Tag: economics

Basic Economics for Financial Journalists and Other Dummies

While driving home last night, I had the miserable experience of listening to a financial journalist being interviewed about the anemic growth numbers that were just released.

I wasn’t unhappy because the interview was biased to the left. From what I could tell, both the host and the guest were straight shooters. Indeed, they spent some time speculating that the economy’s weak performance was bad news for Obama.

What irked me was the implicit Keynesian thinking in the interview. Both of them kept talking about how the economy would have been weaker in the absence of government spending, and they fretted that “austerity” in Washington could further slow the economy in the future.

This was especially frustrating for me since I’ve spent years trying to get people to understand that money doesn’t disappear if it’s not spent by government. I repeatedly explain that less government means more money left in the private sector, where it is more likely to create jobs and generate wealth.

In recent years, though, I’ve begun to realize that many people are accidentally sympathetic to the Keynesian government-spending-is-stimulus approach. They mistakenly think the theory makes sense because they look at GDP, which measures how national income is spent. They’d be much less prone to shoddy analysis if they instead focused on how national income is earned.

This should be at least somewhat intuitive, because we all understand that economic growth occurs when there is an increase in things that make up national income, such as wages, small business income, and corporate profits.

But as I listened to the interview, I began to wonder whether more people would understand if I used the example of a household.

Let’s illustrate by imagining a middle-class household with $50,000 of expenses and $50,000 of income. I’m just making up numbers, so I’m not pretending this is an “average” household, but that doesn’t matter for this analysis anyway.

Expenses                                                        Income                                  

Mortgage           $15,000                        Wages                $40,000

Utilities               $10,000                        Bank Interest       $1,000

Food                     $5,000                        Rental Income      $8,000

Taxes                  $10,000                        Dividends             $1,000

Clothing               $2,000

Health Care         $3,000

Other                   $5,000

The analogy isn’t perfect, of course, but think of this household as being the economy. In this simplified example, the household’s expenses are akin to the way the government measures GDP. It shows how income is allocated. But instead of measuring how much national income goes to categories such as consumption, investment, and government spending, we’re showing how much household income goes to things like housing, food, and utilities.

The income side of the household, as you might expect, is like the government’s national income calculations. But instead of looking at broad measures of things such wages, small business income, and corporate profits, we’re narrowing our focus to one household’s income.

Now let’s modify this example to understand why Keynesian economics doesn’t make sense. Assume that expenses suddenly jumped for our household by $5,000.

Maybe the family has moved to a bigger house. Maybe they’ve decided to eat steak every night. But since I’m a cranky libertarian, let’s assume Obama has imposed a European-style 20 percent VAT and the tax burden has increased.

Faced with this higher expense, the household – especially in the long run – will have to reduce other spending. Let’s assume that the income side has stayed the same but that household expenses now look like this.

Expenses                                                       

Mortgage           $15,000

Utilities                 $9,000        (down by $1,000)

Food                     $4,000        (down by $1,000)

Taxes                  $15,000        (up by $5,000)

Clothing               $2,000

Health Care         $3,000

Other                   $2,000        (down by $3,000)

Now let’s return to where we started and imagine how a financial journalist, applying the same approach used for GDP analysis,  would cover a news report about this household’s budget.

This journalist would tell us that the household’s total spending stayed steady thanks to a big increase in tax payments, which compensated for falling demand for utilities, food, and other spending.

From a household perspective, we instinctively recoil from this kind of sloppy analysis. Indeed, we probably are thinking, “Spending for other categories – things that actually make my life better – are down because the tax burden increased!!!”

But this is exactly how we should be reacting when financial journalists (and other dummies) tell us that government outlays are helping to prop up total spending in the economy.

The moral of the story is that government is capable of redistributing how national income is spent, but it isn’t a vehicle for increasing national income. Indeed, the academic evidence clearly shows the opposite to be true.

Let’s conclude by briefly explaining how journalists and others should be looking at economic numbers. And the household analogy, once again, will be quite helpful.

It’s presumably obvious that higher income is the best thing for our hypothetical family. A new job, a raise, better investments, an increase in rental income. Any or all of these developments would be welcome because they mean higher living standards and a better life. In other words, more household spending is a natural consequence of more income.

Similarly, the best thing for the economy is more national income. More wages, higher profits, increased small business income. Any or all of these developments would be welcome because we would have more money to spend as we see fit to enjoy a better life. This higher spending would then show up in the data as higher GDP, but the key thing to understand is that the increase in GDP is a natural result of more national income.

Simply stated, national income is the horse and GDP is the cart. This video elaborates on this topic, and watching it may be more enjoyable than reading my analysis.

The Gang of Six Is Back from the Dead: Contemplating the Good, the Bad, and the Ugly in Their Budget Plan

The on-again, off-again “Gang of Six” has come back on the scene and is offering a “Bipartisan Plan to Reduce Our Nation’s Deficits.”

The proposal is quite similar to the one put forth by the President’s Simpson-Bowles Commission, which isn’t too surprising since some of the same people are involved.

At this stage, all I’ve seen is this summary (A BIPARTISAN PLAN TO REDUCE OUR NATIONS DEFICITS v7), so I reserve the right to modify my analysis as more details emerge (and since I fully expect the plan to look worse when additional information is available, the following is an optimistic assessment.

The Good

  • Unlike President Obama, the Gang of Six is not consumed by class-warfare resentment. The plan envisions that the top personal income tax rate will fall to no higher than 29 percent.
  • The corporate income tax rate will fall to no higher than 29 percent as well, something that is long overdue since the average corporate tax rate in Europe is now down to 23 percent.
  • The alternative minimum tax (which should be called the mandatory maximum tax) will be repealed.
  • The plan would repeal the CLASS Act, a provision of Obamacare for long-term-care insurance that will significantly expand the burden of federal spending once implemented.
  • The plan targets some inefficient and distorting tax preference such as the health care exclusion.

The Bad

  • The much-heralded spending caps do not apply to entitlement programs. This is like going to the doctor because you have cancer and getting treated for a sprained wrist.
  • A net tax increase of more than $1 trillion (I expect that number to be much higher when further details are divulged).
  • The plan targets some provisions of the tax code – such as IRAs and 401(k)s) – that are not preferences, but instead exist to mitigate against the double taxation of saving and investment.
  • There is no Medicare reform, just tinkering and adjustments to the current system.
  • There in no Medicaid reform, just tinkering and adjustments to the current system.

The Ugly

  • The entire package is based on dishonest Washington budget math. Spending increases under the plan, but the politicians claim to be cutting spending because the budget didn’t grow even faster.
  • Speaking of spending, why is there no information, anywhere in the summary document, showing how big government will be five years from now? Ten years from now? The perhaps-all-too-convenient absence of this critical information should set off alarm bells.
  • There’s a back-door scheme to change the consumer price index in such a way as to reduce expenditures (i.e., smaller cost-of-living-adjustments) and increase tax revenue (i.e., smaller adjustments in tax brackets and personal exemptions). The current CPI may be flawed, but it would be far better to give the Bureau of Labor Statistics further authority, if necessary, to make changes. A politically imposed change seems like nothing more than a ruse to impose a hidden tax hike.
  • A requirement that the internal revenue code maintain the existing bias against investors, entrepreneurs, small business owners, and other upper-income taxpayers. This “progressivity” mandate implies very bad things for the double taxation of dividends and capital gains.

This quick analysis leaves many questions unanswered. I particularly look forward to getting information on the following:

  1. How fast will discretionary spending rise or fall under the caps? Will this be like the caps following the 1990 tax-hike deal, which were akin to 60-mph speed limits in a school zone? Or will the caps actually reduce spending, erasing the massive increase in discretionary spending of the Bush-Obama years?
  2. What does it mean to promise Social Security reform “if and only if the comprehensive deficit reduction bill has already received 60 votes.” Who defines reform? And why does the reform have to focus on “75-year” solvency, apparently to the exclusion of giving younger workers access to a better and more stable system?
  3. Will federal spending under the plan shrink back down to the historical average of 20 percent of GDP? And why aren’t those numbers in the summary? The document contains information of deficits and debt, but those figures are just the symptoms of excessive spending. Why aren’t we being shown the data that really matters?

Over the next few days, we’ll find out what’s really in this package, but my advice is to keep a tight hold on your wallet.

New Study from Swedish Economists Allows Us to Quantify the Cost of the Bush-Obama Spending Binge

The United States has been on a decade-long spending binge. Thanks to the profligate policies of both Bush and Obama, the burden of federal spending has climbed to about 25 percent of economic output, up from 18.2 percent of GDP when Bill Clinton left office.

The political class tells us that more government is good for the economy since it an “investment” and/or a “stimulus.”

The academic research, however, tells a different story. Here are some brief excerpts from a recent study by two Swedish economists, including a critically important observation about the impact of bigger government on economic performance.

…most recent studies typically find a negative correlation between total government size and economic growth. …the most convincing studies are those most recently published. …In general, research has come very close to a consensus that in rich countries there is a negative correlation between total government size and growth. It appears fair to say that an increase in total government size of ten percentage points in tax revenue or expenditure as a share of GDP is on average associated with an annual lower growth rate of between one-half and one percentage point.

Let’s focus on the last sentence of the excerpt and contemplate the implications. The research cited above tells us that annual growth is 0.5 percentage point-1.0 percentage point lower if the burden of government rises by 10 percentage points of GDP. Well, the burden of federal spending has jumped by more than 5 percentage points of GDP during the Bush-Obama years, indicating that annual growth in America is now 0.25 percentage point-0.5 percentage point lower than it otherwise would be.

Now let’s take the best-case scenario, and assume that annual growth has only dropped by 0.25 percentage points, and consider what that means. It may not sound like much, but even small differences in growth rates become very important over time. For an average household over a 25-year period, the loss of 0.25 percentage points of growth means annual income will rise, but the total increase will be about $5,000 smaller by the 25th year.

The budgetary implications of growth also are rather important. According to the Congressional Budget Office, the economy’s performance has a large impact on tax receipts (more growth means higher incomes and more taxpayers) and a small effect on government spending (more growth means fewer people at the public trough). CBO even publishes a “sensitivity table” with specific estimates (Table B-1).

If we once again use the best-case scenario and assume the Bush-Obama spending binge has reduced annual growth by only 0.25 percentage points, the CBO numbers show this means more than $750 billion of additional red ink. This is something to keep in mind as the White House argues that job-killing class-warfare tax hikes will somehow improve the budget situation.

Let’s now return to the academic research. The authors included a very helpful table showing the results of recent studies on the relationship between the size of government and economic performance. Click on the image for a full-size look at how the majority of scholarly research this century confirms that big government is bad for prosperity.

For all intents and purposes, all this research shows that developed nations are on the downward-sloping portion of the Rahn Curve. Named after my Cato colleague Richard Rahn and explained in the video below, the Rahn Curve is sort of a spending version of the Laffer Curve.

It shows that growth is maximized by small governments that focus on core “public goods” like rule of law and protection of property rights. But when governments expand beyond a certain growth-maximizing level (the research says about 20 percent of GDP, by I explain in the video why the right number is probably much smaller), the result is slower growth and less prosperity.

With the exception of high-growth Hong Kong and Singapore, all developed nation have public sectors that consume at least 30 percent of economic output. This means that government spending is undermining prosperity all around the world. And since the burden of government spending is close to 40 percent of GDP in the United States…well, you can fill in the blanks.

Bacon, Duct Tape, and the Free Market

It’s hard to imagine how we would get through life without necessities like bacon and duct tape. But have you ever thought about how the free market gives you so much for so little?

Here’s a video that should be mandatory viewing in Washington. Too bad politicians didn’t watch it before imposing government-run health care.

And since we’re contemplating the big-picture issue of whether markets are better than statism, here’s some very sobering polling data from EurActiv:

A recent survey has found deep pessimism among European Commission staff on a wide range of issues, including the course of European integration over the past decade and the likelihood of success of the EU’s strategy for economic growth. Some 63% partially or totally agreed that “the European model has entered into a lasting crisis.”

This is remarkable. Even the statist über-bureaucrats of the European Commission realize the big-government house of cards is collapsing, yet politicians in Washington still want to make America more like Europe.

Christina Romer’s Naïve Keynesianism

President Obama’s former head of the Council of Economic Advisers has taken to the pages of the New York Times to warn us against pursuing “fiscal austerity just now,” particularly not spending cuts.

Christina Romer’s views are Keynesian. She doesn’t use that word, but she is focused on juicing “demand” with optimally-targeted and well-managed government “investments.”

Economics has numerous schools of thought, but Romer’s writing reflects nothing but the most simplistic Keynesian framework. The fact that the huge Keynesian stimulus of recent years that she supported has coincided with the slowest economic recovery since World War II seems to be of little concern to her.

She also doesn’t seem to be interested in how government spending actually works in the real world. She assures us that “government spending on things like basic scientific research, education and infrastructure … helps increase future productivity.”

That view has a veneer of economic authenticity, but it leaves many issues unaddressed:

  • Most federal spending is on transfers and consumption, not investment. The debt crisis we face is driven mainly by entitlements, which is consumption spending. Romer’s talk of investment spending is a rhetorical bait-and-switch.
  • Romer doesn’t distinguish between average and marginal spending. If some federal investment spending has created positive net returns, that doesn’t mean that additional spending would. Governments already spend massive amounts on education, for example, so the marginal return from added spending is probably very low.
  • If the government investments that Romer touts are so valuable, then why hasn’t the government done them already? After all, federal, state, and local governments in this country already spend 41 percent of GDP.
  • If science, education, and infrastructure investments have the high returns that Romer seems to think they do, then why does the government need to be involved? Private firms seeking higher profits would be all over such investments.
  • Romer mentions that the “social returns” on some investments might be higher than purely private returns. However, that doesn’t mean that the government should automatically intervene. For one thing, the government suffers from all kinds of management failures and other pathologies.
  • Romer also ignores that the government imposes substantial deadweight losses on the economy when it commandeers the resources it needs for its “investments.”

So my reading assignment for Romer is www.DownsizingGovernment.org so she can get a better understanding of how federal programs actually operate.

And readers interested in all the economics of government spending that Romer doesn’t tell you about can consult Edgar Browning’s excellent book, Stealing From Each Other.

CAP Leftists Have Accidental Encounter with the Laffer Curve, Learn Nothing

The big-government advocates at the Center for American Progress recently released a series of charts designed to prove America is a low-tax nation. I wish this was the case.

The United States does have a lower overall tax burden than Europe, which is shown in one of the CAP charts, but that doesn’t exactly demonstrate that taxes are low in America. Unless, of course, you think weighing less than an offensive lineman in the NFL is proof of being skinny.

But the one chart that jumped out at me was the one showing that the United States collects less corporate tax revenue than other developed nations. The CAP document states, with obvious disapproval, that “Corporate income tax revenue in the United States is about 25 percent below the OECD average.”

The obvious implication, at least for the uninformed reader, is that the United States should increase the corporate tax burden.

But here’s some information that CAP didn’t bother to include in the study. The U.S. corporate tax rate is more than 39 percent and the average corporate tax rate in Europe is less than 25 percent.

So let’s ponder these interesting facts. CAP is right that the U.S. collects less tax revenue from corporations, but even they would be forced to admit (though they omit the info from their report) that the U.S. corporate tax rate is much higher. Let’s see…higher tax rate-lower revenue…lower tax rate-higher revenue…this seems vaguely familiar.

Could this possibly be an example of that “crazy” concept of (gasp!) a Laffer Curve? To be sure, it is only in rare cases, when tax rates get very high, that researchers find that high tax rates lose revenue. In most cases, the Laffer Curve simply implies that higher tax rates won’t raise as much money as politicians want.

But have our friends at CAP inadvertently identified one of those cases where a tax cut (i.e., a lower corporate tax rate) would “pay for itself”?

There certainly is strong evidence for this proposition. In a 2007 study, Alex Brill and Kevin Hassett of the American Enterprise Institute found that the revenue-maximizing corporate tax rate is about 25 percent (click chart to enlarge).

Somehow, I suspect this wasn’t their intention, but I want to thank the statists at CAP for reminding us about the self-destructive impact of high tax rates. 

For those who want to learn more about the Laffer Curve, these three videos will make you more knowledgeable than 99 percent of people in Washington (not a big achievement, I realize, but the information is still useful).

 

The “Tax Expenditure” Con Job

For both political and policy reasons, the left is desperately trying to maneuver Republicans into going along with a tax increase. And they are smart to make this their top goal. After all, it will be very difficult – if not impossible – to increase the burden of government spending without more revenue coming to Washington.

But how to make this happen? President Obama is mostly arguing in favor of class-warfare tax increases, but that’s a non-serious gambit driven by 2012 political considerations. Moreover, there’s presumably zero chance that Republicans would surrender to higher tax rates on work, saving, and investment.

The real threat is back-door hikes resulting from the elimination and/or reduction of so-called tax breaks. The big spenders on the left are being very clever about this effort, appealing to anti-spending and pro-tax reform sentiments by arguing that it is important to get rid of “tax expenditures” and “spending in the tax code.”

recently warned, however, that GOPers shouldn’t fall for this sophistry, noting that “If legislation is enacted that results in more money coming into Washington, that is a tax increase.” I also explained that tax breaks are not spending, stating that “When politicians tax (or borrow) money from one person and give it to another, that’s government spending. But if politicians allow a person keep more of their own money, that’s a tax cut.”

To be sure, the tax code is riddled with inefficient and corrupt loopholes. But those provisions should be eliminated as part of fundamental tax reform, such as a flat tax. More specifically, every penny of revenue generated by shutting down tax preferences should be used to lower tax rates. This is a win-win situation that would make America more prosperous and competitive.

It’s also important to understand what’s a loophole and what isn’t. Ideally, you determine special tax breaks by first deciding on the right benchmark and then measuring how the current tax system deviates from that ideal. That presumably means all income should be taxed, but only one time.

So what can we say about the internal revenue code using this neutral benchmark? Well, there are lots of genuine loopholes. The government completely exempts compensation in the form of employer-provided health insurance, for instance, and everyone agrees that’s a special tax break. There’s also the standard deduction and personal exemptions, but most people think it’s appropriate to protect poor people from the income tax (though perhaps we’ve gone too far in that direction since only 49 percent of households now pay income tax).

Sometimes the tax code goes overboard in the other direction, however, subjecting some income to double taxation. Indeed, because of the capital gains tax, corporate income tax, personal income tax, and death tax, it’s possible for some types of income to be taxed as many of three or four times.

Double taxation is a special tax penalty, which is the opposite of a special tax break. The good news is that there are some provisions in the tax code, such as IRAs and 401(k)s, that reduce these tax penalties.

The bad news is that these provisions get added to “tax expenditure” lists, and therefore get mixed up with the provisions that provide special tax breaks. This may sound too strange to be true, but here’s a list of the biggest so-called tax expenditures from the Tax Policy Center (which is a left-leaning organization, but their numbers are basically the same as the ones found at the Joint Committee on Taxation).

Since this post already is too long, I’ll close by simply noting that items 2, 4, 7, 8, 11, and 12 are not loopholes. They are not “tax expenditures.” And they are not “spending in the tax code.” Every one of those provisions is designed to mitigate a penalty in the tax code.

So even if lawmakers have good motives (i.e., pursuing real tax reform such as the flat tax) when looking to get rid of special tax breaks, they need to understand what’s actually a loophole.

But since politicians rarely have good motives, there’s a real threat that they will take existing tax penalties and make them even worse. That’s another reason why tax increases should be a non-starter.