Saturday, April 14, 2012

Ask A Future Economist

A lot of people love to talk about politics and economics. When people find out that I'm an economics student, they like to ask me questions about the state of the economy, where it's going, or some episode in the past. Here's one that I was asked recently:

Mr. Ward, I have a question for you if you don't mind. What do you think of "trickle-down economics"? I think (and I know I am not qualified to have an opinion) that raising taxes on the poor and middle-class, especially the middle-class, while lowering taxes on the upper classes would have a detrimental (is having a detrimental) effect on the economy. If the lower classes have more money left ove...r, they will spend it. I know I spend what I can (doing my part!). Rich people are rich because they don't spend money. They collect it. How would giving them more money to collect help the economy? The lower classes, having more money to spend, would buy more, meaning more profits for the rich, which would then be taxed so that schools, roads and hospitals could be built (in Uganda?). Am I insane or just "European socialist scum"?
(photo: Julian Albert)
The optimal mixture of taxes is far from my main area of expertise.  I do know that having tiers of taxes can create undesirable disincentives for higher production, but those are not usually very large unless the tax differentials are also very large.  Having a graduated tier system of taxation also helps mitigate income inequalities in a society.  So while many economists decry them as wealth redistribution, it’s also important to remember that we live in a democracy, and that mass cooperation is a part of that.  This becomes a significant issue in a democracy as the median income drops relative to the mean income.
One important thing to remember is that rich people are not rich simply because they don't spend it, but rather they are rich because they (or their families before them) were productive.  This is often very confusing to people because they don’t see Warren Buffett or Bill Gates looking like they’re being very productive.  Buffett and Gates are entrepreneurs and investors, which I use interchangeably like two sides of the same coin in this sentence.  Investors are in risky predicaments, but when those risks turn into fruitful enterprises, they are usually the most productive individuals of all.  There is not a business in the world that was not started without capital of some sort, and this is the essence of capitalism: using capital stock to invest in the prospect of creating larger capital stocks in the future.  Often these attempts are met with failure and bankruptcy, but sometimes you can create something special that can provide profits for its owners, new jobs for workers, and new products for consumers.  None of these things happen without capital investment, and rich people, by definition, have capital to invest.
Recessions are often referred to as failures of demand.  It is also often said that supply creates demand, and if that is true then investment, not consumption is the best remedy for a contracting economy.  But how do you induce individuals to invest when the prospects are not very good?  That’s the million dollar question for any government in a recession.  It is because spurring investment in periods of poor economic prospects that we often turn to consumption to restart our economies.  This might work in the short run or if a contraction is slight, but eventually the only way to resume economic growth is through investment.
‘Trickle down economics’ is a bad term, because it is misleading.  The idea that poor people are dependent upon rich people to somehow share the wealth via capitalism is not at all true.  Capitalism is not a game of hand outs, and in those successful businesses, the workers are probably not being paid more than their marginal productivity and the consumers are not receiving anything for free.
To the extent that there is a kernel of truth to the term is that economies are not zero-sum games.  There is not a finite amount of capital that can be redistributed to even everyone out.  Often individuals are best when left to their own invention and enterprise.  The benefits of those new inventions and enterprises are not limited to their owners, but also to the workers who have new jobs and consumers that have new products.  So if there is a trickle down, it is that.
It can also just as easily trickle up; as many of the best ideas don’t come from rich people but are invested in by rich people by way of venture capital.  In this scenario, rich people receive capital gain profits for investing in businesses that individuals’ without capital start and also profit from.  One economist named Wassily Leontief referred to the economy as a circular flow, and I find that to be a much more apt metaphor.

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