Government policies also play a role in determining economic growth. Stabilization policies by the central bank affect interest rates and thus capital investment. Fiscal policy impacts capital investment indirectly through the effect of government debt on interest rates. Tax policies that affect consumption and saving decisions influence economic growth by way of their impact on interest rates and work incentives.
The Fed promotes economic growth when it maintains a predictable, stable interest rate policy. Although monetary policy primarily affects short-term interest rates, it is the Fed’s effect on long-term interest rates that influences growth. Firms are unlikely to make long-term investments in capital if they are uncertain about future interest rates and inflation. To avoid uncertainty, the Fed must maintain a firm lid on actual and expected inflation. The Fed’s policy stance during a recession is to target a lower fed funds rate to encourage borrowing. However, if the Fed keeps interest rates too low for too long, future inflation is more likely. This expected inflation and increased long-term interest rates will discourage capital investment, and ultimately, long-run economic growth. Short-term increases in interest rates to dampen inflation may not please Wall Street, but since the increases reduce expected inflation, they help to keep long-term interest rates low and stable. And low, stable long-term interest rates encourage capital investment.
A group of Chilean economists referred to as the Chicago Boys who studied under Milton Friedman at the University of Chicago were instrumental in bringing market reform to the country under the dictator Augusto Pinochet. The reforms they introduced helped to halt inflation and make Chile one of South America’s fastest-growing economies. Unfortunately, the association with the dictator gave market economics a bad name on the rest of the continent.
Fiscal policy that does not lead to a balanced budget impacts long-term interest rates and capital investment. Budget deficits in the absence of capital inflow or increased domestic saving lead to higher long-term interest rates and hinder investment in capital. If capital inflows or domestic savings are enough to offset government borrowing, the interest rate effect of a deficit is negated. Regardless of immediate interest rate effects, budget deficits, if large enough, create uncertainty and may effectively discourage investment. The presence of budget surpluses reduces long-term interest rates and encourages capital investment.
Changes in tax policy affect businesses and are likely to also impact the rate of economic growth. Increasing the tax burden on firms reduces their ability and incentive to invest in capital. Increasing the capital gains tax on financial investors reduces the flow of savings firms use to make real investments in physical capital. Businesses faced with too high a tax burden may choose to produce elsewhere. It is important to understand that capital is free to flow. Placing taxes on business, although politically popular, is a recipe for reduced growth.
A flat tax is one that taxes all households at the same rate regardless of the level of income. Given a flat tax of 15%, a household earning $40,000 would pay $6,000 in taxes, while a household earning $100,000 would pay $15,000 in taxes. The benefit of a flat tax is its simplicity. The downside is that for many households a flat tax would represent an increase in their tax burden. Even though many are in the 20% to 30% marginal tax brackets, their average tax rates are much lower because of exemptions, deductions, and the fact that the marginal tax rate is only on the incremental income and not the total income.
Taxes on personal income affect work incentives and can thus also influence the rate of growth. In the United States, the more productive you are, the more income you earn. The more income you earn, the higher your marginal tax rate. This is what economists call a progressive tax system. If tax rates are increased on upper incomes, they increase the tax burden of the most productive members of society. Although American tax rates are much lower than in Europe, given a high enough tax rate, the productive worker will either reduce productivity or move to where productivity is not taxed as highly. So far, America has been the beneficiary of high tax rates in Europe. Europe has suffered a brain drain as its best and brightest, thus most highly taxed, move toward countries with lower tax rates.
According to the Organisation for Economic Co-operation and Development (OECD), the brain drain is serious enough that European countries are establishing government programs to encourage expatriates to migrate back. Maybe they should try a tax cut. Europe’s loss is America’s gain as human capital has increased steadily in the United States.
Economic growth is not without its downsides or its detractors. Economic growth has led to increased income inequality, which, if ignored, threatens continued economic growth. Over the last fifty years, income inequality in the United States has increased for a variety of reasons. The loss of union power, reduction in marginal tax rates, foreign competition, and meritocracy are some frequently cited reasons. Union membership has steadily declined since the 1980s, and as a result, workers have lost leverage in negotiating wages. This decline has occurred because of structural changes in the economy and as a result of government taking a more adversarial role with unions. Decreases in marginal tax rates have also widened the gap between low- and high-income earners.
According to the Census Bureau, from 1980 to 2008, the bottom quintile of households saw little or no change in average household income, while the top saw a steady increase in income. Globalization has contributed to income inequality. Much of this country’s unskilled manufacturing has moved overseas, leaving unskilled Americans in lower-paying service-sector jobs. Another theory of why income inequality has increased has to do with the development of a meritocracy.
In a meritocracy, the best and brightest marry the best and brightest and reproduce more of the best and brightest, leaving the not so best and not so bright in the proverbial dust.
For economic growth to continue, the gains must be more evenly distributed across the population. Whether that is fair or not is irrelevant. America practices both capitalism and democracy. The more productive members of society are rewarded by capitalism, while less-productive or less-skilled members of society see their income stagnate. This fact does not sit well with the latter and creates an opportunity for a political solution. Though not all Americans see the direct benefits of capitalism, they do have a vote. Therefore, those who wind up on the short end of capitalism’s stick are likely to exercise their right to vote and change the equation. Income redistribution is a fact of life in a society with universal suffrage. Proponents of economic growth must be prepared to share their earned gains with those who may not have earned it.