Busting an Old Economic Myth

Thanks everyone for your suggestions. As I might have imagined, they were pretty much all across the board. That's bad in the sense that it doesn't really help me narrow down what I want to concentrate on but good in the sense that there doesn't seem to be any one thing I do that bores the living crap out of everyone.

As I sit here watching Mythbusters, I've decided that I want to take down a myth myself. In particular, I want to explode the oft-repeated myth that lowering individual taxes or sending people additional tax rebates has a stimulative effect on the economy. And for this I'll be returning to one of my favorite topics: economic theory. I can hear most of your groans from here, but fear not loyal reader! I am not going to use a lot of detailed stats and arcane theories. I'm going to lay this out in pretty simple language.

First of all I am not a communist, socialist, hacky-sack wielding hippy, or a left-wing ideologue. As a general tax policy I believe that the fairest tax would be one that is flat and low. But I am not talking about a good general tax policy, I'm talking about stimulating the economy.

So let's first go through the conventional argument about why lowering taxes has a stimulative effect. A person makes X amount of money per paycheck. This leads them to consume Y amount of goods. Thus if you increase X by 10% (through an income tax reduction or additional income) they should now go out and spend an amount greater than Y. Multiply this a couple million times and overall demand gets stimulated, which causes businesses to produce more goods, which means they need to hire more people, and pretty soon the economy is roaring again.

So what's wrong with this theory? Absolutely nothing, provided that you are reading this on dried, rolled-up parchment by the soft light of a hogs-fat candle. The problem is that this theory is several hundred years old, and it completely discounts the global economy. There's an old expression that the mistake generals always make is trying to fight a current war just like they did the last one. That's what is happening here too. We're trying to solve today's problem with yesterday's solution.

Allow me to illustrate. Back in the day there existed these things called "local businesses". And when the local townspeople received extra money they spent it at these businesses and all the magic of increased demand and stimulus described above really did apply.

But now when consumers get extra money, there's no guarantee that they'll spend it locally. In fact, there's a good chance that the bulk of your purchase may not even be spent in this country. We know this conclusively by the fact that we have a huge trade deficit ($574.7 billion over the last year - sorry; I know I promised no stats). You make a purchase on Amazon or at Wal-Mart, there's a real good chance that whatever you're buying was manufactured elsewhere. And, sure, Wal-Mart or Amazon do get a percentage from each sale but we're talking in the area of 1-5% (depending on the item). And given the scale of both operations it's unlikely that an increase in volume will cause them to make any significant hiring decisions.

So, in a sense, actually everything with this theory still does in fact hold. If all you care about is that the global economy is stimulated, then it absolutely still works. But I seriously doubt that most of the proponents of a tax cut are doing so because they believe it will help China's economy more than ours.

Here's another issue. There is always the assumption that an increase to a consumer's paycheck will automatically lead to an increase in their disposable income. That's simply not true. Someone who is in debt is actually already over-consuming and thus it's far more likely that they will just use the extra income to pay down debt. While that is better for the individual, it doesn't have any direct stimulative effect. Similarly, someone who has a wealth surplus already has the capacity to consumer more than they do and they have chosen not to. It's unlikely that they will decide to consume a great deal more given a small amount of extra income. Far more likely that they will decide to save or invest the extra cash. Now, both that and the consumer who pays down their credit cards will have net positive effects on the economy. Credit card companies getting paid back and savings accounts getting filled means banks can extend more credit to other consumers and increased investment leads to growth in the industrial and business sectors. But, again, these are long-term effects and not short-term boosts.

So what we are indeed looking for is someone whose income currently is in lock-step with their expenses; they have no net debt or wealth. Now this person is quite likely to spend any extra income on additional consumption. But I would hardly call it efficient to throw a lot of money at every consumer just to hit the 5% (max) in this position. It's like putting out a candle with a firehose.

So if tax cuts are not the answer, then what is? Do I have any thoughts on that? Well as a matter of fact I do.

To be continued . . .