Capital Formation and the Fiscal Cliff: Your Perception Is Your Reality

John Mauldin |

President Obama Meets with Congressional LeadershipThere’s a very interesting article in The Atlantic this week, called “How Partisans Fool Themselves Into Believing Their Own Spin.” While the author, Alesh Houdek, engages in some spin of his own, he makes some very good points that we should keep in mind not only as we look at the potential effects of a tax increase but as we tackle new ideas and accompanying “facts” in general. And he has pointed us to a very interesting study, or at least it’s interesting for those of us who are fascinated by behavioral psychology and behavioral economics:

We weigh facts and lines of reasoning far more strongly when they favor our own side, and we minimize the importance and validity of the opposition's arguments. That may be appropriate behavior in a formal debate, or when we're trying to sway the opinion of a third party. But to the extent that we internalize these tendencies, they injure our ability to think and see clearly. And if we bring them into the sort of open and honest one-on-one political debates that we'd like to think Americans have with each other, we strain our own credibility and undermine the possibility of reaching an understanding.

A defense attorney presents the best case for his client's innocence in court, but he's realistic with himself about what he believes the truth of the matter is. Too often in political arguments we have drunk our own Kool-Aid.

A recent report on three psychological studies by professors from the University of California, Irvine confirms this bias, and points out that it's pervasive across a wide range of human situations. Where our moral judgements come into conflict with evidence, we look for ways to dismiss and minimize the evidence:

Quoting from the report:

“While individuals can and do appeal to principle in some cases to support their moral positions, we argue that this is a difficult stance psychologically because it conflicts with well-rehearsed economic intuitions urging that the most rational course of action is the one that produces the most favorable cost-benefit ratio. Our research suggests that people resolve such dilemmas by bringing cost-benefit beliefs into line with moral evaluations, such that the right course of action morally becomes the right course of action practically as well. Study 3 provides experimental confirmation of a pattern implied by both our own and others' correlational research (e.g., Kahan, 2010): People shape their descriptive understanding of the world to fit their prescriptive understanding of it. Our findings contribute to a growing body of research demonstrating that moral evaluations affect non-moral judgments such as assessments of cause (Alicke, 2000; Cushman & Young, 2011) intention (Knobe, 2003, 2010), and control (Young & Phillips, 2011). At the broadest level, all these examples represent a tendency, long noted by philosophers, for people to have trouble maintaining clear conceptual boundaries between what is and what ought to be (Davis, 1978; Hume, 1740/1985).”

This next paragraph is critical. Read it twice.

The studies further show that this effect is stronger in well-informed, politically engaged individuals. The more information we have, the higher our propensity to cheat with it. I've been talking to a lot of people on both sides of the election, and the thing I'm often struck by is an inability to find any validity in the opposing side's arguments. By blocking our ability to have meaningful conversations, this effect is actually harming political discourse.

Given that my readers are just about the most well-informed and politically engaged group of people anywhere, we have to make a special effort to think through controversial topics. I make the effort to constantly question my assumptions and to read people I don’t agree with. That is why Outside the Box (which highlights the writing of other analysts and thought leaders and is now published in Friday afternoon) features such a wide variety of thinking. And few things are more controversial than the coming tax increase. So let’s walk through a few ideas now and come to some conclusions independent of our biases….

Now, let’s talk about capital formation and tax increases. It seems that a number of people agree that taxes should be raised on millionaires. I’ve been on several panels and in numerous conversations where participants adamantly maintained that raising taxes on the “rich” would have no impact on the economy. I want to do a thought experiment with you and let you decide if there will be an impact.

Please note that this is not an argument for or against raising taxes. It may very well be in the common interest to raise taxes from where they are today. Remember the report on psychological bias we looked at briefly at the beginning of this letter. If you start with the assumption that raising taxes is either bad or good and then look for facts to support your belief, you will not help come to an unbiased conclusion.

Let’s start with your typical millionaire individual. For the ease of our math, let’s round off the numbers. The top federal tax rate is 35%, plus Medicare and property taxes, sales taxes, state and local income taxes, school taxes, etc. Depending on whether the individual owns a business, he or she may pay both sides of the Medicare tax. Let’s assume our millionaire pays 40% “all in” on his $1 million income. That leaves him with $600,000. Note that in some states and cities this could be much closer to $500,000. And some people will pay less. The numbers will change somewhat, but the logic will remain intact.

Let’s assume that our intrepid millionaire spends $300,000 maintaining his lifestyle, leaving him with another $300,000 to save and invest. (I’m also assuming he doesn’t have seven kids in private school, but that’s another story.)

Now, let’s raise his taxes by 5%, which is somewhat less than the likely increase in income taxes and Medicare taxes currently being discussed. Clinging gamely to his lifestyle, our millionaire now has $250,000 to save and invest. This still sounds like a lot to most people, and it is. But the economy now has $50,000 less in gross national savings.

Whether his taxes are 45% going to 50% or 55% going to 60% (think NYC), our millionaire will accumulate less capital over time. And that has to make a difference. How can it not?

Whether or not our individual millionaires decide to put her savings into bonds or to plow them back into her personal small businesses or any of a hundred other things she could choose to do with this money is immaterial. In the aggregate, when you add all the millionaires together, there is now less money available for capital formation. To think that their actions will be exactly the same as they would have been with 20% more money is ludicrous. They may still put money back into their businesses or invest in other businesses, but the simple fact is that they have less money to do whatever it is they want to do.

If they cut back on spending in order to maintain their savings and investment portfolios, then the merchants who sold them goods and services will have less. Yes, that money will be spent by the government on other goods and services, and to that extent it will show up in GDP. But to argue that there will be no impact on savings and investment and thus capital formation simply makes no sense.

This is an outtake from Thoughts from the Frontline, a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics. Each week John provides his insightful analysis on Wall Street, the global markets, and the rapidly changing world economy. Join his over one million readers today! www.frontlinethoughts.com

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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