The Economy

Dec. 21, 2004
Consumers hold key to economic boom.

The recent strength of the economy has finally cleared out the recessionaries who were sure the economy would stumble this year, and now the track is clear for rapid growth forever. Except it isn't. If you ask most people why the economy has performed so well during the last few years, the answers will range from low inflation and interest rates, to balancing the budget, to the technological revolution. Admittedly, all of these have played some role. But the biggest development has been the boom in consumer spending, fueled by a decline in the personal saving rate from 5% to 0% in the last five years. Indeed, during the last quarter the personal saving rate turned negative for the first time since 1933. Personal savings cannot possibly continue to decline at this rate, which means (a) income must rise faster or (b) consumer spending will slow down -- in which case the boom quickly comes to a halt. In 1992 federal personal income taxes were $476 billion, or 10.8% of total personal income excluding transfer payments. By 1998 taxes had risen to $829 billion, or 13.9% of personal income less transfers. If the tax rate had remained unchanged, federal income tax receipts would have been $645 billion, which means consumers faced a de facto $184 billion tax increase last year. Some of that represented higher rates, some represented faster growth in upper-income wages and salaries, and some reflected the booming stock market and bigger capital gains. One of the major reasons consumer spending rose so fast in spite of the massive tax increase was that the stock-market boom created a great deal of additional spendable income that isn't included in the government measures of income. In other words, the drop in the saving rate was caused by the combination of higher taxes and a booming stock market. As long as this combination continues, the budget surplus keeps expanding, and consumption and real GDP keep rising at above-average rates. Also, in many cases, employees receive stock options in lieu of high salaries and hence consider these gains as part of their regular income. The same holds for bonuses and profit-sharing agreements that are tied directly to the price of company stock. Indeed, the proliferation of such arrangements is one of the reasons why the correlation between the personal saving rate and the stock-market gains has strengthened in recent years. The experience of the last five years suggests that a short-term setback in the stock market will have no measurable impact on consumer spending. However, prolonged weakness in the market would topple the consumer boom and cause sluggish growth in the overall economy. Obviously, the stock market cannot continue to rise 30% per year forever. A maximum rate of no more than 10% is sustainable in the long run, even if interest rates remained unchanged and the market were currently at equilibrium. Even that figure would be higher than the average long-run gain of 8% in corporate profits and what appears to have been only a 1% gain last year. In the 1990s an increase in the average annual stock-market gain from 10% to 30% has reduced the personal saving rate from 5% to 0%. Hence a return to a 10% annual growth rate in stock prices would probably boost the saving rate back to 5%. If that occurred over a five-year period, which means the saving rate would rise one percentage point per year for the next five years, it would probably cut the growth rate for the overall economy from 4% to 2%. The way out of this is very simple: Cut income taxes. Yes, I know readers will say that such a move would erode the budget surplus and turn it back into a deficit. I have news for you. If the economy slows down to 2%, the budget will slip back into deficit anyhow. Yes, the economy seems wonderful right now. But as the stock market falters later this year, consumer euphoria will begin to unravel. If substantial tax cuts are not implemented, a year from now the great boom of the 1990s will be only a distant memory. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill. His e-mail address is [email protected].

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