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April 23, 2012 1:12 pm

How to Think About Taxation and Spending (Part 1)

avatar by Gabriel Martindale

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World average GDP per capita 1500 to 2003. QWFP.

One of the great tragedies of the modern world is the widespread belief that the science of economics – a remarkable accomplishment of human thought that, when well used, greatly expands our understanding of the universe – consists in the manipulation of technical terms beyond the ken of the layman and/or complicated statistical analysis. Confronted with armies of experts with letters following their names (the vast majority of whom rely on either the government or central bank for their income) saying things that they can’t understand, the general public either supinely refers to the better judgement of a claque of men and woman who have got literallyeverything wrong consistently for the last ten years, reject economics entirely or fall back on a set of plausible sounding clichés that more or less approximate to the gobbledigook they see on T.V.

We can do better than this. Economics, properly conceived, is nothing more or less than logically thinking about human action within the context of social interaction. Some people are better at this than others, but there is no reason why any reasonably educated person equipped by his education with the basic tools of thought cannot, with a little bit of effort, understand economics. The only thing necessary is to ignore the purveyors of wilfully obscure scholastic jargon and to actually think, starting with what is simple and working to what is complex.

Perhaps no issue more clearly demonstrates the failure of the vast majority of people to exercise their civic duty and think about economic affairs than the area of taxing and spending; commonly held ideas about the “stimulative” impact of government spending are completely nonsensical.  Even worse, conservative “supply-side” arguments are also based on the same errors and non-sequiturs even when they are used to justify correct policies. My modest task over the next serious of posts is to work reasonably methodically through these issues, by making use of illustrative examples. If someone can spot a logical flaw in my reasoning, I would be happy to hear it; if they instead, as is usually the case with economics graduates, prefer to make crude appeals to authority, reference undefined economic concepts or fly from reason into the comfort blanket of regression analysis, they can keep it to themselves.

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Situation 1: At the end of the month Arnold (From now on Mr. A.), a carpenter, works out his profits and, rewarding himself for his toil, takes $20 and sets off on his way to buy a pizza; however, before he gets there Barry (Mr. B.) accosts him, takes the twenty dollars and buys a pizza himself.

Analysis: The economy remains unchanged, the pizza company has the exact same profits and losses as it would have if the burglary had never occurred, no extra purchases are made, none are forgone, no-one new is hired and no-one is fired. The only difference is that Mr A. receives less pizza related enjoyment and Mr. B. more: wealth has been redistributed and the control of social resources has shifted. This is a moral issue, though, not what we would yet call an economic one.

Situation 2: At the end of the next month, Mr. A. goes off once more to buy a pizza and is again robbed by Mr. B. who, as before, buys himself a pizza. This same thing happens again at the end of the next month, and the next one, until, finally, Mr. A. decides there is no point in continuing to try to buy a pizza. Since he makes $20 for every chair he sells, he makes one less the next month and, instead of going on a fruitless quest for a pizza, enjoys his extra leisure time.

Analysis: Now we are starting to get to grips with the problems of tax and spend. Whereas sporadic acts of criminality do not much effect people’s behaviour, persistent and regular criminal behaviour, including government taxation, changes incentives. In this case there is now one less chair per month for other people to buy and so either one less person gets the chair-related enjoyment they would otherwise have or they have to buy a less satisfactory or more expensive chair from someone else. Generally speaking, by confiscating profits, taxation changes incentives in a way that makes people produce less of the goods that other people desire; since prosperity consists precisely in people being able to acquire more of the goods they desire (and not, as some people bizarrely believe, increased nominal wages) this is evidently bad from an economic point of view.

Situation 3: Exactly the same as situation 2, except that instead of buying a pizza himself Mr B. gives the money to Charlie (Mr. C.), perhaps a member of some socio-economic, ethnic or religious sub-group that Mr. B. considers deserving, who then goes to buy a pizza himself.

Analysis: In this step we have reached “re-distribution of wealth”, a political hot-button issue, but of surprisingly little importance. If the pizza is bought it doesn’t really matter who buys it. The pattern of supply and demand has not changed at all and nor and the incentives for Mr A. What has changed in this scenario, though, is that another person has been removed from the workforce. Whereas in a crime free (= ‘laissez-faire’) economy Mr. B. and Mr. C. would have to provide goods and/or services for other people in order to be able to buy the things they want, now they don’t.  Mr. C., a recipient of welfare, now busies himself filling in forms for Mr. B. to justify his receiving free cash or is simply idle; Mr. B., who has become a government bureaucrat, is too busy taking money from one person and giving it to another to perform productive labour. The general public is deprived of the goods and services that might otherwise have been produced by two people.

Situation 4 The same as situation 3, except that when Mr. B. gives Mr. C. $20 he, instead of buying a pizza, goes over the road and buys a kebab instead.

Analysis: In this stage, taxing and spending has changed the pattern of demand, but, again, this is not very important. The pizza maker loses money and the kebab maker gains, but there is no overall economic impact. Assuming this pattern continues, there will, of course, be fewer pizzas and more kebabs produced to meet the changed demand, but that, again, is neither here nor there. There is no “correct” amount of pizzas independent from the number that consumers are willing to buy. We might say that the situation with fewer pizzas and more kebabs is morally inferior to the one with more pizzas and fewer kebabs because it rests on the intrusion of violence into peaceful social arrangements; a socialist will say it is preferable because unfortunate Mr C. deserves his kebab more than greedybags Mr. A. deserves his pizza; economically this is a non-issue.

There is one more thing to consider, though. The pizza maker does not know that without Mr. B.’s income redistribution activities he would be better off, but the kebab shop owner can very clearly see how he benefits from Mr. C.’s income. As the above analysis has shown, income redistribution benefits some and harms others, but leaves the whole community worse off by (i) reducing people’s incentives to produce and (ii) removing otherwise productive people from the workforce as bureaucrats or welfare recipients. However, those who gain from income redistribution can see this much more clearly than those who lose out (with one exception, Mr. A. the taxpayer). Accordingly, it is easy to see how taxation and spending “stimulates” some sectors of the economy, but much harder to demonstrate which areas it is harming. When it comes times for elections, not only do Mr B. and Mr. C. have an obvious stake in voting for more crime, so does the kebab shop owner. Mr. A. would be likely to vote for less crime, but he will have a tougher time persuading even the pizza maker, who directly loses out too, to join him, let alone the general populace who lose out indirectly.

(To be continued)

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  • Bella Ceruza

    Dear Gabriel,

    I am a total ignoramus with respect to economics and thoroughly enjoyed part 1 of – I hope – many more.

    However, I disagree with last line of your analysis of Situation 3 wherein you claim that ‘the general public is deprived of goods and services..that might have been produced by two people’. In fact I believe that it could be argued that the public is deprived of the produce of three people – ie:
    1. Mr A’s additional chair,
    2. the labour that the thief – Mr B – could / would perform if he were forced to – ie the chairs were protected better and theft was not so simple,
    3. – and I guess this one is arguable and the perspective depends on where one sits on the political spectrum – Mr C could potentially also produce something if handouts were not so easy. In any event, if he is not earning, and if handouts were not easy to obtain, and he has time on his hands, he could grind his own chickpeas and make his own kebabs instead of buying expensive take-aways!!

    • Gabriel

      I agree! But unfortunately I didn’t explain myself well enough. I meant that in situation 3 the general pubic is deprived of the services of two people (Mr. B and Mr C.) in addition to the loss of some (though not all) of Mr A.’s.

      I wanted to separate out of the two issues of (i) loss of incentives to producers and (ii) removal of people from the workforce either as government workers or welfare recipients.

      Be well.