Economic Reasoning, Lecture 5

Taxation and Government Spending

Gold and Trade

●Last time, Erika asked an excellent question. Suppose trade is paid for by gold, not separate national currencies. If America purchases Japanese cars, can’t the Japanese use the gold they receive only to buy Japanese products?

●We can’t use the argument that they have to spend American dollars on American products.

Gold and Prices

●If this is true, does it follow that free trade under an international gold standard could lead to loss of employment?

●No. If the gold is spent on Japanese products, this will raise prices of Japanese goods relative to American goods. In the long run, gold will flow out of Japan and into America

●David Hume wrote about this effect.

Ethics

●Jay also asked an important question. What is the the relation between the economic points made in the lectures and ethical statements about them?

●E.g., when I said that tariffs are a bad idea, is this part of economics?

●No, it isn’t. I was assuming that we accept certain ethical claims, but it isn’t part of economics to establish such claims. Its conclusions aren’t dependent on claims about ethics.

Effects of Taxation

●Taxation of wealth and income reduces the incentives that people have to work and invest and thus reduces production. This is called the substitution effect, because people substitute leisure for work.

● If part of the money you make is going to be taken away from you, this is equivalent to an offer of less money to you to work. Your salary consists of all the benefits you actually get.

●The same principle applies to accumulating wealth. If savings are taxed, people will be more reluctant to save than otherwise.

Substitution Effect versus Income Effect

●What is important in estimating the incentive effect of taxes is the marginal rate. This is the rate on income or wealth you expect to get. Action is prospective; it looks to the future.

●Some people object to the incentives argument. They don’t deny it altogether, but they say the substitution effect has to be considered together with the income effect.

The Income Effect

●Some economists argue that people don’t always respond to taxes by substituting leisure for work.

●Suppose that it is very important to someone that he earns $100,000 per year. If taxes go up, he may work more so that he can still earn the money he wants.

●Think of a divorced person who works harder because he has to pay alimony.

Rothbard on the Income Effect

●Whether the substitution effect or the income effect applies in a given case is an empirical question.

●If the income effect does operate, Rothbard noted that taxation still has problems. People have shifted their preference for leisure in a way that they would rather have avoided.

Taxes, Saving, and Consumption

●Many economists have proposed having a tax only on consumption. Robert Frank is one of these.

●The argument he gives is that saving promotes growth and that much consumption expense is wasteful.

●Rothbard asks, why should the government try to alter the consumption-savings preference?

The Laffer Curve

●It turns out that the substitution effect usually prevails. (Again, this is an empirical question. We can’t decide this through a priori reasoning.)

●Arthur Laffer and other supply side economists made this argument. Because of the substitution effect, the government can sometimes get more revenue with lower marginal tax rates than with higher ones. If tax rates get really high, people won’t want to produce and so not much revenue will be taken in.

Laffer Curve Continued

●Laffer said that we can draw a curve showing the relation between marginal tax rates and revenue collected. If tax rates are zero, no revenue will be collected. If tax rates were 100%, no revenue would be collected either.

●This allows us to draw a curve between these points that shows the relation between marginal tax rates and revenue collected.

Problems with the Curve

●It’s true that increasing tax rates doesn’t always add revenue. But it doesn’t follow that this will be true within the range the government cares about. It may turn out that lowering tax rates will reduce government revenue.

●Why should we care about maximizing government revenue? Rothbard made this point.

Another Problem

●There is another problem with the Laffer Curve. Why assume that there is a curve at all?

●Suppose that at a certain tax rate, the government gets a particular amount of revenue. What happens if you slightly change the tax rate? If there is a curve, then the revenue will also change slightly. There won’t be big jumps.

●We have no reason a priori to think that this is true.

Progressive Tax

●A progressive tax is one that taxes higher incomes at higher rates. Suppose there is a 10% tax on everybody’s income. Then someone who makes $1,000,000 per year will pay more in taxes than someone who makes $50,000. But he is paying the same rate.

●A progressive tax e.g., would require people to pay 25% on income over $1,000,000 .

Taxes and Utility

●One argument for progressive taxes goes like this. All goods have diminishing marginal utility. As you get more units of a good, you put them to less valued uses. This applies to money, too.

●Thus, a dollar to a rich person has much less utility than it does to a poor person. Shifting the tax burden from the poor and middle class to the rich will increase utility. A. C. Pigou defended this argument. It assumes that you can compare utility across persons.

Government Spending

●Very often, people favor government spending programs. There are two reasons that people have for this. First, they want particular programs, e.g., infrastructure.

●Second, aside from the benefits of particular programs, people argue that the government’s spending will stimulate the economy. It doesn’t matter what the money is spent on.

Broken Windows

●Both of these contentions commit the broken window fallacy.

●How does the government get the money it spends? If it raises taxes, then people don’t have money then would otherwise have been able to spend. They would have spent the money on other things.

●When they spend it, they would also stimulate the economy.

Another Version of the Fallacy

●Some economists have made this argument. Some public works, such as bridges and in roads, need repair. If they aren’t repaired, they will require more expensive repairs later. Thus, if we raise taxes now, we will be saving money. Robert Frank has made this argument.

Another Broken Window

●This is a more sophisticated version of the broken window fallacy. It’s true that spending money on repairs now can be cheaper than waiting until later.

●But it is still true that money spent now by the government must be compared with money that people would spend on other things. This applies both to now and in future when the repairs will cost more. It could be that it is better to abandon the government projects rather than repair them. The argument wrongly restricts the alternatives.

An Objection

●Suppose the government doesn’t increase taxes. It will then go into debt. If it does this, isn’t it true that government spending stimulates the economy, without taking away from other things that people would have spent their money on?

●Going into debt leads to inflation. Further, the debt has to be repaid eventually and then taxes will increase.

Ricardian Equivalence

●One controversial claim is that if the government increases spending without increasing taxes, its attempt to stimulate the economy won’t be successful.

●People will anticipate that taxes will go up, so they will reduce their spending and increase saving to prepare for the higher taxes.

●The extent to which this happens is in dispute, and it isn’t part of Austrian economics that people always act in this way.

Government Spending versus Private Spending

●So far, we have said that government spending displaces private spending. Can we say anything else?

●Hazlitt points out that if money is in private hands, investment is likely to go to people with a proven track record of success. People are careful about investing their own money. This isn’t true for government spending.