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The New Soul Mates

By David Friedman
Senior Fellow

Los Angeles Times
May 7, 2000

It was no surprise that a House committee extended the federal ban on Internet taxes last week, ahead of schedule and with little debate. By concentrating wealth in the hands of the richest, most heavily taxed Americans, the new economy is pouring money into federal and state coffers as never before. As a result, a new social contract has been struck, harmonizing the interests of a cash-rich bureaucracy, a burgeoning, stock-centered economic elite and middle and working classes who get big government without paying full freight.

This strange turn of events emerged in the mid-1990s when huge sums of foreign capital, drawn to the safety of the world's last superpower, and tax-favored retirement funds flooded into U.S. stocks. Blessed with limitless, relatively unsophisticated money and backed by a fawning media, Wall Street sold the new economy as fast as it could invent it. A torrent of initial public offerings, huge fund-management fees and stock options spectacularly enriched a select group of corporate executives, stockbrokers and investment bankers.

Richer people pay taxes at far higher rates than everyone else. The base federal tax for a family of four with an income of $1 million is a whopping $361,000. The same wealth held by 20 families with incomes of $50,000 generates 75% less federal revenue; Washington takes a paltry $13,000 from $1 million spread among 50 families. A dollar in the hands of the richest Americans is worth far more to the government than one held by working- or middle-class taxpayers.

Driven by stock-market capital gains, which more than tripled, and record corporate bonus and executive stock-option grants, upper-income wealth and tax revenues skyrocketed in the 1990s. Since 1993, the taxable income of the wealthiest 1.5% of all Americans grew by an astounding $600 billion, half the country's total increase in disposable income. As the super-rich pocketed more and more money, the Congressional Budget Office estimated that their share of all federal income-tax revenues climbed to more than 40%, from 29.8% just five years earlier. Nearly 60% of Washington's total tax windfall in the 1990s was drawn from less than 2% of the U.S. population.

These trends are also evident in new-economy hotbeds like California, where Department of Finance data shows that the richest 7.5% of all taxpayers gobbled up more than 40% of the state's income and paid 66% of state income taxes. Californians with taxable incomes of $20,000 or less comprised more than 40% of the state's taxpayers but contributed less than 1% of total income-tax revenues. Giddy state officials recently attributed all of California's $9-billion tax windfall in 1999--a 15% surplus above projected revenues--to capital-gains and stock-option income realized by the state's dot-com millionaires.

It was inevitable that relations among the government, the nation's stock-rich elite and the middle and working classes would be dramatically revised. Where state and federal bureaucracies were once skeptical of wealthy interests, in the 1990s they eagerly embraced the jackpot capitalism and trickle-down economics that so quickly rescued their budgets. Tax subsidies, trade policies and local land-use decisions skewed in favor of anything that created super-rich taxpayers.

Government, in fact, took an increasingly direct stake in its Wall Street benefactor. According to Federal Reserve Board statistics, since the mid-1990s, state and local government pension funds alone boosted their equity investments from $790 billion to more than $2 trillion. Even excluding federal-employee investments, such funds now own more than 10% of the entire U.S. stock market. Nearly 65% of the total retirement assets managed on behalf of state and local public employees depends completely on stocks.

For their part, the new rich have willingly shouldered their vastly disproportionate, growing share of the nation's tax burden as long as their incomes continued to rise faster than everyone else's. The government's take of the nation's gross domestic product could quietly be pushed to postwar highs even as tax rates for all but the wealthiest citizens dramatically fell. This bargain between government and America's wealthiest helps explain some of the new economy's most perplexing politics. For example, because public-sector unions now dominate working-class activism, the fact that working wages and benefits are stagnating relative to stock and corporate profits provokes surprisingly little unrest. Government budgets and public-sector jobs are among the biggest beneficiaries of the nation's wealth disparities.

Despite its apparent logic, tying public-sector finances so closely with stock-market windfalls is not without risk. Everything works fine as long as wealthy incomes and tax revenues rise rapidly and the rest of economy enjoys at least moderate health. Difficult conflicts emerge when the balance is upset.

As share prices rose beyond all rational calculation, Wall Street developed an insatiable need for capital. The supply of stocks so outstripped demand by late 1999, for instance, that many believe only the brokerages' extension of more than $250 billion in margin credit, the most ever, to stimulate buying avoided a painful crash. In a hair-trigger market, anything that shifts money from stocks--the merest threat of rising interest rates, wages or energy costs, for example--can cause a panic.

Government, of course, is supposed to impartially administer the nation's laws. But if public fiscal solvency, and the very health of government-employee pensions, are overwhelmingly dependent on stock wealth, can the state reasonably be expected to dispassionately regulate the economy against what may be its own self-interest?

What happens, for example, when more of the working class tires of slow wage growth during times of plenty and begins demanding a greater share of the new wealth, as Los Angeles janitors did? A reinvigorated private-sector labor movement would redistribute capital from wealthier, high-taxpaying individuals to those with far smaller incomes in much lower tax brackets. Should government encourage such trends and promote social equity even if public budgets and pension funds would be adversely affected?

Suppose environmental or foreign instability drives up energy costs, which fortuitously remained stable, or even fell, throughout the stock-market boom. Should the U.S. abandon its ecological agenda to limit diversions of capital to buy energy and protect public finances? Would the risk of oil or other energy-supply disruptions, a development that would likely wreak stock-market havoc and severely reduce windfall-tax revenues, justify a Desert Storm-like military deployment?

Global economics pose even tougher questions. The United States has been blessed with a mammoth stock-market run-up and low inflation despite a record trade deficit, in no small measure because import prices fell while foreigners exported their capital back to America. In effect, we could buy more things with other people's money at much lower than normal prices, a trade and investment pattern without a historical parallel.

If import prices suddenly rise or overseas investors repatriate capital to home markets, U.S. inflation would likely spike, stock prices plummet and public finances bleed red. Is preserving today's odd global status quo therefore critical to U.S. national security? Must the U.S. limit overseas expansion and consumption of capital, perhaps by encouraging the sort of deflationary financial attacks that so recently crippled the once highflying Asian economies?

The five interest-rate hikes so far by the Federal Reserve Board make clear just how precarious new-economy public policy can be. To curb inflation, the Fed has repeatedly acted to restrain wages and prices by boosting the cost of money and trying to throttle expansion. Stock markets typically like such policies because corporate revenues rise when labor and supply costs fall. But rising interest rates also lure fund managers away from equities into safer investments like higher-yielding CDs. If the Fed's anti-inflationary stance too abruptly upsets the balance between stock-investment flows and slow wage and price growth, it could push the economy into recession.

The United States is woefully unprepared for such possibilities. It has bet the house on information-age business and finance, to the exclusion of almost everything else. This strategy served well over the last few years, but should its profound public- and private-sector conflicts once again become overt, it may yet prove a costly bargain indeed.

Copyright: 2000 Los Angeles Times

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