Monday, 24 May 2010

“Tax cuts don’t cause growth”? [updated]

THERE IS A STRANGE POST over at The Sub-Standard purporting to demonstrate that tax cuts don’t cause economic growth, and that Bill English’s reliance on such a process to balance his budget is therefore illusory. “Tax cuts don’t cause growth” is the post.

33814183_bc322c7343 To call its evidence for that proposition "cherry picking" would be too positive about it.  The argument posted is essentially that of Gordon Campbell, and it would be more accurate to call it the result not of cherry picking but of sifting through an intellectual dung hill.  It first of all accepts at face value that this budget has just delivered tax cuts—which, when you consider all the tax increases in the budget and soon to come (alcohol, tobacco, ACC, GST, electricity, petrol, etc., etc.)  is patently ludicrous—and then purports to show that history itself  is against the proposition of tax cuts causing growth, and that it is in fact high taxes that presage real economic growth.

Before fisking its main claims, it’s worth noting that Arthur Laffer’s famous curve is not itself even mentioned here—which is the actual theoretical construct Campbell and the Sub-Standard are attacking , (Laffer’s Curve itself, along with all its problems, provisos, assumptions and associated literature, is simply not mentioned)—and no mention is made either of any of the notorious historical examples of high taxes strangling economic growth—such as Britain’s famous post-war experiment in democratic socialism and usurious taxes that led it in just thirty post-war years to near bankruptcy.

Now Mr Laffer and his adherents can defend themselves—and post-war British history can speak for itself.  So in the space available in a blog post I want to simply fisk the most stupid of the historical claims made by Campbell and the Sub-Standard. 

BUT FIRST, LET’S UNDERSTAND in very simple terms what does causes economic progress—understand enough at least, to enable us to spot the error in the Sub-Standard’s post.

Now, the seed corn of economic growth is capital—capital put to work producing economic wealth, and still more capital.  It’s an ongoing virtuous cycle dependent on one thing: that you keep growing your seed corn instead of consuming it. 

    “Capital [explains George Reisman] is the accumulated wealth that is owned by business enterprises or individuals and that is used for the purpose of earning profit or interest.
    “Capital embraces all of the farms, factories, mines, machinery and all other equipment, means of transportation and communication, warehouses, shops, office buildings, rental housing, and inventories of materials, components, supplies, semi-manufactures, and finished goods that are owned by business firms.
    “Capital also embraces the money that is owned by business firms, though money is in a special category. In addition, it embraces funds that have been lent to consumers at interest, for the purpose of buying consumers' goods such as houses, automobiles, appliances, and anything else that is too expensive to be paid for out of the income earned in one pay period and for which the purchaser himself does not have sufficient savings.
    “The amount of capital in an economic system determines its ability to produce goods and services and to employ labor, and also to purchase consumers' goods on credit. The greater the capital, the greater the ability to do all of these things; the less the capital, the less the ability to do any of these things.”

The key to economic growth is capital accumulation; and, in a word, the key to capital accumulation is saving.

    “Capital is accumulated on a foundation of saving. Saving is the act of abstaining from consuming funds that have been earned in the sale of goods or services.
    “Saving does not mean not spending. It does not mean hoarding. It means not spending for purposes of consumption. Abstaining from spending for consumption makes possible equivalent spending for production. Whoever saves is in a position to that extent to buy capital goods and pay wages to workers, to lend funds for the purchase of expensive consumers' goods, or to lend funds to others who will use them for any of these purposes.
     [ref: George Reisman: “Economic Recovery Requires Capital Accumulation, Not Government 'Stimulus Packages'”]

As I quoted John Stuart Mill here the other day saying, “What a country wants to make it richer, is never consumption, but production.”

When spending on production exceeds spending on consumption, more capital goods are produced and a process of capital accumulation (and economic growth) is begun. When spending on consumption exceeds spending on production, however, the result is the opposite: capital is consumed instead of accumulated—and since the means by which economic activity is diminished, so too is the economic activity that the consumed capital would have made possible.

So (leaving aside the risks and uncertainties associated with entrepreneurs directing their capital towards all the various places it can be put to best use) the simple equation to look at as a predictor of economic growth is the proportion of productive spending to consumption spending.

The higher the proportion, the higher the rate of economic progress; the lower, the less.

SO WITH THAT BRIEFEST of introductions out of the way to help explain the inescapable relation of capital to economic growth, let’s look at the Sub-Standard Campbell’s argument that tax cuts do not cause growth.

Their argument, in a nutshell, is that history suggests otherwise.

    “For decades, right wing economists have claimed– both here and overseas – that tax cuts are a crucial engine of economic growth. Reality, as often as not, has begged to differ.
    “Here in New Zealand during the mid 1980s, a major package of tax cuts was followed by years of little or no growth, and ultimately, by a recession. In the early 1990s, Bill Clinton’s tax hikes immediately preceded the longest and most sustained economic boom in the US since the Second World War.
    “In 1998, the true believers in the National government were predicting that tax cuts would foster savings – fully one third of that round of tax cuts, Treasury predicted, would be saved. They weren’t.
    “In 2000, the incoming government hiked up the top tax rate – and this neither caused, nor prevented, a prolonged bout of economic good times. Ultimately, there is no essential link, either way, between tax cuts and economic growth.”

money_dn_drain In fact there is an essential link, but it’s one that those right-wing economists themselves have ignored.  Since government spending is overwhelmingly spending on consumption rather than production, the key thing to notice is whether the tax cuts are delivered by accompanying cuts in government spending, or whether the cuts are funded by borrowing—borrowing which takes real savings away from producing new capital (and, thereby, growth) and pours it  instead down all the government’s favourite black holes.

High government deficits stifle growth, whereas lower deficits (if the released capital is put to productive use) tend towards allowing it.

That’s the key to understanding the apparently paradoxical history presented above (which for ideological reasons ignores the eighties boom entirely).  Bill Clinton’s tax hikes were used to reduce the government’s borrowing, leaving more capital available for growth. So too (at least at first) were Michael Cullen’s tax hikes in the 2000s, which left (some) more capital available for productive use. 

It also explains some of the other history cited.  The use if history to prove points in a short post such as this is inherently once-over-lightly, but Gordon Campbell’s cited historical facts are woefully deceptive:

The highest period of growth in U.S. history (1933-1973) also saw its highest tax rates on the rich: 70 to 91 percent [says Campbell]
The period in question is carefully chosen. It saw both low taxes and high taxes; low deficits and high deficits; and encompassed four distinct periods, all of which go against Campbell’s claim:

    1. from the depth of the Great Depression in 1933 to the start of the war, Roosevelt’s meddling created massive regime uncertainty, and his high deficits sucked out capital; the result was not growth but stagnation.
    2. during the war the government both raised taxes and went into deficit, massively consuming existing capital.  With price controls, rationing, military conscription and an essentially command economy “one simply cannot speak with confidence about such
      matters as, for example, the rate of growth of real GDP or the rate of inflation
      from year to year during the period from 1941 to 1947.” [ref: Robert Higgs]
    3. the “economic miracle” in this period is the post-war American boom, which absorbed 10 million servicemen and turned the whole world economy round—a boom that started after both deficits and taxes were slashed, and private savings (built up during the war years of military production when there were virtually no consumer goods on which to spend) were finally put into private investment, converting factories from producing tanks, guns and planes to more fridges, cars, housing and the productive capital that was to sustain the post-war take-off.
    4. when the post-war boon began to wane, however, it was pumped up unsustainably by the Keynesian manipulation of the late-Eisenhower fifties and Kennedy/Johnson sixties (the Keynesian call for high deficits was just one reason the Keynesian Kennedy & Johnson White Houses were meddling in Vietnam), which led inexorably to the stagflation of the seventies, and what should have been the collapse of the “consumptionist” Keynesian world-view.

The authoritative paper to read on the first three periods is probably Robert Higgs’ “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War.” A useful paper on the history of the fourth period is Allan Meltzer’s “Origins of the Great Inflation.”

The rest of subStandard’s pseudo-history is no better. Let’s fisk:

During both world wars, taxes soared to record heights. And the supercharged economies that resulted produced high growth for decades afterwards. World War I was followed by the Roaring 20s…

The Roaring Twenties were powered by low taxes, Low government spending and higher productivity (through the use of new invention like automobiles and reticulated electricity) and, as it was learned subsequently, lower interest rates than was economically sustainable—producing not “decades of growth afterwards” but decades of penury. Campbell’s history is just wrong.

… World War II was followed by the boom times of the 50s and 60s.

See above.

The [US] economy has grown strongly over the past several years because of the [Bush] tax cuts. Reality: The 2001-2007 economic expansion was sub-par overall, and job and wage growth were anaemic…

Bush’s tax cuts were unfunded by equilibrating spending cuts, which meant that once again it was an expansion hobbled once again by deficits (which meant private investment competing with government for credit), by the bureaucracy that was being paid to hamper growth, and fuelled by unsustainably low interest rates -- leading to extensive malinvestment and the inevitable bust.

And in 2008? The American economy, despite all the recent Bush tax cuts, simply imploded.

The tax cuts were unfunded, and the extensive malinvestments caused by unsustainably low interest rates inevitably led to the bust—precisely as Austrian economists said it would.

06-30-04-death-and-taxes THE FACT IS, THAT no matter how much they torture history to make it produce their point, history itself does not at all demonstrate what Mr Campbell and the Sub-Standard say that it does.

Real, sustainable economic growth is not the result of high taxes, but of long-term sustainable capital growth and accumulation—and hence, ever-greater and ever-increasing productivity.

Since government spending is overwhelmingly thrown away on consumption spending instead of on productive spending,however –practically every dollar that governments spend is consumption spending --capital growth is hampered rather than helped, by high government spending.  It’s a handbrake, not a help-mate.

Governments you see have only three means by which they can obtain money to spend: taxes, borrowing, or the printing press.  The higher their spend, the more one or more of these three hurdles are put in the way of successful capital accumulation. The more governments spend, the less private investment can happen.

By that standard then, it should be clear that tax cuts themselves are only an indirect means by which to encourage growth, and without commensurate spending cuts are potentially more destructive than constructive.

In short, tax cuts without govt spending cuts simply imply that a different form of handbrake is to be applied.

By that measure then, it’s true that Bill English’s “tax cuts” (delivered without any spending cuts at all, but with both new borrowing, new spending, and a hint of inflation to come), are at best an illusion--and at worst a destructive nonsense.

But it says nothing at all about the general proposition.

UPDATE: The subStandard’s position is a simple “consumptionist” world view, i.e,, the idea that the government can promote prosperity by exchanging its own consumption for your production.  That position is most thoroughly attacked in George Reisman’s classic article: “Production Versus Consumption.”


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  1. Piffle. You're making up stuff and fudging your numbers.

    Here's a nice simple chart from the USA comparing top marginal tax rate, and median family income, from 1947 to 2007.

    Level of govt spending (as long as you avoid the communist extremes) matters - but it is far from being the most important factor in economic growth.


  2. @Icehawk: Nice to see a "substantive" response. If I may summarise your full argument, it's this: 'Piffle."

    And actually, the parties making stuff up are those to whom I'm objecting, i.e., Bill & Gordon and the Standard Men.

  3. @Icehawk: "Level of govt spending ...matters - but it is far from being the most important factor in economic growth."

    Indeed, it's only importance is as a meaure of one form of consumption spending that holds down propductive spending.

    The single most important factor is capital accumulation.

  4. Great article on the causal underpinnings of economic growth. However, since the Sub-standard writers don’t appear to be sophisticated enough to actually build a theoretical case for their argument, instead they point to the empirical correlates of growth and tax at its inflexion points as evidence, couldn't it be that what they are observing by the usual measures is true?

    Although the statement that "government spending is overwhelmingly consumption spending" is ultimately true, this fails to recognize the bureaucratic laundromat mechanism by which governments launder tax income. The activities that governments enact to “re-distribute” tax income typically sit on the productivity side of the growth formula, rather than the consumption side. I would contend, therefore, that there exists a significant time lag between any evidence of an end to an economic lolly scramble and a realization of the erosion of wealth.

  5. Bevan said...
    However, since the Sub-standard writers don’t appear to be sophisticated enough to actually build a theoretical case for their argument...

    Bevan, I agreed there with you in the unsophistication of knowledge from both Sub-standard and their masters RedAlert.

    I think that I am being banned from RedAlert, because I've just tried to get access to one of the thread there (Grant's post) of which I posted a message last night, since I thought that other commenters will reply, but there is an access violation message returned.

    I'll check it again later to see if RedAlert's service is suspended perhaps for maintenance and then try again. If the same message of access violation is returned again to me, then definitely I am being banned.

    If I am being banned, then the man from the island (me) has scared the whole lot of them with his reasoned arguments. Haha, who would know that the man from the island could rattle the bloggers at RedAlert to a point that he (me) is being banned from there.

  6. Now, I can get access to RedAlert, so I am not being banned.

  7. PC, please check the content of your point #4. It looks like the words have been "processed" a bit more than you intended. (eg bits repeated from point #3)

    Appreciate the analysis.

  8. @W. Wallace: Oops! Thanks for that.

  9. So what came first? The chicken or the golden egg? That article is as inconclusive as constipation.


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