Tuesday, September 12, 2017

A Taxing Problem: Production and Consumption

We’ve covered quite a bit on why a consumption tax might not be the best way to go in this short series.  We have one more reason, and it might not be one that occurs to most people simply because it is highly technical and gets into economic and financial theory.

Consumer demand drives the economy.
It is a basic rule of taxation that if you want to discourage a form of behavior, you tax it.  This is why most of the price of cigarettes and alcohol isn’t profit to the seller or the cost of manufacture, it’s taxes to the government.
So, logically, if you want to cut consumption, you tax it.  And that creates a BIG problem.
You see, it’s demand for consumption goods that drives any economy.  If there is no demand for widgets (economists always talk about widgets), then there is no demand for widget makers.  If there is no demand for widget makers, there is no demand for widget making machinery.  If there is no demand for widget making machinery, there is no demand for machines or people that make widget making machinery . . . .
And so on.  In the end, it’s the consumer who drives everything in the economy, one way or another.  If you divert consumption income away from consumption and into taxes or reinvesting, then you’ve reduced consumption and thus the reason for producing in the first place, and thus eliminated jobs (and more consumption income) from the economy, reducing demand even further.
This is where the problem comes in.  Mainstream economists, especially Keynes, insisted that new capital can only be financed by restricting consumption below production levels (“saving”).
Dr. Harold Glenn Moulton
Dr. Harold G. Moulton, president of the Brookings Institution, however, pointed out something that contradicted Keynes’s assertion about cutting consumption in order to save being essential to finance new capital formation.  It creates what Moulton called an “economic dilemma”:
The dilemma may be summarily stated as follows: In order to accumulate money savings, we must decrease our expenditures for consumption; but in order to expand capital goods profitably, we must increase our expenditures for consumption. . . . [W]hen the managers of modern business corporations contemplate the expansion of capital goods they are forced to consider whether such capital will be profitable. . . . Now the ability to earn interest or profits on new capital depends directly upon the ability to sell the goods which that new capital will produce, and this depends, in the main, upon an expansion in the aggregate demand of the people for consumption goods. . . . if the aggregate capital supply of a nation is to be steadily increased it is necessary that the demand for consumption goods expand in rough proportion to the increase in the supply of capital. (Harold G. Moulton, The Formation of Capital.  Washington, DC: The Brookings Institution, 1935, 28-29.)
In short, no producer will invest in additional capital until and unless there is an increase in consumption to warrant and justify the investment.  Instead of a decrease in consumption prior to new investment in order to provide the financing, what Moulton found for the preceding century was an increase in consumption accompanying every period of significant investment in new capital.  As Moulton concluded,
The traditional theory that an expansion of capital construction and consumptive output occur alternatively . . . finds no support whatever in the facts of our industrial history. . . . We find no support whatsoever for the view that capital expansion and the extension of the roundabout process of production may be carried on for years at a time when consumption is declining.  The growth of capital and the expansion of consumption are virtually concurrent phenomena. (Ibid., 47-48.)
Investment banks help "float" new issues of stock
This finding raised another question.  If periods of rapid capital expansion are not preceded by periods of saving to finance new capital instruments, but instead by dissaving to finance the increase in consumption, how is new capital financed, especially on such a vast scale?  The answer is, By the proper use of the commercial banking system (invented for just that purpose) backed up with a central bank:
Funds with which to finance new capital formation may be procured from the expansion of commercial bank loans and investments.  In fact, new flotations of securities are not uncommonly financed — for considerable periods of time, pending their absorption by ultimate investors — by means of an expansion of commercial bank credit.” (Ibid., 104.)
If, therefore, all current income is used either for consumption purposes, or to retire loans made out of expanded commercial bank credit for capital formation, production and consumption will be in balance, and there will always be enough effective demand to purchase all production.  If, however, income that should be spent on consumption is diverted to reinvestment, there will be insufficient demand to clear all the goods and services produced.
The bottom line here?  Cut consumption, and you kick the economy in the teeth.  A consumption tax is a direct incentive to cut consumption, and therefore is harmful to the functioning of a sound and sustainable economy.


Krzysztof Nędzyński said...

How income tax can be made to work effectivelly? Businesspeople hate income tax, at least in Poland, because it is inherently discretionary. Tax authorities often question decisions of taxpayers regarding costs. Therefore idea of revenue tax is pretty popular in Poland.
What do you think about revenue tax?

Michael D. Greaney said...

If a revenue tax is what we call here a "gross receipts tax," that is, a business is taxed on the amount of gross revenue it takes in rather than its net proft (revenue less costs), the problem is that a business may take in a great amount of revenue, yet make a very small or even no profit if it doesn't cover its costs. For example, two businesses that both take in $1 million in gross revenue, but the first has costs of $999,999, while the second has costs of $1. (I exaggerate to make a point, of course.) The first business has $1 in profits, while the second has $999,999 in profits. If the gross receipts tax is 1% ($10,000), the first company has a net loss of $9,999, while the second company has a net profit of $989,999 for the same period. This is why gross receipts taxes in the U.S. are usually "local taxes" levied by the city or county that granted a license to do business, and is very low, and often not levied at all if gross receipts are under a certain amount; in Fairfax and Arlington Counties in Northern Virginia, for example, if your business takes in less than $30,000, it pays no tax.

A better way is to allow a business to escape all taxes on revenue or income by making dividends or profit distributions tax deductible to the business, but fully taxable to the recipient as regular income, unless used to acquire capital assets, in which case the taxes would be deferred until the capital is sold or the owner dies. To encourage businesses to distribute profits to the owners (thereby stimulating consumption naturally), the corporate income tax rate could be raised, making it much more advantageous to raise money for expansion by issuing new shares instead of retaining earnings, and the shares can be purchase on credit by people who currently own no shares, and pay for them out of dividends on which taxes have been deferred.

Krzysztof Nędzyński said...

Thank you very much for your detailed answer.
I have got another issue:
"fully taxable to the recipient as regular income"
Should regular income be taxable at a flat rate or at a progressive rate?

Michael D. Greaney said...

Good question. Fortunately, I was already working on an answer before I saw it, for tomorrow's blog posting.

One of the most serious problems facing government today is understanding the proper role of taxation. Today (October 18, 2017) and yesterday in the Wall Street Journal there have been articles discussing what tax reforms will best stimulate economic growth. This actually avoids the real issue, which is, What is the purpose of taxation?"

Is it to stimulate or put a damper on economic growth? No. The sole purpose of taxation is to raise the money to run government. That's all. Unfortunately, as ordinary people have lost the means of owning capital at the same time that capital is replacing them from their jobs, the State has had to assume increasing responsibilities for taking care of people, meaning (as the solidarist economist Goetz Briefs pointed out in his 1937 book The Proletariat) that the taxpayer has assumed the responsibility . . . at the same time that taxpayers are less and less able to pay unless they own capital.

In response, the State starts creating money by emitting bills of credit, financing government and redistribution with inflation instead of direct taxation. This creates a vicious circle that puts a greater and greater burden on the people who have only wages or pensions on which to live, and spares the wealthy whose profits increase with inflation as they simply raise prices.

So to answer your question, in the ideal world where people gain income from both capital and labor, ALL income above a level sufficient to meet ordinary living needs (including education and healthcare) should be taxed at the same rate. In the current state of society, however, it makes little sense to tax wage income at a higher rate than property income. That just means that the people least able to pay are paying a heavier burden — which becomes even greater when the government inflates the currency.

In that case, it makes more sense to tax property incomes at a greater rate than wage or ordinary income. This has the added benefit of encouraging financing investment out of future savings by means of which everyone can become an owner, instead of past savings that restrict ownership to the currently wealthy.

Once everyone has the means to own capital and does own capital, of course, the tax system should be reformed to levy the same tax rate on everybody, as everybody would then have an equal ability to pay; one of Adam Smith's four principles of taxation is that you only tax those who can afford to pay taxes(!). After all, why tax people who can't pay, unless you're hoping for an excuse to put them in jail?