Given the backdrop of this whole tax cut debate, I thought it might be important to explain some basic economic fundamentals. Now, admittedly, though I was not an economic major in college, I did earn my degree in History; in that realm, I am what is referred to as an “economic historian,” or someone who believes that most human actions throughout history have as their base catalyst an economic motive. In addition, I have taught economics in a public school as a non-partisan (as any good teacher should be). I guess what I am trying to say is that, while I may not be able to offer you the most thorough or complex understanding of our economic situation, I hope you’ll trust that I have the basics more or less nailed down (if not, call me on it and I’ll publish your essay on this blog). Anyway, onto the lesson!
First, for economic theory to work, one must assume that people make rational decisions if they have appropriate information; that is to say, if Bill can by 3 apples for $5, or 5 apples for $5, (assuming these apples are essentially the same in quality and size) he will choose the latter.
Adam Smith described wealth as, "the annual produce of the land and labour of the society." In this sense, “land” refers to all the physical resources a nation possesses, and “labor” refers to all of the physical, social, and mental ways in which human beings manipulate, or “improve,” natural resources to create goods and services. Smith also established the fact that human beings essentially function selfishly—that is, they seek to fulfill their own best interests, “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages (Smith, The Wealth of Nations).” In doing so, Smith argues, people serve the public good whether they want to or not; this self-regulating effect is known as the “invisible hand.”
This idea was slightly modified by the concept of the “Nash equilibrium,” named for the late, brilliant mathematician John Nash. This concept, at its most basic, states that the best decision for an individual takes into account not only their self interest, but those interests around them, especially as it relates to the particular field of competition in which they are engaged.
OK, so now let’s re-examine the current debate. To more thoroughly illustrate the economic concepts in play, let’s use three hypothetical people as example. First, we have Johnny Laborman, who works at various jobs doing unskilled construction, and whose wife has been laid off from her job as a secretary in the public sector, but is collecting unemployment insurance. Let’s say their annual income after taxes is around $28,000. Next, we have Jackson McMiddle, who works as a warehouse manager, and whose wife still has a job, albeit low paying, as a legal secretary. Their net take per year is $56,000. Finally, we have G.D. Crassworth, who owns a decent sized construction company; his wife stays home and keeps herself in fantastic shape. Their annual salary is about 20 times Jackson’s, at $1,120,000 per year.
Now, let’s use the current compromise between Republicans and president Obama as a template (this has now been passed by the way), and see how our hypothetical’s fare. Suppose that, because of the payroll tax cut and some other provision of the bill, Johnny Laborman and his wife go from making $28,000 to $30,000, a year in 2011. OK, that’s good right? And if Johnny acts in his own selfish interests, we can probably expect him to spend that extra $2,000 on household items, such as a new television, computer, furniture, etc. After all, this is the most direct way that Johnny can improve his life in the short term; although, given their financial troubles related to finding consistent employment, there is a chance that he saves the money, which is not going to stimulate the economy. We’ll assume there’s about a 70% chance he spends the money.
As for McMiddle, say between he and his wife, they take in an extra $4000 a year. Now, given Mac’s self interest, there’s a very good chance that he will spend this money, or save it with the intention of spending it soon (either on a house or an upgrade in furniture), because he and his wife are both gainfully employed, and he has every reason to believe that this will continue.
Of course, Crassworth does much better than either of the other two. The salary that he pays himself from his construction company balloons by $80,000, so now he is making $1.2 million per year. What will he do with his extra money? Well, chances are, if he wanted to have something before, he was able to buy it, so it is unlikely he is now going to spend his money much differently. Sure, he might use that money to buy a yacht, or a new car, or some extremely expensive jewelry for his wife, but even then, chances are this will have little effect on the economy; most luxury items, such as yachts, cars, planes, etc. are manufactured in other countries, where companies can pay their high quality employees better salaries because they don’t have to worry about paying for health care.
In reality, the most likely thing G.D. is going to do is save his money, or use it to buy gold, or some other secure investment. Chances are he’s not going to buy more stock—if he’s smart, he knows that the global financial situation is far too unstable to invest in with confidence, and in all likelihood, he’s already owns a fair sized portfolio.
What about the claim that Crassworth would us the money to hire new employees? Well, he might, but in that case, why would he pay himself a salary, get taxed on it, and then turn around and use that money to hire somebody to work for his company, where it will get taxed again. If he wanted to hire someone, he’d keep the money in the company, where it won’t get taxed more than is necessary.
So, it is likely that most of the $80,000 won’t end up finding its way back into the economy, especially in the short term. This as opposed to our lower and middle class examples, who will likely spend almost all of their tax break in the fiscal year.
Still, what this demonstrates is that cutting taxes is an indirect method of stimulus at its very best. And, unfortunately, acting in their own best interest, McMiddle and Laborman may end up buying products that are manufactured abroad, simply because it is with these products that they get the best bang for their buck.
The other problem is that people in the middle class face other demands for their money that are less economically productive. (1—see footnote)
Getting back to our hypothetical’s, this is why progressives are opposed to cutting taxes for the rich: ultimately, it doesn’t stimulate the economy—if it did, given that we’ve had these cuts for 8 years now, one would think that our economy would be in much better shape than it is. Now, cutting taxes on the poor and middle class is probably a good idea, but what if it was coupled with direct stimulus—what if we took the $700 billion in tax cuts that Obama and the Republican’s want to borrow from China to give to people that make over $250,000 a year, and instead, used it to improve our roads and transportation systems, streamline our electric grid, and supplement state budget shortfalls. Well, let’s run through the effect on our boys.
Laborman, our poor hypothetical, would immediately benefit because he would likely be able to secure a long term, high paying job in construction. Additionally, there is a much greater likelihood that his wife, who has administrative office skills, but no job, will have a much easier time finding work, which in turn will save our government from having to pay her unemployment insurance. With the new employment, suppose he and his wife go from netting $28,000 a year, to $35,000 a year—an extra $5,000 a year as compared to what they would earn through tax cuts alone. Again, because they are poor and have been doing without, we can reasonably expect that they’re going to spend much of that money, which in turn will create more demand for goods and services and provide opportunities for job creation in the private sector.
Because of the multiplying effect of the commerce created by a vast array of infrastructure spending and the resulting job creation, Johnny McMiddle’s business increases dramatically, and he is promoted to oversee an expansion of the warehouse business, hiring new employees to work in his place, and advancing to a new position with a higher salary. His wife’s job doesn’t pay any higher, but still, with his advance, Johnny and his wife now net $70,000 a year. At this point, they are safely in the middle class, and have enough money to spend on all kinds of things, including buying a new home.
This is great news for Crassworth. His construction business, which had been slowing down to a crawl with the bad economy, is now bidding to build numerous projects, and because people are finally buying houses again, he is planning to build a medium sized, suburban housing division close to a decommissioned high school that is now being renovated and rebuilt.
With all the extra business, Crassworth is paying himself slightly more than he used to make, netting about 1.5 million a year (300K more than he’d make with a tax cut). The best part for him, however, is that his business holdings have increased dramatically, and his future is not only secure, but because it is in a business, he can hand it over to his children without worrying about paying an inheritance tax. The best part for his community is that he has created hundreds of jobs, and demand for a tremendously varied list of materials, fueling job creation for all kinds of artisans and manufacturing companies.
As a result of all of this economic activity, society has improved in a dramatic way, because wealth has been created. You’ll notice, that while wealth does not tend to trickle down from rich to poor, it does tend to flow upward once the lower and middle class have job security, upward mobility, and money to spend.
Of course, if one wanted to argue that I created hypothetical situations of my own accord and manufactured the results, I can’t argue with that—I did. However, in no way did I ever suggest that the characters I created act in an irrational way—I simply supposed that they act rationally and in their own selfish, best interests, as Smith suggests is the template for a high functioning, capitalist society.
The great irony is that Republicans like to joke about Obama’s slogan of hope, and they like to crow about freedom. But what are we left to do after we’ve granted these massive tax cuts to the rich—hope, pray, beg that somehow they end up trickling down, that somehow this action creates jobs? Because logic tells us that cutting income taxes on the richest two percent won’t do either—as we’ve seen in the last ten years, it simply fuels our ballooning deficit.
And really, what freedom does a person have if they can’t find a job? Not much. All we can ask of any individual is that they work for a living and contribute to society by spending their money in whatever way seems best to them. But without a job, we can’t even ask them to do that, and that is the true tragedy of all of this: Obama and the Republicans can talk until the apocalypse about how this is going to stimulate the economy, but that simply doesn’t make it so. And it is a tragedy that there is a clear answer to our economic troubles, a clear course of action to take, and yet our government is running in the opposite direction—and doing so in defiance of logic, reason, and historical evidence.
We are not acting rationally, or in our selfish, or collective best interests. I don’t think Adam Smith or John Nash would be very happy at all.
(1) Take insurance for example. At its most basic, insurance that is run for profit is counter productive, because the intent of insurance is to replace value that is lost via accident or catastrophe. The fact that insurance companies skim millions off of top of that pool may create some jobs, but in essence it is only a redistribution of wealth to those who happen to have enough money to provide it, i.e. the wealthy; moreover, if the insurance company is profitable, then the complete value of the capital that was damaged is never fully replaced, meaning that as a net result, the nation loses wealth. Remember, money is only a representation of wealth, a symbol, because wealth can only be created by “the annual produce of land and labour of the society.” Money enables us to trade our goods and services more directly and efficiently, but it is only a token—this is why a country cannot simply print more money indefinitely to cure its financial problems.
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