Skip to main content

Verified by Psychology Today

President Donald Trump

Up with the Wealth Gap!

Basic math shows how the corporate tax cut gives a quantum boost to inequality.

Polls showed that the bad shake the American working class had been getting from global competition and the influence of Wall Street on American politics had been major drivers behind both the competitiveness of Bernie Sanders in the Democratic primaries and the success of Donald Trump in the Republican primaries and general election in 2016. Yet Trump and the Republicans have just delivered America’s rich what may well be the biggest one-time shot in the arm ever, in the form of a 14-point cut in the corporate tax rate with no countervailing high-end income tax increase.

Did you know that all on its own, the corporate tax rate cut can account for an increase of 21.5% in the value of the stock market? With the top 20% of Americans, by wealth, already controlling more than 70% of household wealth in the U.S., the top 1% controlling about 40% of total wealth, and the lion’s share of traded equities being in the hands of these groups’ members, this means a huge boost to U.S. wealth inequality. Those in the top 1% by wealth have about 27% of their assets in the form of stock, with the next 19% by wealth having about 16% in that form, while the middle 60% of households by wealth have only about 3% of their net worth in stock, and the bottom 20% have negative net worth. A 21.5% increase in the value of their stock thus implies a roughly 6% increase in the overall wealth of the top 1%, a 3½% increase in the wealth of the next 19%, and a roughly a half-percent increase in wealth for the middle 60%, further exacerbating the wealth gap.

Why would the bottom 80% of the U.S. income and wealth distributions put up with this? Part of the answer is probably that very few understand the principles of finance. I wager that even most of the congressmen who voted for the recent tax reform can’t follow the simple logic of the next paragraphs. Even your average financial advisor is very likely not to recognize the basic principle. But the billionaires who pressed the Republican congressmen and senators whom they helped elect to pass the reforms that President Trump signed on Dec. 22 get it, and they’ve earned enough extra profit from the deal that they can spend hundreds of millions on advertising in the coming election cycle that will carry the obfuscating message to working Americans that the measures are “good for the economy,” hence “good for you.”

Finance 101: The math

A share of corporate stock is simply a fraction of the ownership rights to the company in question. Suppose that a company has only one class of stock, of which there are 10,000 shares outstanding. The company thus belongs to the owners of the 10,000 shares. Each shareholder’s proportion of ownership is simply that fraction of the shares which he or she owns. A shareholder owning 1,000 shares owns 10% of the company, and one having one share owns 0.01%. If the aggregate value of the shares is $100 million, the one with 1,000 shares owns $10 million worth of that company’s stock, the one with one share owns $10 thousand worth of the company. What does ownership entail? Three things. Owners of a company are entitled to its profits, get to determine how it is managed or appoint its managers (doing this indirectly, in a corporation, through its board), and have the right to sell their shares, thus capitalizing the value others believe the company holds. The value of a share is its fraction of the value of the company, and the value of the company is simply the estimated value of its net profits in perpetuity, with appropriate discounting for waiting as applied to profits in the distant future.

Many fail to understand that the share values of corporations represent anticipated profits quite as much as do shares of privately held companies. The reason is that the link between profits and value is partly obscured by the fact that companies need not divvy their profits up to their shareholders, i.e. pay them out as dividends. However, in law and in practice, the profits belong to the shareholders, who are the legal residual claimants of the corporation’s revenue stream. The reason dividends are typically less than profits is that management is entrusted with the responsibility of deciding whether a given dollar of profit is worth more to shareholders when paid out to them as dividends—in which case the shareholders can invest them in whatever activities they find most attractive—or when retained by the company to invest in the business. If, on her own, the typical shareholder can find investments returning only 5% per year on capital whereas the company has new investment opportunities that will return 6%, management is doing the shareholder a favor by holding onto the money and reinvesting it. This part of the shareholder’s profit is not lost to her. Rather, it is expected to generate still more future profit, and if there is general concurrence on that expectation, the future profit will be reflected in an increased stock price. And that’s all there is to the basics here. In the long run and on average, shareholders receive all of the profits of the companies they own, but in the dual form of dividends and share price appreciation, not in the simpler form of a full profit payout.

So now that we know that the value of shares is the anticipated, time-discounted value of companies’ profit streams, how should we evaluate the impact of a corporate income tax rate change? Also very simple. Just start with the obvious idea that everything said above should really have specified not total profit, but net profit after taxes. It’s only the profit net of taxes that belongs to the owners, not the profit as a whole. And with this, we’re basically done. Until Trump signed the tax reform, the tax rate on corporate profits was 35%. Once he signed it, it became 21%. To make things simple, suppose that the total amount of the corporation’s profits is the same before and after this change. Suppose, again, that that profit was $100 million a year. So, in the year before the tax change, the aggregate after-tax profit of the owners was $65 million. And in the year after the tax change, the aggregate after-tax profit of the owners will be $79 million. So after-tax profit will rise by $14 million. That’s a rise of about 21.5% in the total after-tax profit netted by owners ($14/$65 ≈ 0.2154 ≈ 21.5%). So, if nothing else changes, corporate stockholders’ shares’ values should have risen by over 21% thanks to the cut in the tax rate, provided people believe that the cuts will stick.

Complications

There’s a case, to be discussed elsewhere, that the U.S. corporate income tax rate was too high relative to that in other advanced countries. The issue is too complicated to evaluate in this short post, in part because few companies really paid the full rate. There’s also scope for a much broader discussion of the desirability of negotiating appropriate tax rates internationally, to avoid a race to the bottom that simply enriches the world’s wealthiest at the expense of the vast majority of its people.

A more important point for immediate purposes is that if a downward adjustment in the corporate tax rate was really required by considerations of international competitiveness, this could have been done without exacerbating the already growing U.S. wealth inequality. We often hear complaints about double taxation: corporate profits are first taxed at the level of the corporation, then taxed at the level of individuals and households, in the form of taxes on dividend income and on capital gains. But the flip side of this remark is that it would be easy enough, conceptually, to undo the negative effect on wealth inequality caused by a sharp drop in the corporate tax rate by raising personal income taxes, including those for capital gains, for those at the top of the U.S. income distribution. And of course this didn’t happen under the Republican plan. Quite the contrary, the bill that was just signed included a larger personal income tax cut for those in the highest income bracket than for those in lower brackets, exacerbating inequality still more.

Finally, let me anticipate an obvious counter-argument to the simple financial math above. Stock prices went up when the tax reform passed, but not by a full 21.5% all at once. So is my analysis just ivory tower theorizing? Not at all. The main reason that the share prices of U.S. companies didn’t jump instantaneously in proportion to the percentage increase in after-tax-profits is that prices had already begun to rise in anticipation of such a change the moment the current president and Congress were elected. Expectations continued to adjust gradually as details were negotiated and as the probability of passage became more certain. By the time the new bill had passed, the Dow Jones Industrial Average had risen about 55% from its level before the November 2016 election, factoring in not only the tax reform but also changes in business and environmental regulation, improving global economic trends, etc.

Conclusion

The tax legislation recently passed by Congress and signed by the president elected by Americans unhappy with how the economy has treated them the past few decades, hands a massive wealth increase to top asset owners that is certain to exacerbate, not improve, wealth and income inequality in the United States. The overall effects of current economic policies will work through a great many channels, and some of them will doubtless benefit some working people. But on the whole, the bottom 80% will almost certainly be hurt, on balance, by the cuts in government benefits and services that will be required to pay for this generous gift to the rich. What is the lesson for democracy? One lesson seems to lie on what conservatives like to call the “supply side,” though my take might not match theirs. The demand for people who can be taken advantage of by the wealthy is more than amply matched by the supply. In economics jargon, the supply of gullible people is highly elastic. According to the Census Bureau, the U.S. has about 4 million births a year, which works out to 11,000 births a day and to 7.6 births a minute. Our current political morass suggests that there may have been more than one sucker born each minute, during the decades before the new millennium. And with our education system further hobbled by the defunding the Christmas tax cuts will require, many more of the gullible-at-birth will reach the age to pull a voting booth lever without the wherewithal to understand how badly they’re being taken advantage of.

Can we turn this around?

advertisement
More from Louis Putterman Ph.D.
More from Psychology Today
More from Louis Putterman Ph.D.
More from Psychology Today