Obama’s plan to fix the modern American economy—and why it won’t work

In this silicon wafer, you can see the future of the economy—and it is you.
In this silicon wafer, you can see the future of the economy—and it is you.
Image: Reuters/Joshua Roberts
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Tonight the US president, somewhat quixotically, offered a plan to fix problems that seem inimical to the modern global economy we live in today—the one where everyone seems to be winning except the developed world’s middle classes, where software is eating everything while capital sloshes around the planet like a big, silly golden retriever.

Barack Obama has this opportunity because the US economy seems to finally be out of crisis mode, with the private sector creating jobs and growth at a fairly steady, if not stellar, pace. With time and political capital running out, his administration is trying to address structural problems. Ever the intellectual, Obama has been listening to the debate about economic inequality that has captured even his erstwhile opponent Mitt Romney’s political imagination, and articulated the most comprehensive vision yet of his ”middle class economics.”

The Piketty critique

With global trade and investment restrictions relatively unfettered in recent decades, emerging markets have flowered, and wealthy nations enjoyed the supposed great moderation of inflation and unemployment, at least up until the 2008 crisis. The result was a period of significant income growth, documented in this chart, which the economist Paul Krugman cites as the chart to understand recent global history:

Image for article titled Obama’s plan to fix the modern American economy—and why it won’t work
Image: Branko Milanovic

Obama’s parochial problem is the relatively anemic growth of US middle class incomes in the valley of the chart—the fact that the US is the most unequal country in the developed world.A group of economists focused on the distributional challenges of capitalism, including Thomas Piketty, Emmanuel Saez, Gabriel Zucman and Milanovic, have spent recent years building data sets to track trends in wealth and income inequality. In the US, the last century has been a tale of escape and reversion, as Gilded Age excesses gave way to the broadly shared growth after World War II before the wealthiest of the wealthy began acquiring a significant share of total household wealth:

Image for article titled Obama’s plan to fix the modern American economy—and why it won’t work

You can also see this trend toward inequality in earnings:

Image for article titled Obama’s plan to fix the modern American economy—and why it won’t work

Last year’s breakout economics book, Piketty’s Capital in the 21st Century, argues that economists should stop taking for granted that the worker’s share of an economy’s income will remain stable. Instead, he fears that capital is increasingly able to replace labor thanks to technological development and a lack of massively destructive warfare. Investment returns outpacing low growth in wealthy countries—famously expressed as “R>G”—will exacerbate inequality to the point of undermining the political system. There are critiques of this argument, but so far it dominates the discourse on inequality.

“Let’s close the loopholes that lead to inequality by allowing the top one percent to avoid paying taxes on their accumulated wealth,” Obama said. ”We can use that money to help more families pay for childcare and send their kids to college.”

Obama’s tentative plan to reverse R>G

The biggest proposal from this State of the Union speech was Obama’s plan to raise taxes on inheritances, capital gains, and the liabilities of the largest banks. These tax increases largely target the wealthiest Americans, and are designed to fund tax cuts aimed squarely at the middle class: Tax credits to reduce the cost of raising a child, especially for families with two working parents; and to cut the cost of education.

“Middle-class economics means helping working families feel more secure in a world of constant change,” Obama said. “That means helping folks afford childcare, college, health care, a home, retirement—and my budget will address each of these issues, lowering the taxes of working families and putting thousands of dollars back into their pockets each year.”

His critics say this is redistribution. Indeed it is—but all taxation involves redistribution, and current US tax policy favors the very wealthy with a variety of breaks that leave them paying lower effective tax rates than average earners. In fact, the US does less to redistribute income than almost any other country, according to the OECD, a policy-coordinating organization. While the country’s measure of income inequality before taxes and transfer payments is average, it does less than 22 other advanced economies.

Image for article titled Obama’s plan to fix the modern American economy—and why it won’t work
Image: Janet Gornick/CUNY

Keep that in mind when you learn that, the bulk of what middle-income growth there was between 1979 and 2010 came from tax credits, government health insurance policies and transfer payments.

The other side of the middle income trap

Set aside for a moment that these policies will not be enacted by the current Republican Congress, and are simply Obama’s starting point for tax-reform negotiations. Would they do much on their own to stem inequality?

Probably not: Obama’s plan doesn’t even go so far as to tax investment income as regular income; it merely would raise the top rate to 28%, where it was set under conservative icon Ronald Reagan. And it is far from the global tax on wealth proposed by Piketty in an effort to affect greater redistribution. This isn’t to say that Obama’s tax twist wouldn’t be an improvement on the status quo or increase US prosperity, but it likely wouldn’t be enough to really to bend the curve, as the administration’s economists like to put it. Redistribution is important, but finding policies that encourage more productivity and higher market income for workers is important as well.

Trade deals, immigration reform and infrastructure investment—all part of Obama’s agenda—can certainly goose growth and employment, but they don’t necessarily hit middle-class incomes directly. The challenge for lawmakers is fixing the market structures behind the inequality problem of the modern economy—those that have led to increases in rent income earned unproductively by a few, at the expensive of higher costs for the rest. In the US, that might be real estate values inflated by local regulations and policies like tax-deductible mortgage interest, or intellectual property rules that diminish innovation, or antitrust efforts in highly-concentrated sectors.

It also means finding ways to rein in the rising costs and slowing productivity in sectors like education and health care. At least on the latter, the president’s health care law has shown promise at finding new efficiencies, but his education policy has been more focused on subsidizing access than controlling costs. Obama used his speech to articulate a strategy to fight inequality, but it will take many years and much creativity before the information economy shares its prosperity as effectively as the industrial one did. Or, as Obama put it, to “restore the link between hard work and growing opportunity for every American.”