Creating Wealth, Not Just ‘Savings’

The Wall Street Journal 10/15/96

Bob Dole’s proposal to cut income tax rates by 15% across the board and halve the capital gains tax rate has resurrected all sorts of issues from the policy debates of the Reagan ’80s. The Dole plan also stands — notwithstanding Jack Kemp’s unavailing arguments for it in last week’s debate — as a direct counterpoint to Bill Clinton’s plans to expand government: his tax increase of 1993, his attempts to raise taxes through massive health care legislation and his increase in the minimum wage. The electorate really does have a choice of economic outlooks in November.

With the resurgence of the tax debate, the question of what effects taxes have on national savings has moved once again to center stage. Recall that opponents of tax rate cuts were elated when they unexpectedly discovered a sharp drop in savings rates following Ronald Reagan’s tax cuts, and that savings haven’t yet risen back to their pre-Reagan levels. Experts of every persuasion have been shocked by the drop, because theory virtually guaranteed higher savings.

Saving looms so important in policy debates because it is society’s only way of accumulating capital — and thus of spurring technological inventions, discoveries and developments. Sooner or later an economy will have to come to a grinding halt if it is deprived of new capital. And productivity will stagnate without the technology found only in new capital. Therefore, the faster the amount of available capital increases and the more capital there is, the faster the economy will grow and the more able society will be able to solve its economic problems without resorting to austerity. Without increased savings Mr. Reagan’s critics would be correct in saying that the tax cuts of the ’80s were merely alms for the rich at the expense of the poor — Robin Hood in reverse.

But as so often, things aren’t what they appear to be. The “savings” that government measures have almost nothing to do with the type of national savings we need for economic growth. What the government measures as savings is that portion of income that people don’t consume, literally income minus consumption. What we instead wish to measure is the increase in wealth. The two concepts of savings are as apples and oranges in the old saw — they just can’t be added together.

To see the difference between the two types of savings, imagine two people. The first earns $100,000 in a year and consumes exactly $100,000 as well. But also imagine this person started the year with an investment portfolio worth $500,000 and through astute asset management (or, if you prefer, just plain luck) ends the year with his portfolio worth $2.5 million. How much did he save?

Under the government’s concept of savings, the person in this example saved nothing — his income exactly equaled his consumption. But this notion leaves a lot to be desired. If his wealth went up by $2 million, for all practical purposes he saved $2 million — he had accumulated assets worth $2 million more, which he could use to buy buildings, machines, technology or anything else, just as easily as if he had not consumed $2 million worth of income and thus had it left to invest.

Likewise, the second person — who earns $100,000, consumes $50,000 and then loses $50,000 by buying a dog of an investment — has no more capacity to acquire capital than if he had consumed $100,000 and had had no savings at all. For the purpose of analyzing growth the relevant concept of savings has to be the increase in wealth, not the absence of consumption. And yet, virtually every discussion of the Reagan ’80s uses the wrong concept of savings and comes to the wrong conclusion. The government’s numbers in the first chart don’t make any sense and should never be used to evaluate economic performance.

In the late 1960s and 1970s, individuals and companies invested in tax shelters, inflation hedges and regulatory skirts, and squandered our nation’s capital stock. And yet according to the government’s numbers, saving was high. In the 1980s, by contrast, we finally put our nation’s capital stock to productive use as a direct consequence of tax rate reductions, deregulation and inflation control. As a consequence, the market’s valuation of the country’s capital stock after adjusting for inflation increased as never before. For example, the stock market, as measured by the Dow Jones Industrial Average, rose by 184% from 1982 to 1989; the broader Standard & Poor’s index rose by 170% over the same period. Housing prices and real estate values soared as well. Yet none of this increase in the country’s wealth shows up in the government’s measure of savings.

Once we view savings properly, the picture changes dramatically. The second chart traces changes in the total market value of household net wealth for the U.S. relative to personal disposable income from 1965 through 1993. We can see that after President Kennedy’s tax cuts in the mid-1960s, savings — as measured by increases in wealth — was very high. But in the years following Kennedy’s “go-go ’60s” the savings rate fell. President Johnson’s 1967 tax surcharge and his counterproductive

Great Society spending programs wreaked havoc on U.S. savings and our country’s capacity to produce. President Nixon’s doubling of the capital gains tax rate, devaluation of the dollar, 10% import surcharge, and wage and price controls drove the average true savings rate below zero for a number of years.

The Ford administration’s “Whip Inflation Now” 5% tax surcharge didn’t improve matters much; savings stayed very low. In 1978, however, with California’s Proposition 13 and the Steiger-Hansen federal capital gains tax rate reduction, savings started to rise, and sharply. But it really wasn’t until the Reagan-Volcker policies of the 1980s took full effect that saving rose to earlier highs. In fact, the Reagan era had the longest sustained increase in savings of the past seven administrations. And the Reagan era wasn’t a reverse Robin Hood era, either. Net job growth was 18 million; the poor, the disadvantaged and minorities improved their lots in life along with everyone else.

Once George Bush raised taxes in 1990 and President Clinton raised them further in 1993, savings fell again. Fortunately, monetary policy during the ’90s has been excellent and has kept savings from falling to the lows of the mid-’70s.

Our nation once again stands at a crossroads deciding whether to continue a policy of high taxes and restrained growth, or change course and cut tax rates to foster more growth and more savings. The Reagan-era tax cuts not only spawned excellent economic growth but also enormous savings. Based on such historic lessons, the Dole-Kemp plan looks like a real winner.