Government Spending

The Benefits of Government Spending

     In July 2016 I showed [1], in a very simple and straightforward way, how raising taxes and spending the money thus raised can cause an immediate increase in GDP, while at the same time allowing increased expenditure on infrastructure. My simple model (detailed in Table 2 below, and in [1]) shows how money is recycled; one man’s spending is another man’s income, and so on repeatedly, towards a limit. My analysis has not been widely heeded by the media, and maybe it should be restated. It also raises a number of issues that I did not discuss, such as: who should spend our money — the citizen or the state, and is VAT better than income tax?  I extend the analysis and the discussion here.

     In Table 1 below, I start with an notional GDP of 100 (arbitrary units) and using the estimates discussed earlier (and listed in Table 2) for amount spent on raw materials, infrastructure, luxury goods, taken in tax, or wasted, I come up with different percentages of GDP recycled depending on the tax regime (and my assumptions on how the tax is spent – see Table 2). The recycled GDP will itself split as before, and some of it will itself be recycled. But this is not an infinite regression; there is a mathematical limit given by the formula 1/(1-x), where x is the fraction recycled (e.g. 0.556). We see that recycling adds considerably to the final GDP, and more so in the high-tax regimes.        

I do not think this point has been often made in the literature generally available to the public: that raising the level of taxation can increase GDP.

Table 1.  Initial GDP set at 100 arbitrary units. With recycling it swells to > 220

Income tax rate (p/£)	20	30	20	30
VAT tax rate (p/£)	20	20	30	30
Percentage of GDP recycled (=x)	55.6	57.4	56.4	58.1
Total Additional GDP at limit (i.e. 1/(1-x))	225.2	234.7	229.4	238.7
Total final GDP including initial injection	325.2	334.7	329.4	338.7
Percentage of GDP spent on Raw Materials	36.0	31.5	34.0	29.7
Percentage of GDP spent on Infrastructure	5.6	7.4	6.4	8.1
Percentage of GDP wasted	2.8	3.7	3.2	4.1
Percentage of GDP spent by citizens	72.0	63.0	68.0	59.5
Percentage of GDP spent on VAT-able goods	32.0	28.0	28.0	24.5
Percentage of GDP spent on VAT-free goods	40.0	35.0	40.0	35.0
Percentage of GDP collected in tax	28.0	37.0	32.0	40.5

There are a number of other points that can be illustrated with this simple model besides that just made about the importance of recycling GDP.  

Crucial to the effect of GDP recycling lies the question of what the government does with the taxes it collects. In the model here, it is assumed that some is spent on infrastructure, and it will be noted that higher taxes allow a proportionally higher annual spend on infrastructure (and waste). But a much larger fraction of government income is assumed to be spent on salaries (nurses, police, teachers, etc.), and on benefits (which I have treated as GDP, for it will be spent as such). To keep the modelling simple I have assumed the same split of government resources in each tax regime; so higher grovernment revenue pours more money into the pockets of millions of people. Hence the positive effect on GDP. If the model allowed foreign trade, and people spent their money on foreign cars, the spent money would not recycle as our GDP; it would figure in the economy of the car-makers.

You might wonder why this route of “Tax and Spend” has not recommended itself to governments before now. But of course, taxes take money out of the pockets of the wage-earners. Spending power is particularly hit for what I have called “voluntary spending” or “VAT-able spending”; essentials are slightly protected. Few politicians care to campaign for votes with a proposal to raise taxes, even if that is the sensible thing to do.

Table 2.  Variables used in the model and values assumed in calculations. Only the GDP (i.e. the ‘wages’) is recycled. The model assumes no foreign trade. ‘Waste’ refers to submarines and paperclips. If any reader has accurate data on these issues they can insert their own figures here, and write to me.

Variable	Symbol	Value assumed	Units
Input GDP for round 1	a	100	Arbitrary, e.g. B£
‘Average’ income tax rate	b	20 or 30	Pence/£
‘Average’ VAT rate	c	20 or 30	Pence/£
Portion of net income spent VAT-free	d	0.5
Part of VAT-free -> wages	e	0.5
Part of VAT-free -> raw material	1-e	0.5
After VAT, part -> wages (i.e. GDP)	f	0.5
After VAT, part -> raw material	1-f	0.5
Fraction of total tax on wages	g	0.5
Fraction of total tax on benefits	h	0.2
Fraction total tax on infrastructure	i	0.2
Fraction of total tax on waste	1-(g+h+i)	0.1

There was a theory, promulgated by some macro-economists, that lowering taxes will leave more money in the hands of the spending public, who will spend it and boost GDP. But will they spend it? And what will they spend it on? It is paternalistic to suppose that the government will spend more wisely than the citizen; paternalistic and perhaps also over-optimistic. Our governments since the credit squeeze of 2007 have shown no great wisdom in leading the way towards economic recovery. They have beggared the health service, given tax cuts to those on super-tax rates, and flooded the banks with fake money, ostensibly to cause inflation. On the present model we can see why tax cuts can fail to simulate the economy, when accompanied by spending cuts.

References

[1] http://occidentis.blogspot.co.uk/2016/07/tax-and-spend.html