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April 29, 2012 2:28 pm

How to Think About Taxation and Spending (Part 2)

avatar by Gabriel Martindale

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In my last blog we saw how taxation and spending damages the economy in two ways: first by decreasing the incentives of those taxed to produce goods and services and, secondly, by removing recipients and administrators from the productive workforce. We also saw that it changes demand for various goods and services and so influences the production of them in a way that is inherently neutral (from an economic perspective), but can appear beneficial from a limited or partial vantage point. In the following examples we shall investigate further how tax and spend damages the economy.

Situation 5: Mr. B. has crisis of conscience and decides to desist from his income re-distribution activities. Mr A. can get back to buying his pizzas, but Mr C. has to stop buying his kebabs.

Analysis: In the long run, clearly, the economy is better off. Mr. A. once again has an incentive to produce more chairs that his customers want and Mr. B. and Mr. C. will also have to go back to producing goods for the general market to get what they want. However, in the short term only two effects will be noticed. The pizza shops profits will go up and the kebab shop’s profits will go down. Economically speaking, this is immaterial, but the owner of the kebab shop will likely be very angry, perhaps to a greater extent than the pizza maker is happy.

The case is even worse if, on the basis of the increased custom of various Mr. C.s, the kebab shop owner had expanded his business and hired more staff. He will now have to fire these extra people. Though the pizza maker can now expand his business and take on more employees, this will take time and, in the meantime, you have the phenomenon of unemployment. Though the economy is better off, in the short term you have what looks like a recession. This is important for conservatives to realize: though tax cuts are the right thing to do, they simply cannot result in the type of short term boost to the economy that tax cutters promise the electorate. When it looks like they do so something else is going on, as we shall see in situations 8 and 9. In the meantime, there is the inexorable double political problem that while the winners from taxation and spending are more obvious than the losers, the losers from cutting taxation and spending are more often more obvious than the winners. This is the phenomenon of concentrated gains and distributed losses (and vice versa). Whenever, say, a deprived city is “revitalized” by public funds this is what has happened; wealth has been re-distributed from a large group of people who do not notice to a smaller group of people who do.

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Situation 6: Mr. A. saves up $1,000 with which he plans to buy a new machine that will allow him to make his chairs to a better standard and at lower cost. However, on his way, Mr B. (back to his old tricks) takes the money and gives it to Mr C. who buys a whole lotta kebabs.

Analysis: By not spending that $1,000 on his personal enjoyment, Mr. A. had saved enough resources to invest in producing more, better and cheaper products to satisfy society’s needs. This is the only way an economy can grow. By taxing this money and giving it to Mr. C. to spend on consumption, Mr. B. has arrested this process. Diverting money from one form of consumption to another is, in itself, economically neutral; diverting money from investment to consumption produces short term prosperity at the expense of greater prosperity in the long run. In principle, governments could invest the money they tax; in practice the vast majority goes on consumption (or things like the military, which are actively destructive of resources). When governments talk about “investment” they are usually referring to relatively long term consumption (like hospital beds), not actual investment which increases the productive power of the economy (like a new machine that makes hospital beds cheaper). The reason for this is simple, to take people’s money and then spend it on things that produced no immediate reward would be electoral suicide; in parts of the world with less smoothly functioning political systems it could be actual suicide.

Note that in the short term the kebab maker profits like a bandit. Generally speaking, when economic stimulus “works” this is why.

Situation 7: As in situation 6, Mr. A. saves a $1000, but this time not to buy a new machine, but to replace his existing tools, which are on the point of wearing out. Once again, though, Mr. B. steps in and gives the money to Mr C. who embarks on one of his now legendary trips to the kebab shop. Three months later Mr. A’s tools do, indeed wear out and he has to shut up shop.

Analysis: In situation 6 we saw a situation where capital was saved in order to increase Mr. A.’s (and so society’s) productive base. Here we see a case where it was saved simply to maintain the existing one. The effect of confiscating this money and diverting it to consumption is not merely to restrict potential future prosperity, but to actually decrease it. Re-distribution of wealth can create false boom conditions where it looks like all is well, but, actually, the underlying prosperity of society is in decline.

Situation 8: Mr. B. has another change of heart, and now, instead of taking the $1,000 from Mr A. he offers to borrow it instead. Mr. B. offers to pay him back on the receipts of further burglaries from Mrs. C, D, E and G. and, conveniently enough, Mr A. forgets his former scruples about this sort of thing. Finally, Mr. B. hands over the cash to Mr. C. who takes his increasingly rotund family on another kebab outing.

Analysis: Mr. B. has just sold a government bond and, in the short term, we have a “tax cut”, so mainstream conservatives might be happy, but they shouldn’t be. The money has still been transferred from investment to consumption just as in situations 6 and 7. The only difference is that whereas Mr. A. was previously disgruntled, now he is happy. Expanding and even maintaining a business is always a risky enterprise, but government bonds guarantee a regular rate of return (at least until the whatsits hit the fan). The economic effect though is just the same as if he was taxed. Importantly, while taxation often transfers funds from investment to consumption (situations 6 and 7) government borrowing from private investors always does.

Two more points are worth noting. The responsible, honest tax cut in situation 4 created immediate losers and what we call a recession. In this version the kebab maker is still doing just fine. The second is that because Mr. B. now has a debt with interest, long term taxes will actually have to be more than if he had just taken Mr A.’s money. Again, the long term has been sacrificed to short term satisfaction, exactly as governments like it. We are almost in the worst of all possible worlds, but not yet.

(To be continued)

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