Before we can have a meaningful discussion about tax policy, let me briefly describe the way an economy functions. Until that foundation is laid, the impacts of taxation cannot be fully understood.
The Bucket Analogy
A classic metaphor of an economy is to visualize a bucket of water. The level of water within the bucket is the level of economic activity that is underway. This captures all the trades that happen within the economy. The restaurant meals, dentist visits, accounting services, medical care, education, etc. Now, this is an oversimplification, which I will correct in a moment, but bear with me.
Now picture a water spigot at each end of the bucket. One at the top flowing water in and another at the bottom letting water out. If the valves on each are allowing an equal amount in and out, the water level doesn’t change. Conversely, if the water flowing in is turned down, without an offsetting change at the other end, the water level will fall, and vice versa.
Water flowing in (injections) from outside the economy increase the level of economic activity. Water flowing out (leakages) decrease that level.
The most common injections are exports, retirement spending, non-resident spending, and government spending. All of these increase the amount of money that can circulate in the economy.
The most common leakages are imports, savings, and taxes. Each of these remove money from the economy.
It is important to consider two points here. First, government spending is offset by the revenue collection. The net macroeconomic effect of converting a private dollar to a government dollar is zero from a broad perspective. However, social wellbeing may increase or decrease depending on where that dollar came from and where it goes. It is therefore the microeconomic factors that are of more importance, although the macroeconomic factors make better talking points.
You don’t often hear people conceding this point. That is because they speak from a static model perspective. Ceteris Paribus is the Latin term economists often evoke. It means “all else equal.” Chances are when you hear policy makers speak, they invoke this caveat. The problem is that it focuses only on “first order” effects, and ignores the follow-on impacts.
Governments do not tax for the sake of taxing. They do so for the purpose of spending on things that provide benefits to its citizens. The debate should center on if those benefits outweigh their costs, not solely on the economic cost of taxation without consideration of the economic gains of the spending it enables. Granted, there are different impacts on the economy related to the different types of taxation. That is the discussion I intend to have in part 3.
The second point to consider is that the economy is way more complex than any one factor. Therefore, it is very difficult to distill statistical data into meaningful findings. Given the complexity, it is very easy to find data to support any position you may try to defend.
Multipliers and Propensities
The metaphor of the water level as the economic activity level is exhausted at the visualization of flows in and out. We need a slightly better metaphor to understand how the economy functions. I like to think about it as a fountain. There is a pool of water at the bottom and a pump that takes that water up to some point where the water flows back to the pool. In this metaphor, the paychecks to employees make up the pool and the purchase of goods from businesses represent the pump. An economy cannot function without both the water and the pump. The level of economic activity isn’t the volume of water in the system, it’s a measure of how much water is circulating, so the size of the pump matters, as do the amount of leaks and injections.
It turns out that measuring the economy requires an understanding of not just how much money the individuals make, but also what they do with that money. Some people are more prone to spend their money slowly, others spend it all on payday. Some people don’t spend all the money they make, others borrow money they don’t have. Some people are more likely to spend their money on restaurants, others on Amazon. All of these factors play into how much money circulates in the economy and how much total activity there is in a given time period.
In general, we like to count how many times a new dollar from outside the economy will circulate before it leaks out. For example, a dollar spent by a tourist goes to a store owner, who pays it to an employee, who spends it at the movies, who pays it to an employee, who goes out to eat at a restaurant and leaves it as a tip for the wait staff, who spends it on food at Safeway, etc. We try to count up all the extra activity that was made possible by that new dollar with what we call an economic multiplier. A robust self-contained economy might see a multiplier up to 10, meaning 1 new dollar generates 10 dollars of activity. A leaky economy that relies on importation might have a multiplier of just 2, meaning it passes through just one extra time before flowing out. That leaky economy is therefore far more dependent on capital inflow than a more robust one.
Different sectors of the economy have different multipliers. For example, the transportation sector is much more likely to pay local drivers and purchase fuel from local vendors. The retail industry is going to rely on imports if they cannot find locally sourced products. These two sectors will have different multipliers and moving a dollar from the lower to the higher will generally result in a net increase in economic activity, to a limit. This implies that the difference between the government multiplier and the multiplier of the industry from which a tax dollar comes can result in a net change in activity, either positive or negative.
Likewise, individuals within the economy have their own version of a multiplier. We call it the “marginal propensity to spend” or MPS. Basically, what this means is that some people are more likely to spend their paycheck than others. The MPS, generally speaking, correlates to the income level of the individual. A person that makes more money is more likely to save some of it. The MPS is the percentage of an additional dollar of income that enters the economy rather than savings accounts.
When money is placed in savings, it does not contribute to the economy of today, it contributes to the future economy. Debt is the opposite of savings, it contributes today by reducing future activity.
If a government is most interested in increasing the current economic activity level, it can do so by moving money out of saving and into the economy. One way of doing so is by reducing the incentive to save, that is cut the interest rates or tax investment earnings at a higher rate.
Another way to promote short-term economic activity is to keep more money in the hands of those people with a higher MPS. This means targeting taxation to those dollars less likely to circulate in the economy.
But remember, the economy isn’t a static pool of water, it is flowing. That implies that changes to the system will have impacts beyond the direct change, both in the present and in the future. So decisions on how to address a problem in the present should contemplate the impacts those changes will have on the future as well as the present.
Responsive to Change
It is worth saying one more time, an economic system is dynamic. That is to say, it is constantly changing and adapting to changes. As a quick thought experiment for illustration, imagine there is only 1 good in the entire economy and it costs $100. A person has a budget of $1,000 per month. In the status quo, the person has the purchasing power of 10 units per month and gains the personal value that consuming those 10 units brings. If suddenly the price goes up to $11 per unit, their purchasing power falls to 9 units per month.
This is a very simple analogy that is simply meant to demonstrate that you must take into account the fact that the consumer must adapt to changes in conditions, no matter where that change originates. You cannot simply adjust your model of the economy by applying a new price/tax/quality level to previous activity levels. If you want a real projection of the implications of a policy change, your model must be dynamic and allow for the agents to adjust their behavior to the new economic conditions.
Tenants of Good Tax Policy
It should be clear by now that an economy is a complex system. Easy answers rarely work out the way they should in a complex system. Forecasts are difficult to make as the implications of policy changes are hard to predict. Unintended consequences are prevalent whenever a new policy is adopted. And data is hard to interpret, as cause and effect are hard to link with so much going on.
But, generally speaking, good policy is not hard to spot. Some good policies are easy, they simply improve everyone in the system therefore improve the system as a whole. Other good policies are difficult. They improve some things by harming others. The net effect is hard to determine, especially in advance.
But there are ways to improve the chances that a contentious policy will work out to be a net improvement for society. For one, the policy should be simple and easy to apply. The more caveats, exemptions, deductions, and exclusions that a policy has, the more complex it becomes, the more difficult it will be to administer and evaluate. This leads to inefficiencies as the cost to administer rises and the opportunity for error increases. In turn, this leads to a need for higher levels of audit and litigation, which at best get you back to where a simpler system would have got you and at worse ends up becoming less effective. A good, simple tax policy will minimize administrative costs and should always result in net social gain (the economic loss must be overcome by effective social improvement of more value than its cost).
Naturally there are additional factors to consider. Remember that the economy is complex and nothing should be viewed from a static frame of mind. The first goal should always be to restrict the amount of taxes to only those things that improve society by more than their cost. The secondary goal should be to take those necessary taxes in the least damaging way to the economy. When using fiscal policy to stimulate the economy, there is a whole separate conversation to be had.
Next week I will explore some different tax tools governments use and discuss how they impact the economic system.
The Governor of Alaska recently announced that he would be calling a special session to work on “revenues.” As I currently advise the Commissioner of Natural Resources on several issues, I want to make it clear that I do not advise the Commissioner of Revenue or the Governor on tax policy or revenue issues. This series of posts are not intended to provide any policy guidance. Anything perceived to be an opinion or policy recommendation is mine alone and should not be construed as a reflection of the administration’s position. I intend for these posts to be purely objective and educational. Please do not project any of my words onto anyone other than myself.