Americans are rightly concerned about their current and future economic well-being. Since the 2008 financial crisis, middle class household incomes have seen little overall growth. Owing to business lockdowns and other pandemic-related impacts on economic activity, real household annual income actually fell from about $69,000 in 2019 to about $67,500 in 2020. Although hourly wages by month in 2021 have seen relatively high growth rates over the same month in 2020, the increase is explained largely by the pandemic-produced low 2020 base. Longer term, growth in hourly wages has been tepid, and many families continue to live paycheck to paycheck. Add to these trends the current rise in price inflation, and the result is that the purchasing power of incomes for some families has actually declined. It is not therefore surprising that polls show that Americans are distressed about their financial health and their ability to sustain their standard of living, let alone pass on a better standard of living to their children. Moreover, according to a CNN survey taken in August, 69 percent of Americans now believe that the country in general is not moving in a positive direction.
Should Americans be worried about the future? Indeed, they should. Among other things, as far back as 2017, the nonpartisan Congressional Budget Office was warning that the explosive annual growth in the federal debt over the past several years is unsustainable. Since that warning, the debt has grown by more than $7 trillion (fiscal years 2017-2020). Although not formally debt, ballooning entitlement promises (mostly Social Security and Medicare) are also not sustainable in their present form. Now Congressional Democrats and the Biden Administration are pushing a new $3.5 trillion spending package. Notwithstanding the Administration’s incredible claim that higher taxes on corporations and on high income earners will pay for this spending, the truth is that most, if not all of the spending, will simply add to the federal debt, exacerbating the burden on future generations.
At some point, the piper will demand payment by means of some combination of formal taxes or hidden inflation taxes that lower the purchasing power of household incomes while simultaneously enabling the government to pay off debt with cheaper dollars. Whatever the form, standards of living can be expected to decrease or at least grow at a significantly lower pace.
Although individually powerless to do anything about the federal debt and unfunded entitlement promises, most Americans, I suspect, grasp that persistent deficit spending and growing entitlement promises are not sustainable and that the burden on future generations will be high. Families can relate to the consequences of spending more than they earn. What is less understood, I believe, is how misguided spending and tax policies exacerbate the problem of rising debt levels by stunting economic growth.
In this regard, lost in all of the current rhetoric in DC about corporations and high income earners not paying their “fair share” of taxes and about the wonders of an expanding welfare state is the potential adverse impact of “tax and spend” policies on capital accumulation. Ignoring this impact threatens future standards of living and exacerbates the debt problem. Indeed, the best way to avoid de facto debt default in the future is to grow the economy faster than additions to the debt. Capital accumulation is critical to that end. Capital accumulation, however, requires short-term sacrifice and a limitation on current spending and tax burdens, something politicians seeking to appeal to what they perceive to be the current appetites of voters are disinclined to acknowledge. Consequently, it is not surprising that this crucial factor is missing from the public discussion.
A Little Econ 101
As most every student learns in the first week of an introductory economics course, a nation’s production possibilities – that is, its total potential output — at any given point in time is determined by its endowment of natural resources (including labor), current technology, and its capital stock. Given these endowments, there is a near infinite range of alternative mixes of final goods and services that can be produced, including the mix of consumption goods and capital goods (productive assets). In a free market economy, the actual mix is determined by consumer preferences signaled via market prices. Significantly, however, at full employment, no more goods and services can be produced in the aggregate. Thus, the only way by which the output of any single good or service can be increased is to take resources away from the production of other goods and services.
At first glance, the concept of production possibilities seems to suggest that standards of living are fixed in place or, possibly worse, must decline over time because of depreciation of the capital stock. In fact, experience tells us that this result need not be the case. New natural resources can be discovered, the labor force can increase through immigration and natural population growth, technology can advance, international trade can allow for more specialization based on comparative advantage, and the capital stock can expand through capital accumulation.
Adverse Effects of Government
Although misguided government spending and tax burdens can adversely affect each of these factors, they have their greatest impact on the growth rate of the capital stock. To see why, consider that plants and equipment wear out over time. Thus, if the capital stock is not replaced as it depreciates, production possibilities must necessarily decline. Just to maintain current production possibilities, it is essential that some of a nation’s productive factors be devoted on an ongoing basis to replacing the capital stock that is wearing out. What this means is that, at full employment, some amount of current consumption must be sacrificed in order that resources can be diverted to producing capital goods if a nation is to sustain its capacity to produce. Furthermore, if a nation seeks both short-run full employment and long-run growth, it is not enough simply to replace depreciating capital stock. It must also expand the capital stock. In other words, it must accumulate capital at a rate greater than the depreciation rate.
Taxes on savings and investment hinder this process. They reduce the returns on capital and thus make capital less desirable to accumulate. Such taxes include those on capital gains and income from dividends. Taxes on corporate profits also take away earnings that otherwise could be used to fund investment in capacity expansion. At the least, these taxes cause a nation’s capital stock to expand at a slower rate.
Similarly, government spending that focuses on expanding present services and increasing government’s size consumes resources that free market signals would have directed elsewhere, including private capital investment. Even if some of the spending is not for expanding present services but could arguably be considered investment in future productive capacity – such as various forms of industrial policy and various subsidies to incentivize the flow of resources to specific “infrastructure” activities — the spending, being politically directed, would likely result in resource allocation inconsistent with market signals. This misallocation not only imposes a present cost but also a future cost in that it establishes a continuing path of misdirected resource flows.
Both tax policies and spending policies can then hinder capital accumulation. When they do, they necessarily stunt long-term growth potential and thus rob future generations of goods and services that no longer can be produced because of diminished output capacity. When such policies are claimed by their proponents to be for necessary expansion of government services in the present and to pay for those services, it is simply a claim that current needs are of higher priority than future prosperity. More bluntly, it is a claim that future generations be damned.
In this regard, much of the tax and spending legislation proposed by congressional Democrats is aimed at feeding current appetites for a larger government that funds and advances politically determined social ends. Consider such spending items as “free” community college, expansion of Medicare to include dental and vision coverage, subsidies to support the planning and development of high speed rail projects, grants to energy providers to meet “clean energy” goals, and funding toward the development of charging stations for electric vehicles. With respect to taxes, the proposed legislation calls for increased taxes on corporations, increased capital gains taxes, and increased marginal tax rates on high income earners. One Democratic Senator has even called for taxing unrealized capital gains, an idea for which President Biden expressed support. Each of these spending and tax provisions elevates progressive ideology over long-term growth and the well-being of future generations of Americans.
Americans are rightly concerned about their economic future. The growing federal debt is a serious problem that needs to be addressed. The best way of doing so without burdening future generations with lower standards of living is for the present generation to ensure strong economic growth. Strong growth in turn requires not only technological advancement and labor force growth but also capital accumulation at a rate sufficient to increase the net capital stock on a continuous basis. This means limiting current consumption, most especially government spending that consumes resources that free market signals would otherwise have directed to private investment. Misguided tax hikes on businesses and individuals that discourage saving and diminish funds for private investment similarly must be avoided. Regrettably, much of the Democrats’ proposed $3.5 trillion “spend and tax” legislation fails on each of these counts. Neglecting the legislation’s adverse impact on capital accumulation means robbing future prosperity for the sake of the present social ends.
This article, Capital Accumulation and the Reconciliation Package, was originally published by the American Institute for Economic Research and appears here with permission. Please support their efforts.