personal views of a former fed trader

Taxes Go Up So Rates Stay Down

Advanced economy governments do not need taxes to fund spending. For over 10 years the U.S. has heavily relied on the Fed to finance its ever increasing public spending, with limited effects on consumer prices or the value of the dollar. The same observation can be made in a number of advanced economies. A fiat system that holds the confidence of the public does not need taxes to fund itself (but things change when that confidence is eventually lost). Yet, the Administration is keen on raising personal and corporate taxes to “fund infrastructure.” Another way to view these efforts is simply as a public policy tool to carry out the Administration’s plan on reducing wealth inequality, a byproduct of accommodative monetary policy. In this post we review the policy trade offs in a lower for longer stance, how income inequality leads to asset price inflation, and how taxing the rich in turn moderates asset price inflation.

Low Rates are a Double Edged Sword

Historically, the Fed’s decision to hike rates would be informed by its view on unemployment. It believed in a link between unemployment and inflation (the Phillips curve), where an unemployment rate below what the economy could sustain (a hot labor market) would lead to inflation. Prior to 2020, the unemployment rate was plumbing multi-decade lows and wage growth was accelerating among low wage workers, yet inflation was subdued. In light of this, the Fed realized its not good at estimating the sustainable employment rate and revised its framework so that a low unemployment rate would not trigger rate hikes. Along with the move towards average inflation targeting, the new framework suggests that rates are going stay low for a long time.

Gains in wages were most pronounced among low wage workers

However, it is also clear that low interest rates cause asset inflation by pushing investors out of safe assets and into risky assets. Indeed, the wealth effect is an intended effect of QE. But assets are largely held by the wealthy, so higher asset prices magnifies the wealth gap. The chart below shows the value of financial assets held by the wealthiest top 10% is rising rapidly, while remaining little changed for everyone else. This disparity is the key driver of wealth inequality.

This chart ends in 2019. The 2020 version will show even larger disparities.

The Administration has been clear about its priorities, which include targeting economic inequality among other progressive leaning goals (note the Fed is onboard: it can be seen fighting climate change and expanding ON RRP counterparties on the basis of diversity and inclusion). Any solution to economic inequality must address the massive wealth gap that has emerged. An accommodative monetary policy is thus a double edged sword that helps achieve inclusive employment and wage growth but also leads to significant wealth inequality.

Usually, the unintended consequences of macro policies are addressed separately via targeted regulation. For example, massive support of the banking sector in 2008 saved the world, but also had the potential to creating epic levels of moral hazard where speculators kept financial gains but the public paid for losses. The public sector dealt with this potential untended consequence via stringent regulation that prevented banks from engaging in high risk activity. The obvious solution to maintaining the benefits of an accommodative stance while shrinking the wealth gap is to moderate the asset inflation effects of QE (this would also ease financial stability concerns). This can be done by reducing the money flowing into assets.

Big Corporations and High Earners Push Assets Prices Higher

Asset prices rise when money is flowing into them. In the U.S., income is concentrated in large corporations and a small set of high earners. This is especially true in the Covid world, as higher income earners WFH while lower income earners cannot work, and large corporations absorb the business of the locked down mom & pop shops. These entities take their outsized income and buy assets.

Income distribution is highly concentrated in both corporations and individuals

According to the IRS, the top 1% of corporations by asset size account for over 90% all corporate income. These large corporations tend to be publicly traded and have been taking their profits and buying back their stock at a rate of around $100b a quarter. This was particularly notable in 2018 following 2017’s Tax Cut and Jobs Act, which lowered the maximum corporate tax rate from 35% to 21% and incentivized corporations to repatriate off-shore earnings. The extra profits went into boosting stock prices (less than 30% of buybacks in the S&P 500 are debt funded).

According to the IRS, the top 5% of tax filers by income account for 36% of all reported individual income. In addition, higher earners have higher savings rates (consume less of their income). The contrast is stark, where the bottom 20% of earners consume almost all their income, while the top 20% consume around half of their income (see table below). Someone who earns 10x more than the average person does not eat 10x as many meals, so he tends to have more left over to buy assets like stocks or real estate.

Average propensity to consume (“APC”) by income and wealth quintile. Source: Fisher et al. “Estimating the Marginal Propensity to Consume Using the Distributions of Income, Consumption, and Wealth.” FRB Boston Working Papers No. 19-4.

Higher Taxes Are The Solution

As corporations and high income earners are major buyers of assets, so selectively reducing their income deflates assets and reduces the wealth gap. The Administration’s proposals of higher income and capital gains taxes on high income households, as well as higher corporate tax rates (along with a global minimum tax to ensure enforcement) do just that. Since increasing after-tax corporate profits increases stock-buy backs, it stands to reason that decreasing after-tax profits would reduce buy backs. Since higher income earners save more, reducing their income reduces their demand for assets. Together, this reduces the flow of money into assets and thus moderates asset price inflation.

IMF’s latest Fiscal Monitor is also recommending a special tax on individuals and companies who benefited from the K-shaped recovery

In the context of the Administration’s broader economic goals, higher taxes can be viewed policy tool moderate the uneven effects of accommodative monetary policy. This gives room for a lower for longer monetary policy.

However, so far the tax proposals are just words. Changing the tax code is really hard, especially when it hurts the wallets of those with significant political influence.

2 Comments

  1. Paul Lebow

    If the claim is that taxes are not needed to fund government, I assume the balance is meant to be made up with Treasury sales. Isn’t it important to evaluate the source of tax funds vs funds from Treasury sales? One (tsys) is foreign countries, pension funds insurance companies, the other (tax) is high income and wealth segments of the economy.

    • Fed Guy

      It’s not so much a claim as an observation that has held true for over a decade, and across a number of countries. You are correct that the way of funding has distributional impacts, which is why a greater reliance on higher taxes can narrow economic inequality.

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