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The New Soul Mates

The Stock Market's Latest Convert: Government

May 07, 2000|David Friedman | David Friedman, a contributing editor to Opinion, is a Markle senior fellow at the New America Foundation

It was no surprise that a House committee extended the federal ban on Internet taxes last week, ahead of schedule and with little debate. By concentrating wealth in the hands of the richest, most heavily taxed Americans, the new economy is pouring money into federal and state coffers as never before. As a result, a new social contract has been struck, harmonizing the interests of a cash-rich bureaucracy, a burgeoning, stock-centered economic elite and middle and working classes who get big government without paying full freight.

This strange turn of events emerged in the mid-1990s when huge sums of foreign capital, drawn to the safety of the world's last superpower, and tax-favored retirement funds flooded into U.S. stocks. Blessed with limitless, relatively unsophisticated money and backed by a fawning media, Wall Street sold the new economy as fast as it could invent it. A torrent of initial public offerings, huge fund-management fees and stock options spectacularly enriched a select group of corporate executives, stockbrokers and investment bankers.

Richer people pay taxes at far higher rates than everyone else. The base federal tax for a family of four with an income of $1 million is a whopping $361,000. The same wealth held by 20 families with incomes of $50,000 generates 75% less federal revenue; Washington takes a paltry $13,000 from $1 million spread among 50 families. A dollar in the hands of the richest Americans is worth far more to the government than one held by working- or middle-class taxpayers.

Driven by stock-market capital gains, which more than tripled, and record corporate bonus and executive stock-option grants, upper-income wealth and tax revenues skyrocketed in the 1990s. Since 1993, the taxable income of the wealthiest 1.5% of all Americans grew by an astounding $600 billion, half the country's total increase in disposable income. As the super-rich pocketed more and more money, the Congressional Budget Office estimated that their share of all federal income-tax revenues climbed to more than 40%, from 29.8% just five years earlier. Nearly 60% of Washington's total tax windfall in the 1990s was drawn from less than 2% of the U.S. population.

These trends are also evident in new-economy hotbeds like California, where Department of Finance data shows that the richest 7.5% of all taxpayers gobbled up more than 40% of the state's income and paid 66% of state income taxes. Californians with taxable incomes of $20,000 or less comprised more than 40% of the state's taxpayers but contributed less than 1% of total income-tax revenues. Giddy state officials recently attributed all of California's $9-billion tax windfall in 1999--a 15% surplus above projected revenues--to capital-gains and stock-option income realized by the state's dot-com millionaires.

It was inevitable that relations among the government, the nation's stock-rich elite and the middle and working classes would be dramatically revised. Where state and federal bureaucracies were once skeptical of wealthy interests, in the 1990s they eagerly embraced the jackpot capitalism and trickle-down economics that so quickly rescued their budgets. Tax subsidies, trade policies and local land-use decisions skewed in favor of anything that created super-rich taxpayers.

Government, in fact, took an increasingly direct stake in its Wall Street benefactor. According to Federal Reserve Board statistics, since the mid-1990s, state and local government pension funds alone boosted their equity investments from $790 billion to more than $2 trillion. Even excluding federal-employee investments, such funds now own more than 10% of the entire U.S. stock market. Nearly 65% of the total retirement assets managed on behalf of state and local public employees depends completely on stocks.

For their part, the new rich have willingly shouldered their vastly disproportionate, growing share of the nation's tax burden as long as their incomes continued to rise faster than everyone else's. The government's take of the nation's gross domestic product could quietly be pushed to postwar highs even as tax rates for all but the wealthiest citizens dramatically fell. This bargain between government and America's wealthiest helps explain some of the new economy's most perplexing politics. For example, because public-sector unions now dominate working-class activism, the fact that working wages and benefits are stagnating relative to stock and corporate profits provokes surprisingly little unrest. Government budgets and public-sector jobs are among the biggest beneficiaries of the nation's wealth disparities.

Despite its apparent logic, tying public-sector finances so closely with stock-market windfalls is not without risk. Everything works fine as long as wealthy incomes and tax revenues rise rapidly and the rest of economy enjoys at least moderate health. Difficult conflicts emerge when the balance is upset.

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