Sunday, October 12, 2008

A New Laffer Curve

In economics, many common-sense assumptions turn out to be false and counter-intuitive actions can prove to be the best prescription for a given ailment. A classic example of this is the Laffer Curve. The basic premise is that at certain high tax levels, a nation can increase its overall tax revenue by decreasing tax rates. The idea is that at very high tax levels, people lose the motivation to engage in productive activity (that can in turn be taxed). As tax levels come down, people have more motivation to engage in productive activity, and the increase in productive activity leads more taxes being collected even though the tax rate is lower. [This is not a discussion of where the US currently is on the Laffer Curve, though that's certainly an interesting discussion.]

I propose a similar principle is at work when it comes to taxing extremely high incomes. However, in this case, I believe that by redistributing some of the income taken in at the extreme levels and redistributing it, the wealthy can actually achieve greater wealth in the long run. Here's why I believe this:

People with extremely high incomes usually do so because they have very high numbers of 'clients'.

[I put clients in quotes because some explanation is needed as to what I mean by a client. People with extremely high incomes (at least 7 figures, let's say) probably fall into one of the following categories: business owners or executives, sales people, athletes and entertainers. Business owners and executives need customers for their business. Sales people need buyers. Athletes and entertainers need fans to pay for their works. I am referring to customers, buyers, and fans when I say clients. In general, extremely high incomes come from large numbers of people willing to pay for a product or service.]

The 'clients' need to have an adequate source of income in order to pay for the products and services provided by those with extremely high incomes. People with extremely high incomes do not make for good 'clients' because they generally spend only a tiny fraction of the income on consumption; most of it is saved or invested. People of low to moderate income are generally more effective 'clients' because they spend most of their income on consumption that creates wealth for the business owners, entertainers, sales people, etc. If income is not redistributed through taxes on the wealthy, they end up with ever increasing shares of national income, leaving the rest of the population with little income to spend on goods and services. As a result, those who provide these goods and services wind up with fewer 'clients', and therefore, decreasing income. On a macro-level, the extremely high-income people must give up some of their income in order to sustain the spending that creates their income in the first place.

The last economic expansion in the US was not accompanied by growth in real wages for the middle class. As a result, this economic expansion was entirely driven by credit, and the entire expansion is now being undone. Clearly, the best way to grow the US economy in real, sustainable terms is to institute stronger redistributive policies that will result in real economic gains for the middle class. In turn, this will create a stronger client-base, and therefore higher incomes, for the wealthy. Call it the Martin Curve.



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