RSS Feed MenuThe president has proposed three significant measures, each of which in the short term will cost money. First, businesses will be able to write off new investment in plants and equipment more quickly (which would reduce tax revenue in the short term). Second, the government would provide a research and experimentation tax credit (which would increase government cost). Third, the government would spend $50 billion on transportation infrastructure (which would increase government cost). How should a taxpayer react? Is the additional debt these proposals create a good thing or a bad thing? What is good debt and what is bad debt?
Understanding the concept of a balance sheet would be a good step in making a decision.
Consider two American families. One family rents a roach-infested apartment with carpet and drapes that reek of past cigarettes and mold. The head of the family dropped out of high school (a very bad one, at that), has no further education, and works an unstable minimum-wage job with no prospects for advancement. A 20-year old automobile sits parked at the curb, but does not operate dependably, if at all. It’s 90 degrees outside and humid, but there’s no air conditioning in either home or auto. Adding up all the family’s assets (say, $2000 max, including the car and a new big-screen television) and subtracting debt ($500 for the television bought on a store credit card) the family has a financial net worth of $1500. Their balance sheet is a small one, with very little debt or… for that matter…. equity, and they are struggling to pay down the credit card.
Somewhere else in town lives another family. The head of the family graduated from high school, college, and medical school, and is a physician who developed a specialty and is now earning $400,000 per year. Medical school loans total $200,000. They live in a 3-bedroom, two bath house in a good school district. The house is nicely furnished and air-conditioned. The carpet and drapes are new and odor- and toxin-free. The house has a value of $500,000 and a mortgage of $400,000. Two cars sit in the garage, both late model, both well maintained, both $30,000 in value, one paid off, one with $15,000 remaining. There is a newly established retirement account of $40,000. No credit card debt. The head of the family makes enough to pay the mortgage, pay ahead on the student loan, make scheduled payments on the automobile’s no-interest loan, put money into a retirement account, begin a college fund for children, and still has enough left over for a nice family vacation or two.
Adding up all the assets of the second family (home, autos, retirement account) you get $600,000, from which you subtract debt ($615,000) to arrive at a financial net worth of negative $15,000. Offsetting that negative $15,000 net worth is the value of the educated human resource… the income earner…. who has positioned the family for prosperity, the fruits of which the family even now has started to enjoy. This family has a large balance sheet, including both debt and equity, but in concrete terms is presently lower in net worth than the first family. Still, it was the debt… especially the student loan, the auto loan and the mortgage… which made it possible for this family to assemble a plan for a high quality of life today and into the future.
Which family would you rather be a member of? Which family would you rather lend to with some hope of getting your money back?
The point is that debt, whether national or household, is especially legitimate on one side of the balance sheet when it is used to create an asset of commensurate or greater value on the other side. Unemployment benefits, for example, or tax reductions designed to spur the purchase of consumer goods, both have some important benefit to the recipient no doubt, however no asset is created or encouraged which has a prospect of enhancing our future national prosperity. But just as after World War II, the GI Bill created a generation of well-educated veterans, and our expensive interstate highway system accelerated national commerce, so transportation infrastructure, research and development, and business investment all are more likely to generate return and enhance our long term national prosperity than other types of spending might. As such, the assets produced may substantially offset, and perhaps even substantially outweigh, the debt incurred. It is on this prospect that the proposal should be judged.
C.H. Douglas // Sep 10, 2010 at 10:48 am
Forgetn, with regard to magnitude and strategy of the proposal, you are correct.
WillyP // Sep 10, 2010 at 11:06 am
forgotn,
So living within your means implies depression?
When did America become the land of the terminally stupid?
MSheridan // Sep 10, 2010 at 11:12 am
One thing it’s important to keep in mind is that we haven’t really had what most people think of when the term “stimulus package” is mentioned. Whether you oppose them or support them, you generally expect that they are spending above and beyond the norm. Because of decreased tax revenues at the state level, the stimulus thus far has just about made up the difference in reduced total government spending. In other words, although the actual budgetary line items are a bit different, we’re spending almost the same amount as usual when you look at government spending at all levels. That’s more stimulative than spending a lot less, but it’s not as if we added a lot of extra fuel to the fire.
WillyP // Sep 10, 2010 at 11:33 am
Spending does not equal “stimulus.” Stimulus implies, I would assume, policies that offer a corrective to a depression.
Government spending is consumption by definition. If you want to be rich, you make MORE STUFF. You don’t spend more!
In order to fix the structural problem in the economy – a result of extending “excessive” credit to businesses and lengthening the chain of production across the board – you let investments occur in CONSUMER goods (rather than DURABLE goods – e.g., housing), and let prices normalize.
Anybody who aspires to comment intelligently on these matters should really read…
Prices and Production by F.A. Hayek:
http://mises.org/resources/681
WillyP // Sep 10, 2010 at 11:44 am
The bottom line is that The Great Depression was brought about by very similar means as we’re pursuing now. The New Deal only prolonged the misery. 6 – 12 months of austerity and deflation would have put this economy back on track. Instead we’re getting a lost decade.
People, please stop being knee-jerk statists! Pick up a history book and read some classical liberal literature!
MSheridan // Sep 10, 2010 at 12:58 pm
WillyP,
You wrote:
“Government spending is consumption by definition. If you want to be rich, you make MORE STUFF. You don’t spend more!”
Spending isn’t a stone dropped into a river. Money isn’t spent only once. When it is spent in this country by anyone, there is a multiplier effect as the people receiving the money spend it again. That effect is increased the closer the money is to the streets. That is, the much vaunted “trickle-down” of Reaganomics is a mere trickle, as it involved tax cuts for the wealthy who can afford to save in bad times, whereas economists on the left and the right agree that the most stimulative government spending is food stamps (mostly spent on food, definitely a consumer good), in which money flows up.
WillyP // Sep 10, 2010 at 2:58 pm
MSheridan,
The multiplier might be most contemptuous accepted fallacy of economics. Can somebody please explain this to me, in plain English:
Under what conditions are dollars spent “eligible” for this mysterious effect? Under what conditions are dollars not?
Why is it that government deficit spending creates this magic “multiplication” of wealth? Using the same logic, could not the same be accomplished by cutting taxes and government spending and returning more dollars to the private sector? Why should this not have a similar effect?
The multiplier effect is patently ridiculous. Believing it means believing that printing money would bring lasting prosperity. It does not take into account the problem of economic coordination. It purports to create bread from stones. Furthermore, it puts to government the task of playing savior.
FYI, the fallacy of the multiplier effect has been born out by recent empirical studies, for those of you who insist we must “torture the data”:
http://online.wsj.com/article/SB123258618204604599.html
http://www.ft.com/cms/s/2/79f0c696-f99a-11de-8085-00144feab49a.html
But again, I reinforce that the (il)logic of “the multiplier effect,” if it is to be applied in general, must also apply to private spending. And by this logic, the efficacy of government spending/investment still must be compared against the efficacy of private spending/investment. (All government money is seized, remember.) The track record of governments running business activities has been abysmal.
Finally, there are economic reasons why this is so, but for a refutation of the fallacious multiplier effect this should suffice.
llbroo49 // Sep 10, 2010 at 4:56 pm
WillyP,
Assuming the Federal Government stops spending, how does that help corporate America?
In reference to your questions as to why the government can’t just cut spending or reduce taxes to allow more money to the private sector is not as effective as the government spending- Please look up capital formation in an economics book.
As an example, a railroad company may find itself with a significant profit in one year or quarter. However, instead of hiring more people to exapnd or improve the rail system, the company decides to buy back its on stocks. Now nothing is inherently wrong with any option, but we can agree that the railroad will not have to hire new employees when buying back its stock.
Another example is if taxpayers are given tax refunds. Few Americans today will spend it buying luxury items. As a matter of fact, more are just as likely to save or pay down debt.
The multiplier comes in to play when spending is focused in ventures that encourage or require expansion. Spending money on infrastruture encourages hiring, spending money on buying stocks back only makes individual shareholders wealthy.
Also remember real employers do not hire based on how much revenue they are making; they base hiring on demand of their goods and services.
MSheridan // Sep 10, 2010 at 6:18 pm
WillyP,
You asked: “Why is it that government deficit spending creates this magic “multiplication” of wealth? Using the same logic, could not the same be accomplished by cutting taxes and government spending and returning more dollars to the private sector? Why should this not have a similar effect?”
First, cutting taxes absolutely can create this effect, depending on whose taxes are cut and by how much. If you ever Google the totality of my past contributions in these pages, you will see that I have argued that tax rates for most Americans are too high, certainly higher than historical norms when inflation is taken into account. For decades after the income tax was put into place, the income of an overwhelming majority of Americans fell into the two lowest marginal tax brackets, which were taxed at about 4 and 8 per cent. Think of that–the majority of Americans paid 4% on their entire taxable income and a very large percentage of the remainder of the populace paid 8% on the amount they earned in the next marginal tax bracket that made up the rest of their income. As you are probably aware, all Americans pay the same tax rates on earned income (the millionaire making hundreds of thousands a year in earned income pays the same % on the first $16,750 as the much poorer person for whom that is the sum total of his taxable income). Capital gains, which are not earned income, are taxed differently (lower), but I won’t get into that. We used to have fantastically higher income tax rates on the super-rich, something that we now congratulate ourselves about having gotten rid of. However, we also used to have a lot more marginal tax brackets, and the number of people who paid even a dime in that highest bracket was minuscule. For instance, in 1940 the top marginal rate was 81%, not levied on all a rich person’s income, but on all of his taxable earned income in excess of $5,000,000. If we adjusted the tax brackets for inflation, in 2010 dollars that would be the equivalent of income in excess of more than $75,000,000/year. There are a tiny few in the country who would have to pay anything whatsoever at that top rate, and they would pay at lower rates on the remainder of their income.
The Republican tax hero Reagan slashed all income tax rates in 1981, but because over his presidency he raised payroll taxes quite a bit, for the majority of American citizens the net effect was a wash. His final tax cut just before he left office, in which the top marginal rate was made only 28%, was so fiscally disastrous that Bush Sr. sacrificed a second term by raising it to 31% and we didn’t hit the black again until Clinton raised it to almost 40% (still 30% less than pre-Reagan). So since the 70’s the rich have made out quite well, which doesn’t bother me in the slightest. I have absolutely nothing against extremely rich people (several of whom I’m very closely related to). However, in the aggregate they have by far the most income to tax. Lowering taxes on the poor and middle class is great for the economy, because of the aforementioned multiplier effect and the reduced need for government services of families with more money to spend, and it doesn’t appreciably lower revenue (their deduction to income ratio is generally higher than that of the very rich). Lowering taxes on the rich and superrich does benefit them, but because they have less incentive/need to spend and every incentive to save in tough economic times, past a certain point it doesn’t benefit the country at all. They don’t trickle down nearly as much wealth as the government does when it spends their taxed income. The Laffer Curve applies here, of course, but as neither Arthur Laffer or anyone else has ever quantified the inflection point on that curve, it’s useful only as a theoretical warning.
As a side point, although tax rates on anyone have little to do with fairness and much more to do with funding, Adam Smith, whose Wealth of Nations I’ve been slowly plowing through, did address the question of progressive taxation when he wrote: “The subject of every State ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the State.”
That covers at least a thumbnail response to your question as to why cutting taxes and government spending does not always or necessarily have the same stimulus effect as the government spending more. Currently, the Administration wishes to extend, probably permanently, the Bush-era temporary tax cuts for most Americans (and actually, even the very richest will get some benefit from that extension). It wishes not to extend, at least for the time being, the tax cut on the top marginal bracket of the most fortunate 2%, not because they are any less worthy human beings, but because that’s the easiest way to get that money into circulation.
WillyP // Sep 10, 2010 at 11:28 pm
look, bottom, line, the responses i gather are basically completely and utterly fallacious. you can take this up with ludwig von mises:
http://mises.org/daily/1889
probably the greatest economist of the last century derides the multiplier effect as total ridiculousness. so there’s your intellectual opponent: argue with his arguments.
MSheridan // Sep 11, 2010 at 2:45 am
WillyP,
I’m not a fan of the Austrian school and am not willing to concede the title of greatest economist of the last century to von Mises, but even if I were and did, I don’t believe his analysis squarely addresses the current situation. I’m no Paul Krugman, but I’ll at least attempt a partial rebuttal. I’ll lift a couple of quotes from your linked page:
“Can the lifting of consumption without a prior increase in production set the process of wealth creation in motion? Without the supply of the means of sustenance neither the shoemaker nor the tomato grower nor the baker will be able to engage in the production of shoes and tomatoes. Obviously then, an increase in the baker’s demand for shoes and tomatoes without having any bread or other consumer goods at his disposal cannot expand the overall output in the economy let alone by a multiple of the increase in the baker’s demand.”
Further, in von Mises’ own words: “there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.”
So 1) an increase in spending without a prior increase in production cannot expand total output and 2) a government cannot spend without reducing the ability of the citizenry to spend or invest to the same extent.
1) is assumed to be a problem because there is the danger that inflation can result (money becoming less valuable due to increased availability), but we are currently in a situation in which despite a massive, scary, and unprecedented increase in the money supply, it is paradoxically deflation that is a very real danger because money isn’t available enough (the banks are holding onto it, probably because they’re terrified about the mountain of bad debt they have on their balance sheets (or more to the point, should have marked on their balance sheets). Further, despite the stimulus we have not actually yet seen an increase in spending. The federal stimulus, large as it was, did not quite match the overall decrease in government spending at all levels from decreased revenue. Further, von Mises’ premise here seems flawed, as it appears to assume that production cannot increase in response to increased demand, which may be true in some instances but is certainly not true in an economic slump such as the one we find ourselves in. I agree with llbroo above in what he wrote about when the multiplier does or does not apply.
2) von Mises is quite right about this, but “…without reducing the ability of the citizenry to spend or invest to the same extent” does not take game theory into account. It might well be in the best financial interest of everyone for there to be significant spending and/or investment, and yet a bad risk for any single individual, with the result that almost everyone spends or invests the minimum. In such a circumstance, a reduction in the ability of the citizenry to spend/invest is irrelevant, as they wouldn’t be likely to do so anyway.