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?

GDP and Luca Pacioli

In my last blog, I wrote that GDP ignored the difference between credits and debits, or assets vs. expenses. It only records “transactions”. In a prior blog I also referred to National Debt as a humongous concept and was wondering what we as “peons” can do about it. I think we can do something about it! We have to speak up against the “Enrons” of the world, who misrepresent the accounting principles. They should be forced to explain their accounting processes. Also banks often use very “loose” accounting practices to make their status look good; better than it really is. Paclioli addressed not only double entry accounting, but also the ethics of accounting. Alas, the ethics today are going by the wayside.

Thomas G Rooney: “Paclioli was a Catholic monk who observed local Italian parissoners often in need of a hand out, not able to keep track of their activites, so he came up with a kind of community outreach plan in the form of a work book to help people 500 years ago keep track of their transactions by type. Debitiere is what one was to do with where something was put, and creditiere was what one was to do in recording where something came from. But in the “Nobody is going to tell me what to do” society, people often do not want to be told to keep track of messy things like that, and just enjoy the fact that transactions are occurring.  Paclioli’s system spread far and wide, now used by just about every entity that exists to keep track of things…. banks, trust companies, realtors, insurers, the professions, businesses, many churches, etc. But for some reason, governments only like half the system, emphasizing trnasaction volume, happy with inflows, whether the source is income or debt….. happy with outflows whether the object is an asset or an expense … as long as there is movement, you got that right Bert.”

“Since Pacioli was a Franciscan friar, he might be referred to simply as Friar Luca. While Friar Luca is often called the “Father of Accounting,” he did not invent the system. Instead, he simply described a method used by merchants in Venice during the Italian Renaissance period. His system included most of the accounting cycle as we know it today. For example, he described the use journals and ledgers, and he warned that a person should not go to sleep at night until the debits equalled the credits! His ledger included assets (including receivables and inventories), liabilities, capital, income, and expense accounts. Friar Luca demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. Also, his treatise alludes to a wide range of topics from accounting ethics to cost accounting

Pacioli was about 49 years old in 1494 – just two years after Columbus discovered America – when he returned to Venice for the publication of his fifth book, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion). It was written as a digest and guide to existing mathematical knowledge, and bookkeeping was only one of five topics covered. The Summa’s 36 short chapters on bookkeeping, entitled De Computis et Scripturis (Of Reckonings and Writings) were added “in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business,” and to “give the trader without delay information as to his assets and liabilities” (All quotes from the translation by J.B. Geijsbeek, Ancient Double Entry Bookkeeping: Lucas Pacioli’s Treatise, 1914).”

 

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Luca Pacioli: The Father of Accounting

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 Business Cycle

Business cycle sounds very educational or professional, but is really an everyday concept. Imagine that the population of a country increases over time, which is the case for many countries in the world, that technology makes it possible to produce widgets more efficient, and that new inventions reduce the cost of production. This happens in many western countries today and in many non-western countries as well. As a result the GDP will increase over time, but not in a straight line. There are many ups and downs and these are not the same each time. Sometimes GDP will increase for a longer period of time than other times, or the other way around.

We can graph that as follows, according to another lesson of the Kahn Academy:

business cycle

On the vertical side we have the real GDP and the horizontal line expresses time. Assume population is growing and productivity goes up because of technology, the discovery of new resources, and the development of new processes. This results in an up going slope of GDP over the long run. In the short run we see ups and downs around this graph. The ups and downs are not as evenly spread as shown in the graph, but it gives the idea. In the short run we see expansions when things are going well and recessions when not so well. During an expansion more jobs are needed, people will buy more because they feel the economy is doing well, and more will be produced to meet that demand.

There comes a time when producers find themselves stuck with a bigger inventory, or they are using their equipment to the limit and cutting corners on repairs. They hire more people than are really needed. This results in a smaller profit and manufacturers will start scaling back. Everyone is still optimistic that it is only temporary or only affects some businesses. Even economists remain optimistic. But as it continues, people get a bit nervous. The standard saying applies here: “If my neighbor loses his job it is a recession, but when I lose my job it is a big depression.” Things start to improve and gradually people become more optimistic again. Then we get to the top and a new cycle starts. Not all cycles are the same. We saw this with the 2009-2010 recession, which was at its lowest point since the Great Depression in 1933. Currently, there are more job openings, gas prices are going down, but incomes still remain level so not everyone is convinced yet that the economy is improving.

1950-2014 GDP

Here is the real graph showing how GDP has been growing since 1950, but this is a “sanitized graph” not showing the ups and downs. It is interesting to see the 2008-09 recession as just a “blip” in the overall picture. Below are the details of National Debt:

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Note how under Clinton the National Debt only increased 3.9 %, but the trend started under the old Bush!

What makes it a bit more complicated is when the government artificially lowers the interest rate, as it is doing now.

 The basic story is that when the government artificially lowers the interest rate, it gives the appearance of the prosperity that would accompany a genuine influx of new savings, but this apparent prosperity can’t be genuine since it is fueled by nothing more than pieces of paper (fiat money) . 

Technically, it’s not correct to say that the economy can finance an increase in output of both consumption and capital goods, by ignoring depreciation . this is because the way the economy deals with depreciation is to produce more capital goods . For example, if a particular entrepreneur engages in maintenance on his factory by buying ball bearings and lubrication oil, and by slowly building up a new machine to replace his current one once it wears out, then these actions are all acts of investment in the creation of new capital goods , so really what happens during the unsustainable boom period is that entrepreneurs produce the “wrong” kinds of capital goods, and yet they erroneously think that their total output has increased .  (from: Lessons for the Young Economist, Robert P. Murphey)

Since the government is keeping interest rates artificially low it appears we are in such a situation.  How long will this last?

DEFICIT vs. DEBT

Recently there was an article in the paper explaining that President Obama tried to get credit for reducing the “budget deficit.”  The table (see below) extends out to 2017, gradually reducing that. How it is figured, I don’t know (yet).  Though he cannot run for office again, he wants to explain how the deficit has been declining under his watch, but nobody is paying much attention to that.

us_deficit_pct

Debt, on the other hand has been spiraling out of control.  According to a (Democrat) post, G.W. Bush is responsible for that, by not acting toward the end of his term, which might very well be true. I don’t know how that is figured, but cannot believe that in the past six years President Obama could do nothing about that.  In all fairness, it is very tough to get Americans to agree that we all are overspending, and need to do something about that.

debt-as-percent-of-gdp

October 1, 2014 Trent Lott (Republican Senate Majority Whip in 1995) and Tom Daschle (Democrat Senate Minority Leader in 1995) were interviewed and asked why the current congress cannot get along, between the two parties. They came up with various reasons. It was a very interesting interview. At one point Trent brought up the issue of a balanced budget under President Bill Clinton.  It was the only (recent) president under whom that happened, which was through cooperation between both Houses of Congress. Yet the debt kept, and still keeps, climbing.

Wikipedia has a very nice definition:

Suppose you spend more money this month than your income. This situation is called a “budget deficit”. So you borrow (ie; use your credit card). The amount you borrowed (and now owe) is called your debt. You have to pay interest on your debt. If next month you spend more than your income, another deficit, you must borrow some more, and you’ll still have to pay the interest on your debt (now larger). If you have a deficit every month, you keep borrowing and your debt grows. Soon the interest payment on your loan is bigger than any other item in your budget. Eventually, all you can do is pay the interest payment, and you don’t have any money left over for anything else. This situation is known as bankruptcy. If the DEFICIT is any amount more than ZERO, we have to borrow more and the DEBT grows. “Reducing the deficit” is a meaningless sound bite.  Each year since 1969, Congress has spent more money than its income. The Treasury Department has to borrow money to meet Congress’s appropriations. We have to pay interest on that huge, growing debt; and it cuts into our budget big time.

Some suggest: “tax the rich to make up the deficit”. As of the end of 2010, the total worth of all American billionaires is $1.3 Trillion. We could take ALL their worth, not just high taxes, but ALL their WORTH; and it wouldn’t dent our national debt. It wouldn’t even pay this year’s deficit! And if we did take their money to pay some of this year’s deficit, what would we do next year?

The debt, and Interest payments on the rising debt, will be paid by our children and grandchildren through much higher taxes. Is that Child Abuse?

Screen Shot 2014-10-15 at 9.43.06 AM

Notice how the budget, as approved by congress, has a built in deficit amount of $1.27 trillion in order to balance the total expenses. Also note at the right bottom,  the interest on that debt is $251 billion.

“For society as a whole, nothing comes as a ‘right’ to which we are ‘entitled’. Even bare subsistence has to be produced…. The only way anyone can have a right to something that has to be produced is to force someone else to produce it… The more things are provided as rights, the less the recipients have to work and the more the providers have to carry the load.” Thomas Sowell, quoted in Forbes and Reader’s Digest.

In short:

Deficit is a shortcoming of the annual mount spent beyond income.          

Debt is the accumulative amount of deficits year to year, plus interest.

Correlation Between spending limit and GDP

While a few reductions have been made to the debt limit, the ceiling has generally continued to rise. According to the U.S. Treasury Department, Congress has acted 78 separate times since 1960 to permanently raise, temporarily extend, or revise the definition of the debt limit.

The limit currently stands at around 75 percent of U.S. gross domestic product (GDP).

“It’s only in recent times, as U.S. debt has been allowed to approach the ceiling, that it has been used for rather blatant political leverage purposes,” says Kirkegaard.

In the past few years, opposition Republicans have made support for raising the debt limit contingent upon spending cuts and other policy changes.

This year’s standoff, which pushed Washington closer to the brink than ever before, generated consternation among many Americans. Markets and nations around the world — including China, Washington’s top creditor — also might have wished that the debt ceiling were scrapped. But don’t expect that any time soon, Kirkegaard says.

So, what is GDP?

Following Khan’s Academy economics lessons, the diagram below shows how GDP is defined. It includes all labor, parts, and production stages in say, a year. To not double count, only the final product (jeans in blue) made within the country counts toward the GDP. Otherwise we would be double or triple counting. Notice how each component of the definition is sketched out.

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Gross Domestic Product is just that: domestic, as described in the (blue) definition in the graph above. This means that products from (American) companies who go international with their production, are not included in the GDP.  Yet the American stock market is doing very well. It seems to me that all this talk of shaming American companies to go overseas with their production only represents a small % of what would have been part of the US GDP if it had been produced in the USA. I will look at that figure in a later blog. Does anybody know?

What GDP does not reveal
It is also important to understand what GDP cannot tell us. GDP is not a measure of the overall standard of living or well-being of a country. Although changes in the output of goods and services per person (GDP per capita) are often used as a measure of whether the average citizen in a country is better or worse off, it does not capture things that may be deemed important to general well-being. So, for example, increased output may come at the cost of environmental damage or other external costssuch as noise. Or it might involve the reduction of leisure time or the depletion of nonrenewable natural resources. The quality of life may also depend on the distribution of GDP among the residents of a country, not just the overall level. To try to account for such factors, the United Nations computes a Human Development Index, which ranks countries not only based on GDP per capita, but on other factors, such as life expectancy, literacy, and school enrollment. Other attempts have been made to account for some of the shortcomings of GDP, such as the Genuine Progress Indicator and the Gross National Happiness Index, but these too have their critics.      Tim Callen is an Assistant Director in the IMF’s External Relations Department.