The Counterintuitive Truth About Tax Cuts

It’s labor day, so let’s look at the radically different ways income tax cuts or increases affect working class people versus the morbidly rich.

Over the past 40 years, Republicans have pulled off an incredible magic trick. They’ve convinced average working people that tax cuts benefit them when in fact the opposite is true.

It all boils down to two simple principles, which are—unfortunately—a mystery to most Americans and ignored in both our political and media discussions of income taxes.

1. Income tax cuts for the morbidly rich raise a nation’s debt but do nothing else. Reagan’s BS “trickle down” claims notwithstanding, tax cuts for the rich don’t even stimulate economic growth: they just fatten billionaires’ money bins and offshore accounts. And because tax cuts on the rich are paid for by increasing the national debt, they’re a drag on the economy. They make rich people richer, but make the nation poorer.

2. Cutting income taxes on working-class people, however, actually cuts their base pay over the long run. And, paradoxically, whenincome taxes on working people go up, as they did in the 1930s through the 1960s, it generally leads to pay increases!This shocking and counterintuitive reality is something no politician since FDR has had the courage to explain.

“Wait a minute!” I can hear you saying. “Cutting taxes on rich people makes them richer, but cutting taxes on working class people cuts their pay? WTF?!?”

Here’s how it works with a short story thrown in.

As taxes go up, income typically goes up for working class people but goes down for the very rich: High tax brackets discourage exploitation by the very rich and push up wages for working class people.

Some years ago I did my radio program for a week from the studios of Danish Radio in Copenhagen.

Speaking with one of the more conservative members of Parliament, I asked why the Danish people didn’t revolt over an average 52% income tax rate on working people, with an even higher rate on really high earners?

He pointed out to me that the average Dane was doing just fine, with a minimum wage that averaged about $18 an hour, free college and free healthcare, not to mention four weeks of paid vacation every year and notoriety as the happiest nation on Earth, according to a study done by the University of Leicester in the United Kingdom.

“You Americans are such suckers,” he told me and I reported some years ago. “You think the rules for taxes that apply to rich people also apply to working people, but they don’t.”

“When working people’s taxes go up,” he said, “their pay also goes up over time. When their taxes go down, their pay goes down. It may take a year or two or three to all even out, but it always works that way—look at any country in Europe. And that rule on taxes is the exact opposite of how it works for rich people!”

Economist David Ricardo explained this in 1817 with his “Iron Law of Wages,” laid out in his book On the Principles of Political Economy and Taxation.

Ricardo pointed out that in the working class “labor marketplace,” before-tax income is pretty much irrelevant. The money people live on, the money that defines the “marketplace for labor,” is take-home pay.

After-tax income.

But the rules for how taxes work are completely different for rich people.

When taxes go down on rich people, they simply keep the money that they saved with the tax cut. They use it to stuff larger wads of cash into their money bins.

When taxes go up on them, they’ll just raise their own pay—until they hit a confiscatory tax rate (which hasn’t existed since the Reagan Revolution), and then they’ll stop giving themselves raises and leave the money in their company.

And, history shows, while keeping that money in their company to avoid a high top tax bracket, employers typically pay their workers more over time as well.

In other words, as taxes go up, income typically goes up for working class people but goes down for the very rich: High tax brackets discourage exploitation by the very rich and push up wages for working class people.

We saw this throughout the 1940-1980 period; income at the very tip-top was stable at about 30 times worker’s wages because rich people didn’t want to get pushed into that very tip-top tax bracket of 74%.

But for working class people, Ricardo pointed out 200 years ago, the rules are completely different.

When working class people end up with more after-tax money as a consequence of a tax cut, their employers realize that they’re receiving more than the “market for labor“ would require.

And over time the “Iron Law” dictates that employers will cut back those wages when working class people get a tax cut.

For example, if the average worker on an automobile assembly line made $30,000 a year in take-home pay, all the car manufacturing companies know that $30K in their pockets is what people will build cars for. It’s the set-point in the “market for labor” for that industry or type of job.

Because of income taxes, both federal, state, and local, an auto worker may need a gross, pre-tax income of $40,000 a year to end up with that $30,000 take-home pay, so that $40,000 gross (before-tax) income becomes the average pay across the industry. At that pay and tax rate, workers end up taking home $30,000 a year.

But what happens if that income tax for working-class people is cut in half?

Now, a $40,000 a year autoworker’s salary produces $35,000 a year in take-home pay, and employers in the auto industry know that that’s $5,000 a year more than they have to pay to hire new people to build cars.

Put another way, the employers know that they can hire people in the labor market for $30,000 a year take-home pay, which is now a gross salary of $35,000, so they begin lowering their $40,000 gross wage offerings toward $35,000 to make up for the tax cut and to keep take-home pay within the $30,000 “market for wages.”

Since Reagan’s massive tax cut, we’ve seen this very phenomenon in the auto industry itself! As taxes went down, pay has been more than cut in half for new hires.

In other words, income tax cuts don’t increase the take-home pay of working people who have little control over their salaries. It’s the opposite, in fact.

On the other hand, when income taxes on working people increase, employers have to raise working class wages so their workers’ take-home pay stays the same. And that’s exactly what happened in the period from the 1940s to the 1980s as tax rates were fairly high across the board.

But when income taxes on working people go down, employers will reduce the wages they offer over time to keep their workers’ take-home pay at the same level. That, after all, is what Ricardo’s “market for labor” specifies.

But the rules are completely different for the rich, who live outside the “Iron Law of Labor.”

When taxes change for the very rich, they take home less money when taxes go up and keep more money when taxes go down. It’s the opposite of what happens to working-class people.

The incredible magic trick that the morbidly rich have done in America over the past 40 years is to convince average working people that the tax rules for the rich also apply to working class people, and therefore tax cuts benefit average workers, too.

Economist have known since the early 1800s that this is nonsense, as Ricardo and many others have pointed out.

Tax cuts only help the morbidly rich, while taxes reduce the national debt and help fund infrastructure and other programs that benefit working class people.

But after decades of this “you should worry about tax increases the same way rich people do” message being pounded into our brains by Republican politicians, working people think that tax cuts benefit them and tax increases hurt them.

It’s a real testimonial to the power of the Republican propaganda machine that even though individual wages have been flat or even declining in many industries for the past 40 years because of Republican tax cuts, the average American still thinks tax cuts are a good thing for them.

In fact, the time of greatest prosperity for the working class, when working class take-home pay (and wealth) was increasing faster than the income (and wealth) of the top 1%, was the period from 1940 to 1980 when taxes were high and the nation was prosperous.

FDR raised the top tax bracket to 91% and it stayed there through his administration, as well as those of Truman, Eisenhower, JFK, and the early years of LBJ. President Johnson dropped it to 74%, which held through his administration as well as those of Nixon, Ford, and Carter.

This high-tax period was the time of maximum American working class prosperity.

Reagan’s massive tax cuts in the 1980s put an end to that and started the explosion of wealth at the top which has led America to produce over 700 billionaires today. And gutted America’s ability to maintain first-class infrastructure.

Another way to put this simply is that tax cuts and tax increases on working class people are essentially irrelevant: Tax cuts only help the morbidly rich, while taxes reduce the national debt and help fund infrastructure and other programs that benefit working class people.

Over time, Ricardo’s “market for labor” will always normalize wages, regardless of tax rates on working-class people. But that rule does not apply to rich people because they can simply change their own income in response to tax policy: They are the only winners from tax cuts.

To stabilize our economy and re-empower working people, we must bring back the top tax bracket that existed before the Reagan Revolution. It’ll also provide the necessary funds to rebuild our country from the wreckage of Reagan’s neoliberal policies, which are largely still in place.

By taxing income in the very top brackets at a rate well above 50%, ideally the 74% rate we had before Reagan, we stabilize the economy, stop the relentless poaching of working peoples’ wages for the money bins of the rich, and begin restoring our middle class.

And raising taxes on the morbidly rich also funds government programs that support the middle class: things like healthcare, free public education, and anti-poverty programs.

It’s time to re-normalize taxes on the morbidly rich (and leave them where they are on working class people) so we can again have a growing economy and a prosperous middle class.