The Advantage of a Middle-Out Economy

In advance of the State of the Union address on Tuesday, President Obama has unveiled a number of aggressive policy proposals to combat the wage stagnation that is squeezing the middle-class.

This includes a series of proposed tax cuts for the middle-class that would be funded by new tax revenue from the wealthy. Obama would eliminate a pair of tax preferences that have long subsidized the wealthy through the tax code, closing a loophole that has shielded trust funds from taxation and raising the top marginal tax rate on capital gains to 28 percent (up from 23.8 percent).

This proposal has obvious political appeal for Obama and his fellow Democrats: it’s a populist initiative that forces the GOP to choose between absolutist protection of capital gains and lowering taxes for average Americans.

But it also reflects a deeper debate between the two parties over the core of our macroeconomic policy. Namely, who spurs economic growth in the United States: the wealthy, or the middle-class?

The conservative prescription for accelerating growth has long been to create a business-friendly environment by slashing taxes and relaxing regulations on high earners, who will then invest their savings, expand their businesses, and grow the economy. That’s why conservatives like Sen. Orrin Hatch (R-Utah) were quick to denounce the revenue side of Obama’s tax plan. “Slapping American small businesses, savers and investors with more tax hikes only negates the benefits of the tax policies that have been successful in helping to expand the economy, promote savings, and create jobs,” Hatch claimed.

In response the to top-down growth favored by conservatives, liberals have begun championing “middle-out” economic growth. This budding liberal alternative would have us ease the strain on middle-class budgets on both ends of the balance sheet. It would boost their assets by cutting their taxes and increasing their take-home pay. And it would chip in for their liabilities by making modern-day necessities like health insurance, education, and childcare more affordable.

So which model is more effective for bringing about growth? This largely depends on a pair of economic effects — each of which indicates that liberals have the better path to robust shared prosperity.

There are two different responses that individuals might have to a change in their tax rates. If my tax rates go down, the amount of time I put in working becomes more valuable, which ought to make me work harder and work more, generating more economic activity. Economists call this the substitution effect, because I’d substitute more work hours in place of leisure time.

Alternatively, if my tax rates decline, I might instead realize that I can maintain the same income while working fewer hours. With an unexpected windfall from a new tax cut, I could keep my take-home income constant while working less than I had been. Economists call this the income effect, because I elect to use my new income from the tax cut to “consume” more leisure and thus work less.

So the debate over targeted tax cuts depends on which effect wins out: whether tax cuts make us work more or work less. But there’s reason to think that these effects vary when we look up and down the income scale.

High-income individuals may very well respond to greater disposable income by consuming more leisure. Because they already enjoy economic security, a newfound lower tax burden might incentivize these individuals to work less while taking home the same amount of money. If so, tax cuts for the wealthy are an economic windfall, not a stimulant.

Further down the income scale, middle- and working-class Americans might make the opposite choice and work more hours in the wake of a tax cut. With less of a financial cushion to rely on, making work more valuable ought to encourage more working hours among these individuals. When work becomes more lucrative, leisure time correspondingly becomes more expensive and harder to justify. This generates higher incomes and more economic growth.

So we might expect to get more economic growth out of cutting taxes — and thereby expanding disposable income — for middle-class and low-income Americans than we would by making things easier on the wealthy. This makes intuitive sense: The poor and middle-class simply need new income more than high-earners do for basic survival and security. They therefore respond to policy changes by maximizing their incomes rather than their leisure.

If the wealthy respond to a tax cut by pocketing more leisure time, we’d expect the inverse to be true, too. That is, the wealthy might consume less leisure — and work more — when their taxes go up. This expectation is backed up by behavioral studies demonstrating that individuals tend to react more strongly to prospective asset losses than they do to opportunities for asset gains — a phenomenon known as the “endowment effect.” In the face of a tax hike, then, the wealthy might work more in order to sustain the same after-tax income level.

To promote growth, then, we ought to raise taxes on the wealthy and cut them on the middle-class — precisely what Obama proposes to do. We’d expect this to generate more economic activity than relying on tax cuts for the wealthy. Indeed, this is borne out in the data. Lower income groups have a highermarginal propensity to consume” than the well-off do. That means that they spend a higher percentage of each additional dollar received than the wealthy would, providing greater stimulus for economic growth.

For much of the twentieth century, the United States grew its economy on the back of an ascendant and secure middle-class. It’s not coincidental that rising income inequality corresponded with a shift toward top-down economic policies implemented by conservatives in the 1980s. For the better part of three decades, average Americans have been waiting for a trickle-down that never happened.

As an alternative to the doldrums of supply-side inequality, “middle-out economics” isn’t just some populist platitude. It’s a serious and persuasive prescription for promoting economic growth. It returns the United States to its roots as a society of egalitarian growth and shared prosperity. And best of all, it’s very likely a more effective and pragmatic plan for the economy than the the top-down alternative offered by conservatives.

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