Economic Populist Commentary

Economic commentary by a pro-capitalist, economic populist. Demand-Side Economic theory. Consists of author's economic views. Questions & comments appreciated. Dissenting views are VERY welcome and encouraged. Main "agenda" is crafting and advocacy of a "populist" economic agenda. A secondary goal is prevention of an economic Armageddon. Encouraging open discussion of US economy.

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Location: Southern California, California, United States

The author is a physician by profession, and a "student economist" by necessity. The current status of our economy necessitates the latter. The intent of this blog is to explain and discuss economics in layman terms. It is designed to promote thought and discussion. It is written by a layman. Comments and critiques of these theories and letters are welcome and ENCOURAGED. Dissenting comments are also WELCOME! They form the basis for discussion.

Tuesday, July 05, 2005

TAX CUTS & THE HOUSING BUBBLE





TAX CUTS & THE HOUSING BUBBLE

Optimal economic growth needs to play a bigger part in tax cuts and proposed tax changes. Tax changes should be based on economic reality, instead of "alternate reality." Demand-Side economic theory should be stressed, instead of Supply-Side economic mythology. Recent tax cuts have been designed with the latter in mind. These tax cuts were based solely on self-serving, Supply-Side "voodoo" economics.

Since consumption is necessary to drive economic growth, it must be considered when determing tax rates. Put differently, the "means of production" must be balanced with the "means of consumption." All production must ultimately be sold to make maximum profits. Profits are made by SALE of goods, not by production. Consumers must be able to purchase production. If taxation is slanted too much towards investors, consumers will not be able to purchase all of the potential production. They will have insufficient means of consumption. Spendable consumer wealth limits the amount of production that can be purchased. Spendable consumer wealth determines the size and value of the consumer market. It also limits the aggregate value of production. Unpurchased production does not increase profits. Nor does it contribute to economic "growth." Money used for excess production is money that would have been more beneficial if it had gone to consumers.


In addition, undertaxation of the "investor" class results in misuse or non-use of investment capital. This can be seen when industrial capacity utilization is less than optimal. Investment capital is used to increase industrial capacity. (i.e., buy more equipment, build new factories, etc.) If there is excess industrial capacity, there is no benefit to increased investment capital. There is no reason to increase industrial capacity, if it is already underutilized. Tax cuts for the "investor" class simply have no benefit here. As investors look for investment opportunities, 2 detrimental uses are made of this potential "investment" capital. Investors overinvest in the stock market, increasing price to earnings ratio. Stocks become overvalued. Small investors, and those in 401Ks and IRAs, have their retirement funds invested in overvalued stocks. Ultimately, overvalued stocks lose value. The large investors often see the fall coming. In addition, they can immediately sell their stocks and remove their money. The small investors, including the 401K and IRA investors, often don't see the fall coming. Worse still, they can NOT immediately sell their stocks and remove their money. As a result of these factors, many smaller investors suffer large financial losses when the overvaluation corrects itself. Thus, stock market over valuation hurts the 401K and IRA investors much more than the large investors. This stock market overvaluation ultimately results in transfer of wealth from small investors to large investors. Thus tax cuts that encourage over investment in the stock market increases the upward redistribution of wealth in this manner.

Add the above to the effect of increasing after-tax nominal income to the "investor" class more than the "consumer" class. Since unfunded tax cuts decrease "real" (or inflation-adjusted) income, the consumer class loses even more buying power. This loss of consumer buying power reduces consumer spending and demand for production.

The end result of high income tax cuts (for the "investor" class), is an increased ratio of means of production to means of consumption. If this ratio is already too high, these tax cuts REDUCE economic growth, instead of increasing it. There is no benefit to increasing production if consumers can't purchase the production. There is no benefit to increasing industrial capacity when it is already underutilized. We don't need to build new factories when many are unused, or at least underutilized.

Tax rates need to be adjusted to help the part of the economy needing the most help. Is our ability to produce goods limiting our growth, or is our ability to purchase goods limiting our growth? If consumer spending is 115-120% of consumer income, the answer becomes obvious. (15-20% of consumer spending is from borrowed money.) If corporate profits are high, and markets are "glutted with capital," the answer becomes even more obvious. We need to re-direct taxation to enhance the "means of consumption," not the "means of production." Investment capital is abundant at present. Spendable consumer money is not. Consumer income is only sufficient to purchase 80-85% of current production. With rising interest rates, and the consequent decrease in home equity value, the contribution of "borrowed" money will decrease. Since "real" consumer income has been decreasing, consumption will ultimately decrease. This, in turn, will reduce demand for production. Thus, more production will not help our economy. More capital investment will not help our economy. More spendable consumer income WILL help our economy.

The 2nd detrimental effect of these misdirected tax cuts is on the housing market. Since many high income taxpayers are worried about the stock market, they look for alternate investment opportunities. Real Estate is one of them. Over 1/4 of homes being purchased are for investment purposes only. In fact, in a May 5th article from the San Diego Daily Transcript, it was state that this fraction is even larger. California Association of Realtors President, Jim Hamilton, states that "repeat homebuyers...account for three of four home purchases in the state." The link for this article is:


http://news.yahoo.com/news?tmpl=story&u=/sddt/20050505/lo_sddt/majorityofcaliforniansmakelessthanhalftheincomenee

These are 2nd homes purchased by buyers intending to re-sell homes at a higher price. These homes are purchased largely by high income taxpayers, who have benefitted the most from the tax cuts. By purchasing 2nd homes, they greatly increase the price of real estate. They effectively reduce the supply of homes by 25%. By doing this, they raise the selling price of the remainder. (This is basic supply-and-demand theory. Decreasing supply ALWAYS increases price.) These 2nd home purchases make homes unaffordable for many people in this manner. Only 17% of Californians can afford a median-priced home. The unaffordability of homes is multi-factoral. Low mortgage rates and "creative" financing have added to tax-cut enhanced real estate speculation. Low mortgage rates simply allow buyers to purchase homes with higher assesed value, due to the reduced cost of borrowed money. Many buyers borrow off the equity of one home to purchase a 2nd home for investment. This makes it even harder for the average American to purchase a home.

unlawflcombatnt

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16 Comments:

Anonymous Anonymous said...

You following comment is not accurate:

"Small investors, and those in 401Ks and IRAs, have their retirement funds invested in overvalued stocks. Ultimately, overvalued stocks lose value. The large investors often see the fall coming. In addition, they can immediately sell their stocks and remove their money. The small investors, including the 401K and IRA investors, often don't see the fall coming. Worse still, they can NOT immediately sell their stocks and remove their money. As a result of these factors, many smaller investors suffer large financial losses when the overvaluation corrects itself. Thus, stock market over valuation hurts the 401K and IRA investors much more than the large investors. This stock market overvaluation ultimately results in transfer of wealth from small investors to large investors. Thus tax cuts that encourage over investment in the stock market increases the upward redistribution of wealth in this manner."

Firstly, small IRA and 401(k) holders can sell their holdings quickly, as they only have a few thousand shares of this or that company. If they are overvalued, sell the stock, and wait for a correction to make it a value buy. They can park their money in a money-market fund until the correction ensues.

Large investors have a much more difficult time pulling there funds out of the market, because they own millions of shares of a company. They need a buyer to sell to, and it takes a much longer time to distribute their millions of shares than it does for an individual to sell his hundred shares.

It is true that the small investor often does not see the correction coming, for which there is no excuse for the individual, or blame to the larger investors. If the individual does not know what he is doing with his money, he should not be doing it. Just as someone who buys a $3M home which is only worth $500k is asking for a loss, so is the unwary investor with his IRA investing into over-valued companies.

If anything, tax cuts for the rich, entice them to place their extra funds into an over-valued market, which then disappear with the next correction. This then levels the playing field. The poor don't even know what the S&P500 is, maybe some NASCAR race. Much less do they have any money in the market.

10:05 AM  
Blogger unlawflcombatnt said...

Anonymous,

Thank you for your comments. I disagree with you about large vs. small investors. Large investors usually do understand the market better and do understand how to get their money out faster. They usually are aware of market changes sooner than small investors. They are also more likely to be in more direct control of their stocks than small investors are. I doubt many people would agree with you when you state it is more difficult for large investors to get their money out than it is for small investors.

You've stated that small IRA and 401K holders can sell their holdings [more] quickly. I assume you mean as compared to large IRA and 401K holders. That may be true, but IRA and 401K holders have more trouble selling their shares than people whose funds are not in IRA or 401K accounts. And there are a lot more large investors holding money outside of IRA and 401K accounts. And for that reason, it is generally easier for large investors to liquidate than small investors.

I have to agree with you that those who don't know what they're doing should not be investing. However, many small investors rely on the advice of brokers, and have been brainwashed by the media that they simply must invest in the stock market. Furthermore, many of those with retirement accounts that are invested in the stock market have limited control over their investments. Again, this is completely in contrast to the extensive control many large investors have over their investments.

I again agree with you about tax cuts for the rich causing them to overinvest and overvalue the stock market. They've also done the same thing in real estate.

Though you state this excessive investment and overvaluation will disappear with the next correction, it is often the sale of stocks by large investors that causes the correction. Many of them get their money out before a full correction takes place. As a result, much of the effects of the full correction are born by small investors. That's exactly what happened in 2001. I know because I was one of those small investors. Though I lost quite a bit, I didn't lose everything. However, many relatively small investors did lost almost all of their retirement funds in the crash.

The overinvestment by the wealthy is what caused the bubble in the first place. A lot of the less wealthy were sucked in as well. A great way to prevent this problem is to tax the affluent enough so that they can't overinvest. The excessive availability of investment capital is doing nothing good for our economy. It is simply overvaluing assets if it's actually invested. And it pulls money out of our economy if it is not invested. That tax-cut money would be better used if it was going into the pockets of consumers, rather than investors.

Real estate is the site of most current overinvestment. It has made homes largely unaffordable for many Americans. In California, only 14% of our 35 million population can afford a median-priced home. The only "benefit" to this tax-cut facilitated overinvestment is that it has allowed for increased consumer spending through borrowing off the inflated home equity. But this "benefit" is going to make the ultimate deflation of the housing bubble that much worse. When this debt bubble does finally pop, our economy is going to "pop" as well.

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