The multiplier is not prosperity

“I’m doing my part to help the economy!”

I’ve heard many folks make this joke after a big purchase. We snicker. We know they really bought it for the personal benefits they expect to gain. As we’ve been discussing in the comments, they bought it because they valued it more than what they gave up.

The joke implies the multiplier effect — the idea that your purchase stimulates economic activity. You buy a car, which means income for the car maker and workers, they spend that income on suits and shoes, and so on. And, by the time it’s all said and done every dollar of your purchase ‘stimulated’ more than a dollars worth of economic activity, which is measured as GDP.

For some reason, we don’t snicker when economists and politicians make this same claim. We should.

David Henderson, who doesn’t make this claim, does a great job explaining why we should snicker in his aptly titled essay, GDP Fetishism, which I discovered after reading a recent post of his about the ‘multiplier’ of foreign aid.

Also recommended, his latest post about subjective value, which is a topic we’ve touched on here recently in the comments.

Thoughts on taxes II

In my first Thoughts on taxes post, I listed reasons why I prefer a simple and broad tax system.

In this post, I will elaborate on the first reason I listed for preferring a simple tax code:

  •  No matter the complexity of the income tax system, government collects about the same percent of the overall economy’s income (GDP) in taxes.

Since World War II, our country has had a fairly wide variation in complexity and rates in its income tax code. Yet, the chart on this page shows individual income taxes collections have stayed in a relatively narrow range between 8% and 10% of GDP.

Politicians often say they want to raise tax rates to increase tax collections. This chart suggests that rates — at least for the various tax codes since about 1950 — don’t have significant effects on government’s take of the economy as a percent of GDP.

So, making moderate changes to get more (or less) revenue doesn’t seem to work.

This doesn’t seem to be widely known and is rarely brought up when discussing tax rate proposals.

It also doesn’t seem intuitive. It’s fair to ask, how could it be that tax rate changes don’t seem to have much effect on the total percent of income collected in taxes?

Great question. I’m not sure I know the full answer, but a key part of it is that the complexity of the tax code itself.

Different types and amounts of income are taxed at different rates and we all have choices that allow us at least some flexibility on how much taxes we pay. We’ll tend to favor the types and amount of income that we feel are a good deal on an after-tax basis.

If the tax rate for dividend income, for example, is lower than the tax rate on capital gains (both are investment income) — then it’s worth our while to favor dividends over capital gains. Investment advisers will encourage us to switch investment strategies to invest in companies that pay dividends to help us minimize our tax bill. Management teams will respond by distributing more money back to owners through dividends than share repurchases.

Consider the recent example where Great Britain raised the tax rate to 50% on those making more than a million pounds. The number of folks reporting more than a million pounds dropped in one year from 16,000 to 6,000 and taxes collected from this group declined from 13.4 billion to 6.5 billion pounds.

The article states:

It is thought that many of the highest earners moved abroad or reduced their taxable incomes to avoid paying the new levy.

So, while the tax rate went up, the amount of income exposed to this tax rate when down meaning the weighted average tax rate in England probably didn’t change that much.

There are other decisions we can make that change our tax rates. How much you donate to charity, how big of a mortgage you decide to get, deciding not to sell a stock because you won’t make enough after taxes on the gain, how much you decide to save in tax deferred retirement accounts and how much you decide to contribute to your HSA or cafeteria plan are some of the more common decisions that have clear tax implications.

Raise tax rates on folks like Warren Buffett, a vocal tax increase advocate, and he’ll just donate more to charity to lower his tax rate.

I learned something new today

I didn’t realize Australia had private social security accounts and it appears to work well for them. Thanks to Dan Mitchell for this excellent post.

I like this line (emphasis added):

This system, which was made universal by the Labor Party beginning in the 1980s, has turned every Australian worker into a capitalist and generated private wealth of nearly 100 percent of GDP.

That’s what I’d call properly aligned incentives. It seems like a good way to turn a Ponzi scheme into a wealth-producer.

Update:  Here’s the Wikipedia article that contains more information about Australia’s pension program.

Lemonade Stand Economics

Thanks to Russ Robert of Cafe Hayek for pointing me to Jerry Jordan’s Investors Business Daily article,  Government Accounting is Like Lemonade Stand Economics.

I attempted to explain the same topic that Jordan writes about last September in my post, Government is an expense.

My key point then was that GDP is often misused as a measure of health for the economy, but that is like measuring the health of a business by adding its revenues and expenses together.

Jordan explains it better than I did with a lemonade stand example.  In his example, kids invest $10 in a lemonade stand, make $7 back by selling cups of lemonade and folks think that is good because there was $17 worth of economic activity, instead realizing there was a $3 loss.

GDP is not a good measure of the health of the economy because it’s like considering the $17 of lemonade stand spending and saying that was good, rather than realizing that $3 of value was lost in the process.  None of us would last long if we kept turning $10 into $7.  But, that’s essentially what we do when we increase government spending to keep GDP up.

The lemonade stand kids should learn from the signal they received from the market.  The signal is that selling lemonade in the neighborhood is not worth their while because customers do not value a glass of lemonade in that time and place to pay enough for it.

So, the kids should try other things.  Maybe they should try a different drink or different corner.  Or maybe they should offer to do yard work for their neighbors.

They should keep experimenting to discover things that their neighbors do find worthwhile enough to pay enough to make it worth the kids’ while too.  Full disclosure, I tried the lemonade stand experiment a few times too.  I tried it in the street and at family garage sales.  It never produced profits for me.  I did much better doing things like mowing lawns, raking leaves, shoveling snow and assembling bicycles.

We do no good encouraging the kids to keep at turning $10 into $7 to maintain that $17 of economic activity.

Government is an expense

In this post, I wrote about how government is overhead.

If you believe this view of government, then you shouldn’t use GDP (Gross Domestic Product) as an indicator of the health of our economy.

Gross Domestic Product is calculated by adding consumer, investment and government spending.  If consumer and investment spending decline, as usually happens in a recession (and usually for good reasons), people believe that boosting government spending is a good thing because it helps offset the declines in the other components of GDP.

What’s wrong with that?

GDP tells us how much economic activity there is.  It doesn’t say if that activity is healthy or not.  But we assume it does.  We assume GDP is like to our income.  We assume (and I think we are taught) that it’s the “income” of the economy, so more of it is good and less is bad.

But it’s not really income of the economy.  It’s the total economic activity of the economy.

Let’s say you made $50,000 in income, spent $40,000 and invested $10,000.  Your GDP, or total economic activity, was the sum of the three or $100,000.

$5,000 of your income came from a part-time job that you decide to quit.  Your income drops to $45,000 and your total economic activity drops to $95,000.

Confusing your total economic activity with your income, you decide to borrow $5,000 and spend it to keep your economic activity at $100,000.

Many people will instantly see the problem with using economic activity in this fashion and advise against borrowing the money.  They would also likely point out that your income level and how much you have left to invest after spending are better measures of your economic health.

But if you cloak such words as income, spending and investment with other words like GDP, consumer, investment and government spending, we lose our senses and start to believe it’s okay to borrow $5,000 to keep GDP at $100,000.

If we recognize that consumer and investment spending is the better estimate of the economy’s income and view government spending as an expense, we will make better decisions.  For example, when economy’s “income” declines, we will want to reduce our expense, rather than increase it.

Not quite convinced?  Here’s one more way to look at it.

Again, the three components of GDP are consumer, investment and government spending.  Where does each of these come from?

Consumer and investment spending are the result of value created in society.  Chipotle makes a burrito, I buy it.  We both come out ahead (or we wouldn’t have traded).

Government spending also comes from this value creation process.  Your expenses are enabled by the value you create at your job or with your business.  I do something for my employer, they pay me.  We both come out ahead.   I spend some of that income on a Chipotle burrito.

As an expense, government spending comes from our income.  Without income from our productive pursuits, we would not have government.  As our productive pursuits have become ever more productive over the centuries, we’ve been able to afford bigger governments.  Increase government spending and that leaves less income to spend on other things.

Since government spending comes from our income, it makes no sense to increase it in response to a decline in income.  Rather, we should reduce it and look for ways to increase our income.

And, the secret to increasing our income is by encouraging, rather than discouraging, market-based innovative pursuits, just as it has been since humans have been evolving.