Sunday, March 14, 2010

Tax Foundation nonsense.

Most economists have learned something from the 1930s depression. A sizeable proportion of politicians have learned nothing. The “almost a century out of date” views of these politicians are unfortunately backed by a number of ultra conservative publications produced by some vociferous and well funded conservative organisations. The Tax Foundation seems to fall into this category, if it’s latest publication is anything to go by: “Can Income Tax Hikes Close the Deficit?”

The basic claim of this publication is that, taking the U.S. deficit as about 3% of GDP, income tax increases of horrendous proportions will be needed to “close the deficit” as they put it.

Tax specialists and accountants may be good at tax and accountancy law and at adding up columns of numbers. But macroeconomics is a different ball game, and therein lies the mistake in this publication.

The central mistake is that the authors have not cottoned on to something which has been going on for at least the last hundred years: this is that a portion of government spending (as it happens, roughly 3% of GDP) is funded by seigniorage. That is, the deficit is more or less already covered. This takes some explaining, so here goes.

The private sector likes to save a certain amount. Apart from saving in the form of physical assets like houses and cars, the private sector also (quite understandably) likes to have a stock of financial assets, e.g. to fund retirement.

Investing in the stock exchange is one source of “financial assets”, and another is government debt (e.g. Treasuries). This government debt amounts to a large figure in the average Western country: roughly 50% of GDP.

But inflation eats into government debt: a slight problem. That is, assuming the private sector wants to hold an amount of government debt that is a constant proportion of GDP, then this debt will need to be continually expanded in Dollar or Yen or Pound terms. That is, the relevant “government central bank machine” will need to constantly print more currency units just to keep the debt constant in real terms. I’ll illustrate with some figures.

Most economists nowadays recommend an inflation rate of about 2%, rather than 0% or anything much above 2%. So let’s assume 2% inflation. And let’s also assume GDP growth in real terms of 2%. Plus we’ll assume the above “debt relative to GDP” figure of 50%.

On these assumptions, the amount of extra money that government will need to print every year will be 2 x 2 x 50% = 2% of GDP.

So out of the 3% of GDP that the Tax Foundation says needs to be added to income tax a full 2/3rds is not needed. That is, just 1% of GDP needs adding to tax: not a catastrophic figure.

The above, however, are very much “back of the envelope” figures. In particular, the deficit as a proportion of GDP has not been anywhere near a constant 2% since World War II, as the above back of the envelope calculation might seem to imply. There are some charts here and here giving the actual deficit since World War II.

As these charts show, the deficit was round 0% of GDP immediately after WWII: not surprising, since a near record debt had been incurred by the war itself, and the private sector doubtless did not want to hold this much debt on a permanent basis. This 0% gradually rose to around 5% of GDP in about 1985, and then declined back to around 0% and then rose again.

In other words the 2% that results from the above back of the envelope calculation is about right as an AVERAGE for the sixty years or so since WWII.

Paradox of thrift unemployment.

Many politicians have not yet grasped a very simple point made by Keynes and others. This is that if the private sector has what it regards as an inadequate stock of savings (in the form of cash and/or government debt), the private sector will attempt to save in order to build up its stock of savings.

But this necessarily means cutting down on spending. And cutting down on spending means people out of work. Thus the “paradox” is that while saving money is very laudable, it can be self defeating in the sense that it throws people out of work.

So what is the solution? Easy: make sure that government supplies the private sector with its desired stock of savings. And that normally means running a deficit. Not a ludicrously large defict: that would cause hyperinflation. But a deficit, nonetheless.

Thus the above idea put by the Tax Foundation that the deficit should be “closed” is nonsense. Very roughly two thirds of the deficit does not need closing.

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