Tax lever of fiscal policy

In the last blog I explained about monetary and fiscal policy. Here, in the Khan Academy, it explains some more about taxes as they pertain to fiscal policy. In the last example, under fiscal policy, taxes remained constant and spending went up. To do that, the government has to take on more debt. So the formula looks like this:

⬆️ GDP = C + I + G ⬆️ – NX

Where C = private consumption, I = mostly business investments, G = government expenses, and NX is net exports.     C and I remain constant, government expense goes up, so GDP goes up.

If taxes go down and government spending remains constant, private consumption and business investments will go up, so GDP will also go up. It is another way government can influence GDP:

⬆️ GDP = ⬆️ C + ⬆️ I + G – NX

Another way show it is in diagram format:

Govt. spending constant

As I stated in my last blog, the difference (for the most part) between the two parties, Democrats and Republicans, is that the Democrats, usually tend to want to increase taxes and the Republicans want to decrease, or at least not increase, taxes. In both cases National Debt takes the brunt. The Republicans want to see business investments increase, and consumption along with it. Fiscal policy, as desired by the Democrats, is a more direct government influence, so they see quicker results than the Republicans. Again, this is just a very generalized point of view, and depends very much on the market conditions.

The question remains: How much more debt can the government take on?

The correlation between GDP, taxes, and debt.

This will be a lesson based on the Khan Academy economics course to explain how government tries to affect the economy. I say “try to,” because evidently government cannot fully control the economy as it might wish. This makes sense, when we want to compare government policies between, say Democrat vs. Republican leadership. There is no clearly defined border between the two. There is always a delay, number one, and number two: depending on the conditions (economic and otherwise) the implemented policies may or may not result in its intended purpose to the desired degree.

There are basically two kinds of policies: Monetary and Fiscal policy. Monetary policy deals with how much money to print by the “Central Bank”. In the USA that is a quasi independent institution. It is run by the government, but also gets input from private industry, such as banks. It is given the right to print money, but it is mostly electronic money. It buys “debt”. An interesting way of “lending money”. When someone buys bonds, he/she directly lends money to the government. This increases the amount of money.

Screen Shot 2015-02-24 at 6.17.40 PM

When the supply curve moves to the right, interest rate will drop, as seen in the graph by the little yellow line on the demand curve, while the supply of money increases as seen on the yellow line on the horizontal supply axis. This is like micro economics. When more money is available because of the shift in money demand, that shifts the aggregate demand on the macro economical side to the right, stimulating the economy, thus increasing GDP as can be seen in the graph below:

Screen Shot 2015-02-24 at 6.18.14 PM

This graph compares Price on the vertical axis to GDP on the horizontal axis. So, GDP can increase because more money is available.

Another way that aggregate supply can increase is through fiscal policy. Fiscal policy is the government directly demanding goods and services from the economy. It uses two sources to finance those demands: taxes and / or debt in the form of treasury bonds and other means. Say, the government issues more bonds, thus increasing the debt, but taxes remain the same. This will increase spending, having the same effect as the increase in money supply in the previous example.

This brings up an interesting difference between the Democrats and Republicans. Typically, but not always, the Republicans want to hold the line on taxes and at the same time not increase the debt. Democrats tend to want to increase social programs meaning increased taxes. The way I see it, is that the Republicans, for the most part, want to increase or stimulate the economy, at the appropriate time through printing more money (micro economics), while the Democrats want to stimulate more directly through tax increases (macro economics). Both parties want to promise the moon, so need more money to fulfill their promises, but since neither can get the full amount they want in their own way, debt on the fiscal side goes up, unchecked. I say “unchecked”, because debt keeps rising no matter which party is in the majority. That is just my simplistic opinion, looking at how our economy functions.

GDP – The Nation’s Economic Hero

By the curious standard of the GDP, “the nation’s economic hero” is a terminal cancer patient who is going through a costly divorce. The happiest event is an earthquake or a hurricane. The most desirable habitat is a multibillion-dollar Superfund site. All these add to the GDP, because they cause money to change hands. It is as if a business kept a balance sheet by merely adding up all “transactions,” without distinguishing between income and expenses, or between assets and liabilities.

The strange fact that jumps out from Bennett’s grim inventory of crime, divorce, mass-media addiction, and the rest is that much of it actually adds to the GDP. Growth can be social decline by another name. Divorce, for example, adds a small fortune in lawyers’ bills, the need for second households, transportation and counseling for kids, and so on. Divorce lawyers alone take in probably several billion dollars a year, and possibly a good deal more. Divorce also provides a major boost for the real-estate industry. “Unfortunately, divorce is a big part of our business. It means one [home] to sell and sometimes two to buy,”a realtor in suburban Chicago told the Chicago Tribune. Similarly, crime has given rise to a burgeoning crime-prevention and security industry with revenues of more than $65 billion a year. The car-locking device called The Club adds some $100 million a year to the GDP all by itself, without counting knock-offs. Even a gruesome event like the Oklahoma City bombing becomes an economic uptick by the strange reckonings of the GDP. “Analysts expect the share prices [of firms making anti-crime equipment] to gain during the next several months,” The Wall Street Journal reported a short time after the bombing, “as safety concerns translate into more contracts.”   by:  Clifford Cobb, a policy analyst, is the author of Responsive Schools, Renewed Communities (1992).   Ted Halstead is the founder and executive director of Redefining Progress, a nonprofit public-policy organization in San Francisco.  Jonathan Rowe has been an editor at The Washington Monthly and a staff writer for The Christian Science Monitor.

That is the economy for us. Next time you read in the paper (or see a graph) how the GDP has increased, don’t get too enthusiastic too quickly. Consider why it increased. Is it an “asset” or a “liability”?  National Debt is seen, in part, in relationship to GDP. If GDP goes up, typically National Debt is allowed to move up as well.

US GDP growth rate

The Multiplier, a theoretical concept invented by John Maynard Keynes in the 1930s

The most fundamental concept in the whole of macroeconomics. The “multiplier” measures the eventual impact on the economy as a whole, GDP, of a sustained increase or decrease in public spending. An increase in such expenditure brings more people into work, they in turn will have more to spend, the companies whose products they buy will have more revenue, and will employ even more people. The initial impact is multiplied through the economy.  Paul Ormerod, an economist at Volterra Partners

Sounds simple, but what is that number? Economists cannot agree on that. The multiplier works both ways. If it is large, the economy will decrease substantially if GDP decreases, or increase substantially when GDP increases.  Most economists believe that figure is pretty small, but IMF chief economist Olivier Blanchard and his colleague Daniel Leigh published an IMF working paper on the size of the fiscal multiplier, according to Paul Ormerod, trying to prove that the multiplier is rather large.

So a fiscal contraction, the basis of the chancellor’s policies, will lead to a sharp reduction in GDP. Events have shown this to be wrong.  Paul Ormerod The IMF duo approvingly cited other estimates, derived from the exotically named dynamic stochastic general equilibrium (DSGE) models, that the multiplier is large. These models have been all the rage in both top academic circles and central banks. Blanchard eulogised them in a MIT discussion paper published three weeks before the collapse of Lehman Brothers in September 2008. “Great progress had been made with DSGE models in understanding how the economy really worked. The state of macroeconomics, he declared, was good (according to Oliver Blanchard in this publication).”  Paul Ormerod

My point is, that in my research, National debt is not all about economic models. Even the IMF cannot predict the economy! I did find it interesting, that the recession really did not affect GDP by that much, and that companies adjusted their production and seemingly, easily survived for the most part. It were the people who lost jobs and homes (7,000,000 of them!)

An inescapable problem for these highly mathematical models is that they do not take into account sentiment, the narrative which emerges around policy changes. Osborne’s fiscal contraction has gradually created a positive narrative across companies, so they are willing to create jobs and invest. Psychology rather than hardline math is needed to tell us what the multiplier really is in any particular situation.      Paul Ormerod is an economist at Volterra Partners, a visiting professor at the UCL Centre for Decision Making Uncertainty, and author of Positive Linking: How Networks Can Revolutionize the World.