Cut or Spend

Cut or Spend

Why is the "austerity" question still being debated?

     Still the battle rages! Ann Pettifor and Veronica Chick (Financial Times 4^th Oct 2010) declared (ex cathedra) that cutting government spending (or increasing taxes) would not decrease the deficit, but increase it. But no one headed. The Nobel Prize winner Paul Krugman ran a column week after week with the same argument. In June 2012, he and Layard published "A manifesto for economic sense" [1], calling for a policy of fiscal stimulus to reduce unemployment and foster growth. Yet the ordinary citizens and their ordinary governments are very loath to spend further money as a way to reduce the deficit; it is too counter-intuitive.

     Part of the argument is easy: "A sovereign state is not the same as a household."  Obviously! But that point is not enough to persuade the averagely cautious to borrow money on world markets in order to "restore growth". Though I have grappled before with this topic [2],  I take it up again now, and attempt a more quantitative approach. I do not have the mental power to follow an algebraic analysis, and nor will my intended readership. But I have evolved a robust and glaringly simple approach to numerical problems of this sort. I assume very rough figures for the way salaries enter into the prices of goods, and have simplified grossly to expose the argument, but I believe that this approach could be 'tuned' rather accurately if the correct splits (of one sum between its 2 or 3 parts) were determined and inserted. My conclusion is startling.

     Imagine for simplicity the United Kingdom to be a closed community with no external trade. I can therefore equate GDP with the sum of all income in the country [3]. Suppose, initially, that the annual GDP is 1trillion GB£. (1Tr£) [Table 1; Stage 1]  Suppose that the government collects 20% of all income as income tax and 20% of non-exempt spending as VAT. The income tax revenue stream is therefore 0.2Tr£ [Stage 2].  

     If all the remaining net income (0.8Tr£) were spent, half on VATable commodities, and half on VAT-free items [Stage 3],  the VAT stream would be 0.08Tr£, as that is 20% of 0.4Tr£ [Stage 4]. Of the VAT-free portion of GDP, I am going to assume that half represents salaries for farmers and shopkeepers, etc, while half is the cost of "raw materials". The salary portions, of course, constitutes part of the eventual GDP [Stage 4]. (It is arguable that much of "raw material" is also income, e.g. for the forester.)    

     The VATable portion of net income, after deduction of the VAT, is spent on our voluntary purchases. I shall assume (in the first instance) that this also will be distributed 50:50 between raw materials and salaries (of boat-builders, opera singers and the like). The latter, as before, becomes part of GDP.

     Let us now spend the tax we have collected (IT+V) [Stage 5], and suppose that 50% is salaries of civil servants, soldiers, nurses, etc.; so eventually part of GDP. A further 20% might go on benefits (which I shall count as GDP in that it will be treated as income by its recipients), 20% on infrastructure, leaving 10% as waste (e.g. paper clips, rubber bands, and shredded paper.) [Stage 6]

     In this very crude first analysis it seems that, with an initial GDP of 1Tr£, a certain amount is lost to the economy on raw materials, infrastructure, and waste (0.444Tr£), while the remaining 0.556Tr£  recycles and becomes part of the final GDP of 1.556Tr£. (This may relate to what economists know as the 'fiscal multiplier' [4].) [5]

     In Table 2 the argument is repeated with none of the assumptions changed except that VAT and income tax are both raised to 30%.  It turns out that the losses to the economy now amount to 0.4175 with 0.5825 returning to GDP to produce an eventual GDP of 1.582Tr£.

The surprizing result is that raising taxes, in addition to improving infrastructure, has raised GDP, for the taxes in this model are largely returned to the economy in the form of salaries and benefits.

Table 1.  Recycling of GDP with VAT and income tax at 20% (Units=Trillion £GB)

Initial GDP=1Tr£
Inc tax  0.2				Net income  0.8
				VATable spending  0.4			VAT exempt (rent, food) 0.4
				VAT 0.08	Spent voluntarily 0.32		GDP 0.2	raw material 0.2
Total tax  0.28					GDP 0.16	raw material 0.16
Waste 0.028	InfraS 0.056	Benefits 0.056	GDP 0.14

Table 2.  Recycling of GDP with VAT and income tax at 30% (Units=Trillion £GB)

Initial GDP=1Tr£
Inc tax  0.3				Net income   0.7
				VATable spending  0.35			VAT exempt (rent, food) 0.35
				VAT 0.105	Spent voluntarily 0.245		GDP 0.175	Raw material 0.175
Total tax  0.405					GDP 0.1225	Raw material 0.1225
Waste 0.04	InfraS 0.081	Benefits 0.081	GDP 0.203

References:

[1] http://www.manifestoforeconomicsense.org/

[2] http://occidentis.blogspot.co.uk/2011/10/deficit-spending_11.html

[3] http://www.investopedia.com/terms/g/gdp.asp

[4] https://en.wikipedia.org/wiki/Fiscal_multiplier

[5] Strictly speaking the recycled GDP will itself recycle after splitting into 'waste', 'infrastructure' etc., adding progressively smaller amounts to GDP with each cycle: 0.556, 0.309, 0.172, 0.096, etc..  But for simplicity I consider only one cycle through the table for that is sufficient to make the argument. For the higher tax rate the additional GDP with successive cycles is: 0.582, 0.339, 0.198, 0.115, etc..