high-level roles — what Piketty titles, “Supermanagers.” This big influence has the biggest impact on new profits — profits above and beyond the business’ plans to operate and grow. Money it doesn’t know what to do with.

If taxes are low, the economic history Piketty has diligently gathered shows that Supermanagers tend to pocket more of it. Why, if it’s painless, not reward oneself, for your business having a windfall? But if taxes on the rich are high, it appears Supermanagers find those taxes to be painful, and move to avoid the pain. They reroute that money by reinvesting it in the business, and one way they reinvest it, is to create jobs. Other kinds of reinvestment, like buying equipment, can indirectly create jobs by increasing purchase orders at peripheral businesses. It can also lead to the creation of new businesses to respond to the increasing demand.

And therein lies the fatal flaw that killed Kansas. We need higher taxes on the rich, not lower, if we want to see a rising Middle Class and broader job growth.