Supply-side economics, advocated by most Republican politicians, including presidential candidate John McCain, places great emphasis on the idea that investment is the main engine of economic growth, price level stability, and low unemployment. To encourage firms to invest, government should play a minimal role in the economy; taxes should be sufficiently low to incentivize firms to invest, while at the same time government spending should be reduced to avoid crowding-out of private investment.
In the article below, The Economist’s Free Exchange explores the relationship between tax rates and long-run economic growth. The Economist takes the position of “supply-siders” who study the impact of tax rates on the level of output. The idea of supply-side economics is that lower taxes encourage more investment and thus higher growth rates.
Here’s the gist of the supply-side argument:
Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.
On the other hand…
…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.
In the case of the Laffer Curve, which shows the relationship between tax rates and tax revenue, the article concludes that:
Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.
Supply-side economics, folks. Understanding the effects of fiscal and monetary policies on not only aggregate demand, but on aggregate supply (both short-run and long-run) is a crucial skill in answering AP free response questions.
Inequality in the distribution of income is an inevitable result of an economic system that rewards the households with the highest skills, best education and most access to capital with higher wages and incomes in the marketplace.
The existence of poverty, both relative and absolute, poses several obstacles to the improvement of well-being for a nation’s people. Social unrest among the poorest members of society can lead to political and economic instability for a nation as a whole. The hardships experienced by society’s poorest members are ultimately felt by the rest of society as the needs of the poor must be met in one way or another, and in extreme circumstances may lead to a violent struggle between economic classes.
The existence of absolute poverty poses the greatest obstacle to national economies and society as those who experience it are unlikely to contribute whatsoever to national output and economic growth given the desperate state of their health and education. Without promoting some degree of equality in the distribution of income, governments run the risk of undermining their accomplishment of other social and economic objectives. So how do governments achieve more equal income distribution? Before we look at the modern mechanisms by which this objective is achieved, it is important to examine the historical ideology that frames modern economic policy.
For centuries the role of government has been debated among economists. The extent to which it is the government’s job to assure equality in the distribution of income has never been fully agreed upon by policymakers, whose opinions differ depending on the school of economic ideology to which they prescribe. On the far left of the economic spectrum is Marxist/socialist ideology, which believes that households’ money incomes should be made obsolete and each household’s level of consumption should instead be based on the “use-value” of the output which it produces. In a pure Marxist or socialist economy, money incomes do not matter since the output of the nation will be shared equally among all those who contribute to its production. Private ownership of resources and the output those resources produce is wholly abolished in a socialist economy and the ownership and allocation of resources, goods and services is in the hands of the state and production and consumption is undertaken based on the principle of equality.
The slogan “from each according to his ability, to each according to his need”, made populate by Karl Marx, summarized the view that a household’s consumption should be based on its level of need. To take this idea to its logical conclusion, all households in a nation have essentially the same basic needs therefore household incomes should be equal across the nation.
On the other extreme of the economic spectrum is the laissez faire, free market model which argues that the only role the government should play in the market economy is in the protection of private property rights, which assures that the private owners of resources, including land, labor and capital, are able to pursue their own self-interest in an unregulated marketplace where their money incomes are determined by the “exchange-value” of the resources they control. In a laissez-faire market economy, the level of income and consumption of households varies greatly across society as the exchange-value of the resources owned by households determines income, rather than the principle of equality underlying socialism. Each individual in society is free to pursue his monetary objectives through the improvement of his human capital and the subsequent increase in its exchange-value in the labor market.
In today’s world, there exists neither a purely socialist economy nor a purely laissez fairfree market economy. In reality, all modern national economies are mixed economies in which governments do much more than simply protect property rights, but do not go so far as to own and allocate all factors of production. The role of government in the distribution of income in today’s economies is relegated to the collection of taxes and the provision of public goods and services and transfer payments.
A tax is simply a fee charged by a government on a person’s income, property, or consumption of goods and services. Taxes can be broken into two main categories: direct and indirect.
Direct taxes: These are taxes paid directly to the government by those on whom they are imposed. An income tax is a direct tax because it is taken directly out of a worker’s earned income. Corporate and business taxes are also direct taxes based on the revenues or profits of firms. Direct taxes cannot be legally avoided since they are based on the earned income of each individual. The burden of direct taxes is born entirely by the households or firms paying them.
Indirect taxes: These are the taxes paid by households through an intermediary such as a retail store. The consumer pays the tax at the time of his purchase of a good or service and the amount of the tax is usually calculated by adding a percentage rate to the price of the item being purchased. Indirect taxes include sales taxes, value added taxes (VAT), goods and services tax (GST) as well as ad valorem taxes (or excise taxes) which are placed on specific goods such as cigarettes, alcohol or petrol. Indirect taxes can be avoided simply by not consuming certain products or by consuming less of all products. The burden of indirect taxes is born by both households and firms, the proportion born by each is determined by the price elasticities of demand and supply (as demonstrated in chapter 4).
Taxes can be either progressive, regressive or proportional in nature, meaning that different taxes place different burdens on the rich and the poor.
Proportional tax: A tax for which the percentage of income taxed remains constant as income increases is a proportional tax. The rich will pay more tax than the poor in absolute terms, but the burden of the tax will be no greater on the rich than it is on the poor. A household earning 20,000 euros may pay 10% tax to the government, totaling 2,000 euros. A rich household in the same country pays 10% on its income of 200,000 euros, totaling 20,000 euros in taxes, but the burden is the same on the rich household as it is on the poor household. Proportional taxes are uncommon in advanced economies, although some “payroll taxes”, which are those collected to support social security or welfare programs, are payed by employers based on a percentage of employees’ incomes up to a certain level. For instance, the US social security tax is 6.2% of gross income up to $108,000. Regardless of a person’s income below $108,000, he or she will pay 6.2% to the government to support the country’s social security program.
Regressive tax: A tax that decreases in percentage as income increases is said to be regressive. Such a tax places a larger burden on lower income households than it does higher income earners since a greater percentage of a poor household’s income is used to pay the tax than a rich household’s. You may be wondering what kind of government would levy a tax that harms the poor more than it does the rich, but in fact almost every national government uses regressive taxes to raise a significant portion of its tax revenues. Most indirect taxes are actually regressive, which may not make sense at first, since a sales tax is a percentage of the price of products consumed consumed. The regressiveness is apparent when the amount of the tax is compared to the income of the consumer, however.
To demonstrate how a sales tax is regressive, imagine three different consumers who purchase an identical laptop computer for 1,000€ in a country with a value added tax of 10% added to the price of the computer.
Income of buyer
Amount of tax paid
% of income taxed
10,000€
100€
1%
50,000€
100€
0.2%
100,000€
100€
0.1%
The higher income consumer pays the same amount of tax as the lower income consumer, but the the tax makes up a lower percentage of her income than it did the lower income consumer’s. Although they appear to be fair since everyone pays the same percentage of the price of the the goods they consume, indirect taxes such as VAT, GST and sales taxes are in fact regressive taxes, placing a larger burden on those whose ability to pay is lower and a smaller burden on the higher income earners whose ability to pay is greater.
Progressive tax: This is a tax for which the percentage of income taxed increases as income increases. The principle underlying a progressive tax is that those with the ability to pay the most tax (the rich) should bear a larger burden of the nation’s total tax receipts than those whose ability to pay is less. Lower income households not only pay less tax, but they pay a smaller percentage of their income in tax as well. Most nation’s income tax systems are progressive, the most progressive being those in the Northern European countries which, not surprisingly, also demonstrate the most equal distributions of income. Of the various types of taxes, a progressive income tax aligns most with the macroeconomic objective of increased income equality.
A progressive income tax typically consists of a marginal tax bracket in which the increasing tax rates apply to marginal income, rather than to total income. In such a system, the average tax a household pays increases less rapidly than the marginal tax, since the higher marginal rate only applies to additional income beyond the upper range of the previous bracket.
Notice in the table above that the total tax paid by Americans at the top of each income bracket is NOT the simply the tax rate times income. Rather, the tax rate for each income bracket only applies to income earned above and beyond the upper boundary of the previous bracket. An American worker earning $8,000, for instance, will pay $800 in income tax. But if his income increases to $10,000 he will NOT pay 15% of the full $10,000, or $1,500. Rather, he will pay 15% on the income earned above $8,375. Such a worker would therefore pay 10% of his first $8,375 ($837.50) plus 15% on the additional $1,625 he earned, which is another $243.75. The marginal rate of taxation (MRT) is the change in tax (t) divided by the change in gross income (yg). His total tax would therefore equal $1,081.25.
The marginal rate of taxation between the first and second income brackets above is found using the equation:
The average rate of taxation (ART) is equal to the tax paid (t) divided by the gross income (yg):
The average rate for workers who fall in the second income bracket above can be found using the equation:
For workers in each of the income brackets above, the average rate of taxation is always lower than the marginal rate of taxation, since tax increases only apply to additional income earned beyond the previous bracket. The graph below shows the marginal (in blue) and the average (in red) rates of taxation for individuals earning between $0 and $500,000 in the United States in 2010.
Marginal and average tax rates in the US
The main argument against progressive income taxes is that taxing higher incomes at higher rates creates a disincentive to work, in effect punishing any increase in productivity or effort among the nation’s workers. However, the fact that higher rates only apply to marginal income, rather than total income, assures that a worker’s after tax income will always be an increasing function of gross income; therefore there will always be an incentive to increase income by working harder, longer, or more efficiently since the increase in taxes will always be less than the increase income.
A progressive income tax system provides governments with an effective means of re-distributing the nation’s income since those with the greatest ability to pay (the rich) provide the nation with far more of its tax revenue than those with the least ability to pay (the poor). The graph below shows the total amount of tax revenue generated by each of the five quintiles of income earners in the United States in 2006. While the lowest 20% of income earners accounted for around 1% of total tax receipts, the top quintile contributed nearly 70% to America’s tax revenues.
In other Western economies, progressive income taxes typically account for the largest proportion of total tax receipts by the government. America’s neighbor to the north, Canada, has an even higher top marginal tax rate than the US, and rather than applying to people earning above $370,000, as it does in the US, Canada’s top tax rate kicks in for workers earning just $100,000 per year. In Canada, personal income taxes account account for around 50% of total federal tax revenues, while the corporate tax and the national goods and services tax make up the next largest portions.
As mentioned, the highest marginal tax rates tend to exist in the social democratic nations of Northern and Western Europe. Denmark, a country with a Gini index of 29, has the highest tax rate on top income earners. More significant than the high rate, however, is the fact that it kicks in at such a low income level, around $50,000 per year. This means that a large number of Danish workers are paying a high marginal and average tax rate. The burden of the income tax in Denmark is born not by only the rich, but by the middle class as well. In contrast, Germany’s top marginal tax rate of 47% is only reached when a worker’s gross income exceeds $300,000 per year, meaning the income tax burden in Germany will be born more by the rich than those earning lower incomes, as is the case in the United States.
Arguments against progressive income taxes – the Laffer Curve:
The primary argument against the use of progressive income taxes as a means to redistribute national income comes from the “supply-side” school of macroeconomic thought. Supply-siders, whose views are formed by the classical theory of macroeconomics based on the belief that a free market economy left entirely to its own devices will always gravitate towards a level of production corresponding with full employment of the nation’s resources, believe there is a certain level of taxation at which a nation’s total tax receipts will be maximized. Beyond this point, further increases in the tax rat actually lead to a decline in the amount of taxable income due to the disincentive created by the higher tax rate. The Laffer Curve demonstrates the relationship between tax rate and tax revenue graphically:
At a tax rate of 0% households and firms will keep 100% of their gross income and there will be no tax revenue for the government. At a tax rate of 100%, however, there will also be no tax revenue since no rational individual will choose to work if the government takes everything he or she earns. The supply of labor falls as the tax rate increases since fewer individuals will be willing to work as the government collects higher percentages of their earned income. Therefore there will be no income for the government to tax when the tax rate is 100%.
Since both 0% tax and 100% create zero tax revenue, the Laffer Curve theory holds that at some tax rate (m) in between 0% and 100% the government’s total tax receipts will be maximized.The Laffer Curve is often cited by supply-side advocates as an argument for reducing marginal income tax rates on the top income earners. If, for instance, the tax rate is at y, it is possible that a lower tax rate could lead to higher tax revenue if the falling taxes incentivize individuals to join the labor force and existing workers to work harder and longer hours, creating more taxable income. In addition, entrepreneurs may be more inclined to start businesses and firms to increase their investments in physical and human capital, both activities contributing further to increases in national output and taxable income. At lower tax rates, argue the supply-siders, the level of taxable income may increase leading to higher tax revenues for the government.
It is not clear from the Laffer Curve at what precise level of taxation tax revenues are maximized. The model is most commonly employed by supply-siders to justify their desire for lower income and corporate taxes and a general reduction in the interference of the government in the functioning of the free market. The supply-side argument holds that lower taxes lead to an increase in the supply of labor and capital as households and firms are incentivized to become more economically active, leading to increases in the nation’s aggregate supply and thereby promoting the accomplishment of the macroeconomic goals of full employment and economic growth.
Externalities are a common concept, that we unknowingly encounter each day.
Externalities relate to the spillover costs or benefits that arise from the consumption or production of goods and services. To put this more simply, your friend’s consumption of products can sometimes have an effect on you. For instance his increased level of education can make him a valuable asset in quiz games, or his over-indulgence in caffeine can make him a hard person to work with in class. Sometimes society would prefer more social benefits and less of the spillover costs. The concept is called a social equilirium, where price and quantity reflect the social beliefs.
Spillover costs and benefits are things that exist in many nations. Governments for instance, work hard to discourage consumption of products with substantial spill over costs such as alcohol, cigarettes or chewing gum in Singapore. They will also aim to subsidize the production of goods, which generate positive spillover costs such as public gyms, swimming pools, running tracks or national immunization schemes.
Here are a few examples from Singapore to get you thinking about this new topic.
Negative Externality of Consumption – Cars
Living on a small island a mere 50km by 60km with 5 million people brings about many problems including traffic congestion. Whilst Singapore has an excellent system of public transport, including buses and a subway system, people still demand cars in ever increasing quantities. The spillover effects of private car use are traffic congestion and pollution. The government therefore has developed an array of policies to curb the rate of car ownership.
When you purchase a new car you must pay, an additional 100% of the cars value to the government as an indirect tax. Imagine a new Audi, retailing for $50,000 now costing $100,000 including the tax.
When you purchase a car you must also purchase a registration permit to drive it on the roads. These permits last for 10 years, after which you must sell the car overseas. A permit is sold through an auction system. When the demand for cars is high the price of the permit rises and demand for new cars may drop. A permit for a 2 litre engine car costs about $14,000 SGD for 10 years.
Throughout the inner city and freeway system an electronic road-pricing scheme operates. When you drive you car under one of the gantry’s you pay a small congestion tax which is deducted from a debit card in your car. When congestion is high the early evenings the congestion tax is increased from $0.50c to $1.50 on bad days. An evening commute can result is five or six congestion charges, costing drivers anything between $6 and $12.
Negative Externality of Consumption – Chewing Gum
Chewing gum is a product, that to different people, brings either a cost or benefit to society. The consumption of chewing gum can boost the production of saliva and help reduce chance of tooth decay. On the other hand chewing gum is a sign of urban decay with pavements littered with sticky blobs and grey scars.
The Singapore government feels that society would to prefer to minimize the spillover costs of chewing gum. Instead of imposing a tax on a packet of gum, it has been banned. You can not buy gum at any supermarket in Singapore. The result is pristine pavements that allows council cleaners to focus on other tasks.
Funnily enough, the nicotine gum (used to help smokers kick the habit) is legal with a prescription from your doctor.
Discussion Questions:
Why is chewing gum not banned in every country, if it produces spill over costs?
What are some possible alternative government interventions to reduce traffic congestion in Singapore?
Can you apply the concept of externalities to the consumption of deodorant? Draw a graph to show the private and social equilibriums.
With appreciation, I re-post his blog here in its entirety. Tim’s “Questions to consider” are perfect for IB and AP Econ students to answer in their Market Failure unit. Read and answer Tim’s discussion questions in the comments:
Today’s Econ 101 topic–actually AED Economics 200 but same diff–the deadweight loss from taxes in otherwise well-functioning markets. In my neverending–futile?–attempt to stay current, I plan to use this example from today’s Wall Street Journal:
Senate leaders are considering new federal taxes on soda and other sugary drinks to help pay for an overhaul of the nation’s health-care system.
The taxes would pay for only a fraction of the cost to expand health-insurance coverage to all Americans and would face strong opposition from the beverage industry. They also could spark a backlash from consumers who would have to pay several cents more for a soft drink.
The Center for Science in the Public Interest, a Washington-based watchdog group that pressures food companies to make healthier products, plans to propose a federal excise tax on soda, certain fruit drinks, energy drinks, sports drinks and ready-to-drink teas. It would not include most diet beverages. Excise taxes are levied on goods and manufacturers typically pass them on to consumers.
…
The Congressional Budget Office, which is providing lawmakers with cost estimates for each potential change in the health overhaul, included the option in a broad report on health-system financing in December. The office estimated that adding a tax of three cents per 12-ounce serving to these types of sweetened drinks would generate $24 billion over the next four years. So far, lawmakers have not indicated how big a tax they are considering.
Proponents of the tax cite research showing that consuming sugar-sweetened drinks can lead to obesity, diabetes and other ailments. They say the tax would lower consumption, reduce health problems and save medical costs. At least a dozen states already have some type of taxes on sugary beverages, said Michael Jacobson, executive director of the Center for Science in the Public Interest.
Questions to consider:
How do you reconcile the seemingly conflicting goals of reducing soda consumption and raising revenues to pay for health care?
Which effect do you expect to dominate: reduction in quantity demanded due to higher prices or increased revenue from higher prices?
Assuming the market for sodas (pop around here) is currently working efficiently, what effect do you expect a new tax to have on consumer well-being, producer well-being, government revenue and total social welfare?
What role do the elasticity of demand and elasticity of supply play in your answers to 1,2 and 3?
Harvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.
Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bondmarket. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:
One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“
There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.
Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.
Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.
But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.
Fareed Zakaria asks Ferguson:
“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”
Ferguson’s reply:
The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.
Finally Fareed asks the question everyone wants to know:”What the hell do we do?”
Ferguson:
One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.
Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.
The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.
Discussion Questions:
Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
Do you think investors will ever totally lose faith in US government bonds? Why or why not?
In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?
To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:
Here in Switzerland I enjoy the luxury of having to pay a relatively small federal incometax of 9.6%. In the US, at my current income level, I would be paying a 25% federal income tax. On the other hand, everything I buy here in Switzerland, from food to clothes to train tickets and bike parts, costs me an additional 7.6% of value added tax. If a product is imported, chances are there is also an additional 20% import tariff. In other words, what I save coming in (because of the low direct tax) I lose going out (through high indirect taxes).
The incentive, therefore, is to save as much of my income as possible. I shop much less than I would in the US where indirect taxes are much lower, but when I do shop prices are much higher. Much of Switzerland’s government revenue comes from the value added tax and other indirect taxes, which means households keep much more of their earned income.
In the United States, where the government has not seen a balanced budget since 2001, there has been much talk about creating a national sales tax to help raise revenue to pay for many of the social plans that the Obama administration wants to pursue, such as national health care. VATs and sales taxes are regressive, which means more of the tax burden is born by low income households compared with high a direct, income tax, which is progressive, meaning the higher a household’s income, the greater percentage it pays. But with budget shortfalls expected to reach $4 trillion over the next four years, new sources of tax revenue are needed.
“Everybody who understands our long-term budget problems understands we’re going to need a new source of revenue, and a VAT is an obvious candidate,” said Leonard Burman, co-director of the Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution, who testified on Capitol Hill this month about his own VAT plan. “It’s common to the rest of the world, and we don’t have it.”
The surge of interest in a VAT is testament to the extraordinary depth of the nation’s money troubles. While some conservatives have long argued that a consumption tax would provide a simpler and more efficient alternative to the byzantine U.S. income tax code, this time it’s all about the money.
To counter claims that a national sales tax is regressive, advocates point out that such a tax would allow the federal government to lower income tax rates for low income Americans, giving them more disposable income to spend on goods and services, which would be more expensive because of the VAT.
Another option the government should consider is a tax on greenhouse gas emissions. Currently, Obama is advocating a carbon permit market, which would be less effective at generating income for the government as permits, once they are issued or auctioned to industry, are bought and sold by firms, creating revenue for companies and not the government. A carbon tax, on the other hand, would create new tax revenue for the federal government and help reduce the negative externalities causing global warming and encourage development of alternative “green” methods of production.
In the short-term, it is unlikely that the US government will legislate any significant new taxes. Carbon taxes have been ignored by the Obama administration and Congress, under the argument that during a recession any new tax on industry might just break the nation’s manufacturing and energy sectors’ backs. A VAT is just as unpopular, for the reason that any policy raising consumer prices puts even greater burden on already strapped household incomes. Tradeable carbon permits are popular for the reason that they appear to be a “market based” approach to reducing greenhouse gas emissions; but Congress is talking about putting a price ceiling on carbon permits of $28 per ton, a price at which the incentives to reduce emissions among firms is minimal.
America’s long period of strong growth, low savings, and deficit financed government spending will necessitate belt-tightening in the near future as ultimately the government will have to start financing its budgets through tax revenues, not the issuing of new debt. Carbon taxes, higher marginal income taxes, or a national sales tax are all options the Obama administration can choose from. For now, it appears it’s choosing none of these, and instead selling more bonds to the public, foreigners, and the Fed, increasing the moneys supply in the hope that households and firms begin spending once more. The path towards fiscal discipline is a hard one to get started on, especially during a recession when no new taxes are politically viable.
Discussion Questions:
What make’s a sales tax regressive if everyone has to pay, say, 10% on top of the regular sales price of a good or service?
How does the US government finance its massive budgets when its revenue from taxes don’t even come close to equaling the amount of spending?
Why is it important for a country, in the long-run, to achieve a balnced budget?
What would you prefer to do: pay a higher income tax or a higher sales tax? What are the pros and cons of direct versus indirect taxes?
We all understand that fiscal stimulus is one of the tools that governments can use to increase the level of economic activity during a recession. The fiscal medicine can be delivered in one of two ways. The government can tweak the tax systems to boost incentives to spend and work or it can increase government spending. One tool that we can use to evaluate the merits of these two policies is to compare the relative multipliers that relate to government spending and taxation.
The multiplier is the key component of Keynesian theory and shows the possibility of a given increase in injections, e.g. government spending, investment and exports, increasing aggregate demand by more than the initial value. This logic fits with our understanding of the circular flow where say increased government spending will lead to increased derived demand for other products, and increased demand for labour. Workers will spend additional wages on other products which leads to further increases in aggregate demand. This flow on effect can be diluted by withdrawals from the system such as taxation or savings.
An essential skill for IB and AP Economics students is to be able to evaluate the effectiveness of Keynesian demand-side policies as well as classical supply-side policies, both fiscal and monetary. An understanding of multipliers can improve a student’s ability to evaluate fiscal policy. Greg writes:
“Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.
In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment.”
This low multiplier effect implies that any government spending must be used in an effective manner where it will increase the long-term productivity of the country. During a “jobs think-tank” recently in New Zealand, a media release announced an idea of the government spending a vast sum of money to develop a walking track from one end of the country to the other. Would this lead to increased tourism? How much money would these hiking visitors spend? Would it create more jobs?
Should we therefore expect that tax cuts will lead to a greater increase in GDP through the feedback loop compared to government spending? Well, we have to remember that not all tax cuts will be spent immediately, according to the marginal propensity to consume. In a recession some workers will be pessimistic about the future and save the money. Will tax cuts compensate workers who are working shorter hours? Greg suggests that tax cuts might actually be more potent than government spending according to current research.
“Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.
The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.
Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.”
So the current research indicates that one-dollar of tax cuts can increase G.D.P by $3 compared to an additional dollar of government spending increasing GDP by $1.40. But why is there such a large difference? Is this related to the arguments about the efficiency of increased government spending? The verdict is still out and we may need to wait till the next global recession to find out.
Below is a picture of the aptly named Bridge to Nowhere located in the central North Island of New Zealand. It was built by the government in a spending splurge in the 1936 to open up land in the area. The land is now no longer fertile or accessible and all access to the area is cut off except for this concrete relic. The area is now popular with trampers.
Discussion Questions:
How do economists calculate the multiplier?
What are leakages from the circular flow that reduce the multiplier effect?
Explain the link between the accelerator model and the multiplier.
What would multipliers for other injections such as export receipts or investment look like? Would they be higher or lower than multipliers for taxation or government spending?
Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
The following was published in the Chicago Tribune’s “Voice of the People” page on October 29, 2008 in the midst of the US presidential race:
Redistributing wealth
On my way to lunch recently, I passed a homeless guy with a sign that read “Vote Obama; I need the money.” I laughed. In a restaurant my server had on an “Obama 08″ tie. Again I laughed. Just imagine the coincidence. When the bill came, I decided not to tip the server and explained to him that I was exploring the Barack-Obama-redistribution-of-wealth concept. He stood there in disbelief while I told him that I was going to redistribute his tip to someone who I deemed more in need—the homeless guy outside. The server angrily stormed from my sight. I went outside, gave the homeless guy $10 and told him to thank the server inside as I’ve decided he could use the money more. The homeless guy was grateful. At the end of my rather unscientific redistribution experiment, I realized the homeless guy was grateful for the money he did not earn, but the waiter was pretty angry that I gave away the money he did earn even though the actual recipient deserved money more. I guess redistribution of wealth is an easier thing to swallow in concept than in practical application.
—A. Hart, Forest Park
The comment reflects a general contempt for the concept of taxation, specifically progressive taxes, or those that tax high income earners at a higher rate than those who earn low incomes. The idea behind a progressive tax, of course, is that higher income earners have income left over after they have provided themselves with the necessities of life, therefore should bear a larger burden of the nation’s tax revenue, which thereby enables the government to “re-distribute” wealth from the nation’s higher income earners across all levels of society through the provision of public goods.
The federal income tax in the United States is progressive in that the higher one’s income, the higher the percentage he or she pays to the US government. As seen in the table below, America’s poor will pay as little as 0-10% in income tax, while the nation’s richest households can pay up to 35%.
Opponents of progressive income taxes, which are also known as direct taxes because they are taken directly from a person’s income, argue that such a tax system creates a disincentive to work among American households. They argue that progressive income taxes penalize hard work and innovation, since the higher a worker’s productivity, the more of his income he must relinquish to the government.
One commonly misunderstood fact about the US income tax, however, is that it is a marginal tax system, meaning that when a person goes from, say the 25% to the 28% bracket, he does not pay 28% on ALL of his income, only on the marginal income above $82,250 (according to the 2009 column above). The implication is, therefore, that the average tax paid by an American will at any level of income be lower than the marginal tax. Below is a graphical representation of this concept. [source: http://aufrecht.org/pictures/images/858554/tax400.png]
It is the re-distributive intentions and effect of a progressive income tax system such as America’s (and every other country, click here to see tax rates from around the world) that has led to such intense opposition to the US tax system. Many in America’s government have proposed a “fair tax” that does away with America’s current direct tax system in favor of a nation-wide indirect, or sales tax on most goods and services. Watch the video below:
The fair tax is a indirect tax, meaning it is levied not directly on peoples’ income but indirectly on the purchase of goods and services in the economy, and is described as follows:
The sales tax rate, as defined in the legislation, is 23 percent of the total payment including the tax ($23 of every $100 spent in total—calculated similar to income taxes). This would be equivalent to a 30 percent traditional U.S. sales tax ($23 on top of every $77 spent before taxes).[4] The effective tax rate for any household would be variable due to the fixed monthly tax rebates that are used to “untax” purchases up to the poverty level.[3] The tax would be levied on all U.S. retail sales for personal consumption on new goods and services.
The two guests argue that the fair tax “is the only tax that totally untaxes the poor; the poor get a free ride totally across the board at the federal level under this plan.”
However, a national sales tax is a “regressive tax” meaning that as a percentage of income, the fair tax places a larger burden on lower income earners than higher income earners. An example is useful:
Two shoppers walk into a computer store. One earns $50,000 a year, the other $100,000 a year.
Both are looking at a computer that costs $2,000. Under the fair tax, $460 of the purchase price of this computer will go to the government as tax.
$460 represents .92% of the income of the shopper who earns $50,000 per year.
$460 represents .46% of the incomeof the shopper who earns $100,000 per year.
The higher income earner pays a lower percentage of his income to the government in tax than the low income earner, making this a regressive tax.
One of the four macroeconomic goals governments aim to achieve in their policy making is more equal distribution of income. The fair tax, despite the arguments its advocates make, does not achieve a more equal distribution of income in America. It does place a smaller tax burden on the rich than the current system, but on the other hand America’s lower income earners bear a relatively larger burden of tax.
Discussion Questions:
Are taxes necessary? Why? What are some of the “public goods” tax revenues are used to provide in America and your country?
Discuss the claim that a progressive tax system stifles innovation, entrepreneurship and incentive to work.
On whom does the largest burden of a sales tax (like the fair tax)fall? Is a sales tax “fair”? Why or why not?
On my way to work this morning I listened to the latest episode of WEBZ Chicago Public Radio’s excellent show This American Life. The theme of this week’s radio show was “the New Boss”. America’s new boss, Barack Obama, has embarked on an ambitious experiment aimed at rescuing the American economy from the most severe recession it has seen since the Great Depression. The economic theory behind Obama’s nearly $1 trillion economic stimulus package was developed by a man we have all heard of in our AP and IB Economics classes, but probably know little about in a historical sense.
The clip from This American Life that I have included below presents a fascinating examination of Keynes’ life and times, and puts his theory into perspective in the history of macroeconomics of the last century. We learn that Keynesian theory has not been truly put to the test, and that Obama’s $830 billion stimulus package is the first real test of Keynesianism.
The clip is a bit long, but it is definitely worth listening to if you are a student or teacher of economics. I know that when I come teo Macroeconomics and Fiscal Policy in my course this spring, I will have my kids listen to and discuss the podcast below. If you’re teaching or learning Macro now, feel free to listen and leave comments about your impressions of the story here.
I love this discussion between John Stewart and former director of the National Economics Council Lawrence Lindsey. Stewart pitches his own version of a fiscal stimulus package to the economist, and is surprised when Lindsey agrees with the plan.
I find Lindsey’s suggestion that a stimulus package should include subsidized mortgage rates to home owners fascinating. According to Lindsey, a homeowner with a $200,000 mortgage paying 6% interest on his loan would save $4,000 per year on interest payments if the government accommodated a refinanced rate of 4%. Millions of Americans currently struggling to meet all of their monthly debt obligations while continuing to put food on the table and participate in the consumer economy would benefit from such a scheme. In its current form, Obama’s stimulus package with its $150 billion or so in tax cuts will only put approximately $500 per year for two years into taxpayers’ pockets.
As a homeowner paying a 6% mortgage myself, I can personally say I’d prefer $4,000 in savings on my annual interest payments for the next 23 years (the time remaining on my mortgage) than I would $1000 in cash over the next two years. The mortgage relief plan would result in nearly $100,000 less in interest payments, freeing that income up to be spent on goods and services and contributing to real job creation.
And check out last night’s “moment of Zen”. While Obama’s stimulus package is not quite $1 trillion, it is darn close. Senator Mitch McConnell puts the vast size of the spending bill into perspective for us:
