Who should have the money?

There’s a lot of talk right now about taxes and whether or not the “Bush tax cuts” should be extended or not. The left argues that the rich don’t need the excess, and the government, with its huge deficit, does. The right argues that any tax increases in the time of economic decline is a bad idea. Philosophically, they argue that it’s their earned money, their property, and we’re arguing whether or not to steal it from them.

I hear very few arguments of the economic virtues of letting them keep their money. It would seem that both left and right would at least agree that the rich don’t really need the money, but differ only in whether it’s moral to take it from them. But let us examine the economic impact of taxing the rich.

In the debate of the economic impact of taxes, we must examine each side of the debate for what happens with the money that is to be taxed. It’s tough to predict reliably what will happen to money in the possession of any one group. It’s a psychological issue requiring intimate knowledge of each individual’s mind. Each individual’s response depends on that person’s education, culture, persona, and many other factors and influences. Since we haven’t the ability to measure and analyze these details, we must deal in generalizations, using historical trends and (mostly accurate) stereotypes to predict popular response.

Let’s start with the left’s argument for redistribution from the wealthy to the poor. Theoretically, because the wealthy already have their wealth building infrastructure established, their wealth will continue to grow, while the poor will now have the ability to establish their own. Thus you increase the pool of wealth creators to include all parties, thus expanding economic growth. Theoretically it sounds nice. But practically it’s never worked. After all our redistribution efforts, welfare, progressive income tax, etc, the poor still remain poor. And after all of our foreign aid to poor nations, they yet remain just as poor as before. Why?

When a lower income family gets a bonus check, what do they do with it? Most likely, they spend it. They buy the 60” flat screen TV they’ve always wanted, they go on the cruise they could never afford before, they use the money to live a little richer for a short period of time. This is the typical response. Alternatively they save the money for a rainy day. The spending a predictable response. The poor tend to develop a sense of envy toward the lifestyles of the rich and the famous. Celebrity lives are closely examined by the lower classes, an unerring sign of this envy. Predictably, as soon as a poor family obtains sufficient wealth, they use it to purchase the lifestyle they’ve longed for. But once this wealth is consumed, it is gone, and the poor remain in their state.

What does this consumption do for our economic state? Keynes argued that consumption is the driver of economic growth. In a nutshell, if you buy a coat for $100, the coat maker will use the $100 he just gained and spend, say, $90 of it on a watch. The watch maker then spends $80 of his $90 on shoes, etc. Thus that $100, if not saved, gets passed around and creates many times its value (multiplier effect) in goods. Instead of being a saved $100, worth about the value of a coat, it has produced a coat, a watch, shoes, etc, worth far more than $100 because it was passed around. This was the concept behind the stimulus bill.

But look deeper at the argument. Does it really hold water? Money is simply a medium by which we exchange goods and services. If we removed the cash medium, I’m really trading my services for a coat. Let’s say I produce TVs. I exchange a TV, or a portion of one, for a coat. The coat maker now has a TV. What does he do with it? He can either keep it, or trade it with the watch maker for a watch. The coat maker now has a watch, and the watch maker now has a TV. So the watch maker, needing shoes, trades the TV for shoes. The point is that the money used to trade did not create a multiplier of wealth. The $100 wasn’t really worth $1000 after it was passed around. It simply aided in the exchange of such goods. I once had a TV that I made, now I have a coat. The watch maker once had a watch, now he has shoes. Substitute $100 for the TV, and you have what really happens today. We each may be better off than before, but it is because of the trade of our goods (I needed the coat more than the TV I made), not a multiplier effect. There aren’t 10 TVs at the end of the exchanging.

Now, let’s consider if we let the rich keep their money. What do rich people do with money? Rich people are rich because they put their wealth to work. Money can create more money if wisely invested. How many rich people do you know who saved their way to wealth? The don’t save their money, they invest it or spend it, and they invest far more than they spend.

What does this do for the economy? Let’s consider the multiplier that we discussed earlier. If I had $100 and instead of spending or saving it, I invested it in my TV business, and purchased equipment that cut my costs by $10, the TVs that I make, which once cost $110, would now cost $100. How does that affect the economy? It boosts demand (lower prices = higher demand). If demand goes up, supply must go up (unless there is a resource shortage). Production goes up, I make more money (which I can invest or spend), I hire more workers, and everyone else gets to pocket the $10 that they otherwise would have had to spend to get a TV. More people have a TV and the standard of living goes up.

Consumption is just trade, and trade makes us all wealthier insomuch that the goods we receive are worth more to us than that which we give. But there is a point at which we stagnate, where we have what we want which we can afford (in relation to our own production level), and we don’t want more except what we can’t afford. (Of course, once you hit this point you just save until you can afford what you want, but the growth is very slow.) In a stagnant economy, where we all just produce what we produce at the current prices and levels (i.e. no investment), we all would reach this point rather quickly considering the ease of trade. Also take note that some goods and services are literally consumed. Once they are used up, they are gone, and no longer benefit us. It is wealth destroyed (this does not necessarily mean the one-time expense is not worth it if your life experience benefits sufficiently from it).

In other words, it is not consumption that drives economic growth. Consumption (trade) just optimizes our current overall wealth. Take note that consumption spending has not declined in this recession. It has remained fairly stable throughout the downturn. It is investment spending that has dropped, causing a stagnant economy. Economic growth is in reducing prices so that more people can afford the goods they once could not. It is in creating new products that benefit us. It is investment that creates growth.

As such, we must consider who is the driver of innovation and invention. Who should have the money in question? Should we take from the rich and give to the poor? By so doing, we take money from investors and give to consumers. If we desire growth, we must seek the opposite: consume less and invest more. No, we wouldn’t accomplish this by taxing the poor and redistributing it to the rich. But there are many ways to do it: investment incentives, the FairTax, etc. But we must not let the investing class be destroyed if we are to save our economy.