I have been busy working on a graph. It has required lots of number crunching going back to 1953. I had to do over 240 circular flow charts. Each chart is needed to calculate each point of data I wanted to look at. What is the data that I wanted to look at?... The percentage of capital income that is used for consumption of finished goods and services.
The consumption rate of capital income is revealing in many ways. Theoretically, capital income, especially in the form of retained earnings by corporations and capital gains would be used for saving and investment, while labor income is used for consumption for personal needs and desires. However, a portion of capital income is used for consumption, when the incentive is there.
Here is the graph showing the changes in the consumption rate of capital income since 1953...
The consumption rate of capital income reached 40% in the 1960s and then fell to almost 0% during the 1980 recession. Why the dramatic drop? And if we look to 2013, we see that the rate is making a comeback.
What could be going on here?
Well, as I inputted decades of data using dozens of sheets of paper, patterns appear. One clear pattern is the effect of tax rates. In the following graph I show the effective tax rates for capital income and for labor income. These are the effective tax rates used to determine the data in graph #1 along with the national income accounting numbers. (source for effective tax rates on capital income.) (source for national income account data.)
The main thing to look at in graph #2 is the spread between the effective tax rate for capital income (yellow line using left axis) and the effective tax rate for labor income (red line using left axis). As the effective tax rate for capital income fell in the 1950s, more capital income was used for consumption purposes, because we see the rate for capital consumption rise and reach a peak over 40% in 1965. (Capital income consumption is the blue line using the right axis.)
Then in 1967, the effective tax rate for capital income began to rise, while the effective tax rate for labor income began to fall. It became cheaper to use labor income for consumption. The result was a fall in using capital income for consumption. The fall continued all the way to almost 0% during the 1980 recession, at which point the effective tax rate for capital started to fall. The "writing must have been on the wall" that the effective tax rate on capital income was too much.
Since 2003, the consumption rate for capital income has been rising. We also see that the effective tax rate on capital income has been falling since 2003 too. The effective tax rate on labor income has been falling too, but the spread has narrowed which makes using capital income for consumption marginally cheaper.
There is an interesting thing in graph #1... The start of each recession since 1970 (taking out the Volcker induced recession of 1981) was preceded by the consumption rate of capital income falling. The implication is that one could foresee a recession by watching capital income's rate of consumption.
There is a reason why capital income could foretell a recession.
Leading up to a recession, profit rates will peak and then back-off. At that moment, more capital income is retained by the corporation for its protection. The result is less funds for consumption. It looks as though the consumption rate of capital income will decline for at least a year before a recession.
Graph #1 shows us that the consumption rate of capital income is still rising, which means that a recession is not yet on the horizon. When the consumption rate of capital income and the UT index are combined, it appears that the ability to foretell a recession becomes better. That issue will be for another post.