For decades the US has experienced a capital shortage. The result of this has been the high cost of capital for existing firms and lack of opportunity for new firms. The federal government makes the problem worse by removing trillions from capital markets to finance the annual deficits and the huge public debt. It is time to fix this.
There are basically two inputs into the economy: capital and labor.
Regarding labor, the US has been experiencing a labor shortage for the past three years since the pandemic shutdown ended. That’s mostly due to a decline in the labor force participation rate. That means there is a lower percentage of adults either working or actively seeking work.
The labor shortage has pushed up wages in general and particularly in some key industries. While the labor shortage has decreased, even today there are more job openings than unemployed people.
This exists mostly because the unemployment problem is structural, meaning that there is a mismatch between the skills needed for the open jobs and the skills that the unemployed workers have. Eventually this should be minimized as market forces will drive young people toward the industries where job openings exist.
However, the labor shortage means that the economy must produce more new capital to see higher rates of economic growth, especially because ours is a capital-intensive economy.
The shortage of capital drives up capital costs. Most large corporations estimate that when new equity capital is raised the investors expect at least a 13% to 15% return. While corporations prefer to use internally generated capital or new debt, externally raised equity capital is also needed.
The cost of debt for most corporations is in the 6% to 8% range. The after-tax cost is in the 5% to 6.5% range, since interest expense is tax deductible.
The high capital cost often means potentially profitable projects may not be undertaken. If a new investment projects a 12% return, paying 13% or more for capital doesn’t make sense. However, if capital can be raised where investors expect only a 10% return, that investment will proceed.
New capital is created from two areas. One is from retained earnings of corporations. After a corporation pays their taxes and distributes dividends to stockholders, the remaining funds are retained for future growth.
Most of the new capital, however, comes from households, after personal taxes are paid and after funds are set aside for consumption. Higher income earners have the most savings.
If tax rates were lowered for the highest income earners, large amounts of new capital can be created. This can result in higher economic growth rates, increased tax revenue, reductions in government spending and perhaps a balanced budget.
President Bill Clinton realized this.
In 1996, Clinton was faced with large budget deficits and a slow growth economy. His solution was to lower the capital gains tax rate from 28% to 20%. The result was very positive. Total tax revenue increased, economic growth reached 4% annually for each of the next four years and he was able to incur a surplus in the budget.
Of course, he held the line on government spending when he declared, “The era of big government is over.” He worked with Speaker of the House Newt Gingrich to keep spending down.
His tax policy increased capital formation which led to lower capital costs and more capital available to business.
President Trump helped the capital shortage situation when he convinced Congress to reduce the corporate tax rate from 35% to 21%, in 2018. In addition, he convinced Congress to reduce tax rates from all Americans. The top rate was lowered from nearly 40% to 37%. That helped create new capital. It is not enough.
Despite some misconceptions, the Trump tax cut did not add one penny to the deficit as more tax revenue was collected in 2018 than in 2017.
Tax rates for entities that create capital should be reduced further. Clinton’s experience shows this will not add to the deficit but will indeed increase tax revenue which reduces the deficit.
Politically this will be difficult as the opposition will say this is just another ploy to give tax breaks to the wealthy. However, because the wealthy’s income will increase, they will be paying more, not less, taxes. And the goal is to increase tax revenue.
We are trying to bring manufacturing back from foreign countries. More capital will be needed since the manufacturing here will have to be capital intensive rather than labor intensive.
Let’ hope Trump can convince Congress and more importantly the American public that his economic policy must concentrate on capital formation.
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Michael Busler is a public policy analyst and a professor of finance at Stockton University in Galloway, New Jersey, where he teaches undergraduate and graduate courses in finance and economics. He has written op-ed columns in major newspapers for more than 35 years.