Tax  and  Spend

Why is the "austerity" question still being debated?

     The argument between 'fiscal prudence' and 'deficit spending' has not yet been won by either side. Why is that? Back in 2010 Veronica Chick and Ann Pettifor  showed that cutting government spending would fail to decrease the deficit, but would instead increase it, by depressing the economy.

     In June 2012, Paul Krugman and Richard Layard published "A manifesto for economic sense" [2], calling for a policy of fiscal stimulus to reduce unemployment and foster growth. Yet our coalition government cut taxes, and the Debt continued to rise [3]. Week after week, year after year Krugman ran a column in the New York Times pushing the same argument.

     The Opposition declares itself "anti-austerity" but gets little support from the electorate. The ordinary citizens (and the governments they elect) are very unwilling to spend further money as a way to reduce the Debt; it is too counter-intuitive. It is easy to see [4] that a sovereign state is not the same as a household, and that borrowed money could be paid back with worthless paper. But that point is not enough to persuade the averagely cautious citizen to borrow money on world markets in order to "restore growth". We already spend 8% of GDP servicing the Debt; what if rates should rise? We are already in the hands of the money-lenders. Why has the Keynes-Pettifor-Krugman lobby failed to persuade?

It is unfortunately a quantitative problem, which makes it almost impossible for the average citizen to solve. Public works will cost the government, but will raise national income, and hence taxes. Is the latter enough to compensate for the increased expenditure? I therefore attempt a simple quantitative approach to test that question.

     It is not an algebraic analysis, but a robust and brutally simple approach to the numerical problem. 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 incomes in the country [5]. Suppose, initially, that the annual GDP is 1trillion GB£. (1Tr£) Suppose that the government collects 20% of all income as income tax and 20% of non-exempt spending as VAT. [Table 1; Stage 1]   

     The income tax revenue stream is therefore 0.2Tr£ [Stage 2]. 

     If all the remaining net income (0.8Tr£) were spent, with 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, constitute part of the eventual GDP, and are recycled back into the economy; the "raw material"  (**) is lost to the economy. [Stage 4]

     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. [Stage 5],

     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 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 swells the GDP to 1.556Tr£. This may relate to what economists know as the 'fiscal multiplier' [6]. [7]

     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 fall to 0.4175 with an increased 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 to a considerable extent returned to the economy in the form of salaries and benefits. Raising taxes is very different in its effect from cutting government spending. (***)

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.debtonation.org/wp-content/uploads/2010/06/Fiscal-Consolidation1.pdf

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

[3] http://www.tradingeconomics.com/united-kingdom/government-debt-to-gdp

[4] John Lanchester, London Review of Books, 8^th Sept 2011

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

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

[7] Strictly speaking the recycled GDP will itself recycle in exactly the same way, after splitting into 'waste', 'infrastructure' etc., adding progressively smaller amounts to GDP with each cycle: 0.556, 0.309, 0.172, 0.096, etc. tending to GDP=1/(1-0.556)=2.252.  But for simplicity I consider only one cycle through the table for that is sufficient to make the argument. For the higher tax rate of Table 2 the additional GDP with successive cycles is: 0.582, 0.339, 0.198, 0.115, etc..

*  Spending of OUR money on FOREIGN goods is thereby avoided.

**  Though crude, these figures are careful not to overestimate the contribution to GDP. It is arguable that much of "raw material" is also income, e.g. for the forester. Likewise I am told that in a typical NHS Region, salaries make up more like 75% of the total cost.

*** Good government could spend taxes with this effect on salaries and GDP in mind.