Posts Tagged Tax and Spend

Why Tax Increases Can Be Expansionary

In my quest to rationalise my desire for the state to control every aspect of people’s lives, I have formulated and collected together a few reasons that tax increases may actually be expansionary. This is an ex post justification, in light of apparent empirical evidence that they don’t have the negative effects so often attributed to them.

To understand why tax increases might be expansionary, we don’t have to abandon the logic of ‘econ101’ entirely – that is, if you reduce the reward somebody gets for doing something, or increase its cost, they will do it less. However, a couple of real world mechanics – which are omitted from economic thinking – can use this logic to conclude that tax increases could potentially be expansionary:

(1) Many productive activities are tax-deductible. Profits that are reinvested are not taxed; similarly, corporation tax is deducted from the cost of employing someone. So the higher these taxes, the greater the incentive to engage in these activities. There is potentially a point where the negative impact of the tax outweighs these positive effects, but we don’t appear to be anywhere near it.

(2) Economic rents are highly pervasive, particularly at the top. Taxing this activity discourages it and hence encourages productive activity. According to Michael Hudson, this was the intent of the original income tax. A clear example of this effect is the Land Value Tax – if landlords are charged for sitting on their land doing nothing, it encourages them to make some money, or sell the land to someone who does.

There are also some other mechanisms that suggest tax increases might be expansionary, some of which I have explored in earlier posts:

(3) The fact that the income effect is stronger than the substitution effect can mean that higher income tax makes people produce more; that is, when faced with higher taxes, people will have to work longer hours to recoup their post-tax income. This adds to gross national product.

(4) Cutting taxes at the top can simply inflate the price of positional luxury goods and hence do nothing to help real production; if that money were redistributed, it would be spent on ‘normal’ goods and hence have more impact on growth.

(5) Governments can spend your money better than you, so higher taxes and spending will increase the productive potential of the economy.

(6) Another interesting proposition from James Kroeger: tax and spend means more money is spent.

The crux of the argument is that it is reasonable to say the population as a whole has a Marginal Propensity to Consume (MPC) of less than one – they save some of their income. The government, on the other hand, has an MPC of at least one. Hence, should money be taxed and spent, there is a high possibility that this increases national income.

Kroeger also notes that people often confuse the expansionary effects of borrowing with those of tax cuts. To fund tax cuts, the government often has to borrow to sustain current levels of spending. However, in this case it is the borrowing that is expansionary, rather than the tax cuts. To truly see the effects of reducing taxes, we’d have to reduce taxes and spending by the same amount.

Another point worth noting is that, whilst taxes might have a deadweight loss in the area to which they are applied, the money that would have been spent does not disappear – it can go into other areas. In other words: if you tax cars then people might spend less on cars, but they’ll also have more to spend elsewhere. So taxes are more likely to change the composition of national income than the total.

Some of these effects are stronger than others; maybe some are negligible or based on faulty reasoning. But the overall combination of conflicting effects makes the story far less clear cut than the basic ‘econ101’ approach to taxes would have you believe.



Tyler Cowen’s Awful Reasoning

Tyler Cowen, in the interests of making the blogosphere waters ever muddier, has written a deeply misleading and confusing post about what exactly constitutes ‘austerity’:

Let’s say that private gdp is 100 and government spending is 100.  Gdp then suddenly goes up to 200, so government spending as a percentage of gdp falls from 50% to 33.3%.  This is not a contractionary event.  It is fully possible to argue “government spending should go up too, to slot more public goods into the larger output,” but the initial change is expansionary, even though government spending as a percentage of gdp took a steep dive.

OK, here’s the problem: this is an absolutely ridiculous scenario that, for all intents and purposes, cannot happen. GDP and government spending/revenue are inextricably intertwined, so an increase in one will almost certainly affect the other. The only way this wouldn’t be true would be if the sector of the economy that grew were completely taxless, and so separate from the other sectors of the economy that it could barely be considered a part of the economy*.

If GDP grows, we expect government spending as a sector of GDP to grow by roughly the same amount**, in the absence of any changes to policy. This is because taxes are collected as a percentage of income, and as income grows governments must pay their staff more, too (I despair that I had to write that sentence). If the government were to pay its staff comparatively less this would be contractionary.

Let’s take the UK economy as an example. The government hasn’t really adopted any major new functions since the welfare state was established post-WW2:

Anyone familiar with UK economic history will recognise the various fluctuations, but overall, spending has hovered around 40% of GDP, even though the economy has obviously grown a lot over the same period. For government spending to decrease as a % of GDP, there would have had to be tax cuts and spending cuts (e.g. what happened around 1980).

There’s also the point that overall spending doesn’t tell us much about what’s going on in individual departments. As many on the left have been pointing out for quite some time, if you cut some areas too fast and during a downturn, you may create unemployment and so welfare spending will go up. This is what has happened in the UK. However, it doesn’t mean that large spending cuts aren’t taking place.

Government spending as a percentage of GDP doesn’t tell us everything, but it’s a good guide as to whether a country is cutting spending or not, even if you do need to factor in tax increases. In any case, it’s certainly better than real or nominal magnitudes with no context whatsoever.

*Insert snarky comment about the financial sector.

*Actually we’d expect it to increase due to Baumol’s Cost Disease, but I’ll put that to one side.

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A (Very) Brief Thought on MMT

If I have any MMT readers, I’d appreciate it if they could answer this brief query:

MMT suggests that governments are not revenue constrained; they are only constrained by inflation, and until that becomes a problem they can print however much money they want to fund expenditures. Once inflation does become a problem, they can tax away the excess income. This is correct, no?

So here is my problem: if governments are inflation constrained, and they reduce inflation via taxation, isn’t this ultimately the same thing as if they were revenue constrained? Why not eliminate the middle man and simply raise taxation to fund expenditures?

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Can Governments Spend Your Money Better Than You?

A standard objection to tax and spend policies is ‘how can the government know what to spend better than millions of individuals?’ Allow me to try and provide an answer to this question.

Firstly, the truth of modern capitalist economies is that large amounts of the process of production go towards creating demand that wouldn’t formerly be there – advertising, marketing and so forth. Standard rebuttals to this point tend to rest on the idea that people behave like perfectly logical robots, but the fact is that people are influenced by advertising to buy things they didn’t previously know they wanted – if they weren’t, it wouldn’t exist. So a decent proportion of private spending is ‘artificially’ created, and hence people wouldn’t miss it if it were gone.

Secondly, consumption tends not to increase happiness past a certain point, as humans fall victim to two cognitive biases that, as Jonathan Aldred says, put them on the ‘happiness treadmill’:

  • Adaptation. This is when people become accustomed to new things they have, and their happiness level adjusts back to where it was previously. This is pretty extensively documented – there are many examples of lottery winners who do not feel any happier than previously, and there is the well known phenomenon of ‘buyer’s remorse‘.
  • Rivalry. This is the fact that a large part of our desires for consumption rest on what we see around us and what our neighbours have – ‘keeping up with the Joneses‘.

So people buy things because others have them, and quickly adapt, resulting in no net gain of happiness or utility. This continues, fuelled by advertising, and growing consumption fails to deliver the goods, so to speak. Hence, reducing people’s private purchasing power does not necessarily make them less happy, though of course it depends on the stage of development and on the type of good.

Even if you accept this, you might ask ‘well how can the government improve on this once it has the money?’ The answer is actually very simple, neoclassical (!) economic theory: the government provides public or quasi public goods, which would be under provided or not provided at all in the private sector. Private individuals do not have the incentive to provide these goods, so the government is required to step in. After all, it’s better than spending money on things for which demand has been artificially created, and which do not appear to increase people’s happiness.

The idea that governments can spend money better than the private sector has been suggested as as a reason for high tax rates appearing to be a net positive for economic growth, though there are numerous other possible explanations. It also may help to explain the relative success of the Scandinavian economies, where consumption (and other) taxes are high and advertising is strictly regulated. As a result, consumerism is lower and public services are, broadly speaking, the best and most well-funded in the world.

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