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Conservative policies hurt the middle class

If you accept the theory presented in my last article that high income inequality helps create persistently weak and unstable economies, the question then becomes what causes inequality and how can it be reduced?

In my opinion, high inequality is a natural outcome of free-market capitalism. A healthy middle-class is a government-created phenomenon requiring strong labour laws and a progressive tax code (where rates increase as income increases). That's what we had in the postwar period until Margaret Thatcher and Ronald Reagan convinced much of the world to undo those very successful policies.

During the 1980 US Presidential election campaign, Ronald Reagan popularized the term "supply-side" economics. Also referred to as "trickle-down" economics, it advocates strengthening the economy from the top and allowing the benefits to trickle-down to the average person. The main tools of supply-side economics are income tax cuts, which primarily benefit the wealthy; deregulation, which benefits business; and union-busting. In the UK, Margaret Thatcher pursued similar policies.

Almost forty years later, we still have politicians — especially in the English-speaking world — promising to strengthen the economy by deregulating business and cutting tax rates. It doesn't work.

All things being equal, the wealthy will always have more economic power than the average person. They certainly don't need government policies that give them an even bigger advantage. Even the father of modern capitalism, Adam Smith, understood this back in the eighteenth century.

What are the common wages of labour, depends everywhere upon the contract usually made between those two parties, whose interests are by no means the same. The workmen desire to get as much, the masters to give as little as possible. The former are disposed to combine in order to raise, the latter in order to lower the wages of labour.
It is not, however, difficult to foresee which of the two parties must, upon all ordinary occasions, have the advantage in the dispute, and force the other into a compliance with their terms. ... In all such disputes the masters can hold out much longer. A landlord, a farmer, a master manufacturer, a merchant, though they did not employ a single workman, could generally live a year or two upon the stocks which they have already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment. In the long run the workman may be as necessary to his master as his master is to him; but the necessity is not so immediate.

The natural tendency for workers is to bargain collectively. But even then, when employers are motivated, they will always get their way in negotiations. As long as they hold out long enough, the workers will eventually concede. Just ask the BC teachers union.

And when corporations get big and powerful enough, it becomes very easy for them to prevent any collective bargaining in the first place. When eleven meat packers in Texas tried to form a union, Wal-Mart eliminated their positions and contracted out the work. When a store in Quebec unionized, Wal-Mart simply closed it.

How the income inequality problem was solved last time

Because of the Great Depression and the Second World War, income taxes rose dramatically to fund social safety nets and pay-down war debt. In 1949, the top combined federal and provincial tax rate in Canada was 84%. The rate stayed above 80% until the tax cuts of 1972. Today, the top rate is under 50% for all provinces except New Brunswick.

In the United States, the top federal tax rate went as high as 94% and remained above 70% until the Reagan tax cuts of 1981. Today it is under 40%.

Several economic studies, including Piketty, Saez and Stantcheva and the Congressional Research Service have demonstrated a high correlation between tax rates and inequality.

Tax Rates Vs Income Inequality

When tax rates are high, there is very little incentive for those at the top of the income ladder to grab all they can. There is also more willingness for executives to work with labour to adequately fund pension plans and other benefits. However, when tax rates are low enough, executives have a very strong incentive to maximize their compensation — usually at the expense of their employees.

Over the last few decades, we’ve seen plenty of examples of corporate actions designed to increase executive compensation: lagging employee pay, decreasing pensions, outsourcing, temporary foreign workers, stock buybacks, union busting and demands for business tax credits.

These things were not happening when top tax rates were over 70%.

The way back to a healthy middle-class seems pretty straightforward.

We did it once after the Second World War and I see no reason why the same policies wouldn't work again. We need to return to the progressive income taxation, strong labour laws and financial regulations put in place after the last failure of under-regulated free-market capitalism in the 1930s.

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