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.

Injections and Leakages

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.

If the water flowing in is turned down, without an equal change in the rate flowing out, 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.

Impact of Taxation

Governments do not tax for the sake of taxing. They do so for the purpose of spending those tax dollars on things that provide benefits to its citizens.

That is, the net macroeconomic effect of converting a private dollar to a government dollar is zero, from a broad perspective. Of course there are limits to doing this, there are efficiencies to consider, and there are different winners and losers from taking this action.

That includes the impact on microeconomic factors (income and consumption), which are also important. That is the discussion I intend to have in part 3. 

But, pointing out the negative impacts of taxation without also considering the positive impacts of spending is disingenuous. The debate should center on if those benefits outweigh their costs.

Multipliers and Propensities

I like to think about the economy as a fountain rather than a bucket. 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.

Multipliers

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 a vendor, who goes out to eat at a restaurant and leaves it as a tip for the wait staff, who spends it on food, etc.

We try to count up all the 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. And, the leaders of such an economy have very limited ability to influence the economic system with fiscal policy tools.

Propensity

Individuals within the economy have contributions to the multiplier. We call this their “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 with lower income is more likely to purchase bare necessities. A person that makes more money is more likely to save some of it.

This difference in MPS implies that taxation has different impacts on different people. That is something many governments take into account.

Secondary Impacts

An economic system is dynamic. That is to say, it is constantly changing and adapting to changes.

When you tax someone’s income by $1,000, that is $1,000 less money they have to spend on things businesses sell. Therefore, the impact of taxation is not just on the individual. It flows through to the rest of the economy.

Likewise, when the government purchases goods from a local business, that business can hire more people.

Everything in connected.

Tenants of Good Tax Policy

It should be clear by now that an economy is a complex system. Data is hard to interpret with so much going on.

But there are ways to improve the chances that a policy will work out to be a net improvement for society.

For one, the policy should be simple. The more caveats, exemptions, deductions, and exclusions that a policy has, the more difficult it will be to administer and evaluate.

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.

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).

A policy should also be “fair.” That is, a good tax policy usually understands that taking a dollar from a poor person has different effects than taking one from a rich person. But, a good policy also strives to ensure that the people paying a tax are also benefiting from it. This whole issue of “fairness” is one of the most complicated problems to address.

Naturally there are additional factors to consider. Remember that the economy is complex and nothing should be viewed from a static frame of mind. You will never gain understanding of the system by focusing on one element and ignoring the big picture.

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 and the individuals within it.