Business tax cut or Increased Govt. spending?
This is a quick post to a question in the comments section by Jerry Critter on the circular flow model using labor income.
He asks, “To improve the economy, we hear two somewhat conflicting stories. One, we need to increase government spending, or, two, we need to reduce business taxes. Can your model compare the relative benefits of these two approaches?”
We start with the current conditions…
Then we will lower net taxes on capital income from 15% to 13%, then solve for equilibrium.
We see that the result is an increase in consumption for capital income and a decrease in consumption for labor. Overall consumption has not changed. The government must borrow more. Business can borrow less. We see that the marginal propensity to invest did not change. The assumption underlying this result is that capital saving continues at $1 trillion. Overall imports remain unchanged, even though capital is importing more and labor is importing less.
If I hold labor MPC constant in graph #2, the fall in capital income taxes goes straight into capital saving to be used for investment.
Now we will raise government spending from 18.5% to 19% as a share of GDP, then solve for equilibrium.
When we compare graph #3 to graph #1, we see that consumption decreased for labor almost the same amount. Consumption for capital did not change as a result of holding capital saving constant at $1 trillion. We see that saving for labor increased almost the same amount ($806 b.). Overall consumption is lower by raising government spending, because part of it has been transferred to government spending. Business will borrow less (change from $2404 b. down to $2170 b.). Government borrowing has increased almost the same amount in this scenario. Business borrowing changed pretty much the same. Marginal propensity to invest did not change.
If I hold labor and capital MPC constant in graph #3, then the MPI (marginal propensity to invest) goes down to 15.6% and capital investment drops to $2442 b. Consumption would not drop but investment would.
UPDATE: It makes sense to hold labor’s MPC constant in graph #2, and to hold MPC constant for labor and capital in graph #3.
Both options involve…
equal decrease in consumption for labor.equal increase in government borrowing.equal increase in saving for labor.equal change in business borrowing.
The differences are…
Capital consumption increases by lowering business taxes, but overall consumption stays constant.Overall consumption falls by raising government spending.- In graph #2 holding labor MPC constant, if capital income tax is lowered, the effect would be more capital saving for investment.
- In graph #3 holding both labor and capital MPC constant, if government spending is increased, the effect would be a drop in business investment.
It is thought that an increase in government spending would actually crowd-in business investment in a depressed economy. But the problem is that demand is constrained at this point, much more than one or two years ago. There is a limit to investment when the economy is near the effective demand limit. Even businesses crowd each other out for investment.
Neither scenario will change the eventual effective demand limit, which sets the peak of the expansion phase of the business cycle. Thus, neither scenario is very helpful.
In my opinion, the only place for a stimulus is during the recession and recovery phases of the business cycle. That’s the portion highlighted with white in this graph from investopedia. Those phases require expansionary fiscal and monetary policies in order to protect efficient companies.
According to the effective demand limit on the business cycle, we have already passed the recovery phase and entered into the expansion phase.
Stimulus or expansionary policies aren’t the name of the game right now… it’s raising labor share of income, which should be a normal part of the expansion phase, but the mechanism is breaking down due to the effective demand limit being far below full-employment. High unemployment and spare capacity don’t encourage raising wages.
So if the government “could” do something, I would recommend they raise the minimum wage and other wages in a progressively increasing manner, irrespective of what other countries do with their wages. Someone has to be bold enough to start the move back to normalcy, and why shouldn’t it be the largest economy in the world, that of the United States?
lambert
i am going to suggest that if your model is wrong if it does not count government spending as consumption.
especially if (as?) government spending creates jobs for workers who certainly will consume.
to the extent that this is financed by debt (government borrowing), well so is business investment.
Coberly,
Government spending is not household consumption. The model shows that government spending can crowd out household consumption due to the low limit of effective demand that we have now. In normal times, that would not be a problem because either way full-employment will be reached. The problem with government spending is that now it would want to push employment down below 6%, which is beyond the effective demand limit. The government will have to spend more and more to push against the economy which wants to go back to equilibrium at 7% unemployment. The government would run into a problem.
In the two scenarios, we see that government borrowing and business borrowing both changed by the same amount. Govt borrowing went up, biz borrowing went down in both scenarios.
So the way to improve the economy is to raise wages, in effect increasing the cost to do business, and lowering profits in the short term, but will be beneficial in the long term through increased demand and thus increased sales? While critics are quick to suggest increased Labor cost is detrimental to business, it is not.
Jerry:
Keep in mind Direct Labor wages is the smallest component in the cost of manufacturing and in many cases other business as well. Raising wages is incrementally smaller (~10%) than Overhead (SS, Unemployment, etc.) or Materials.
When Papa Johns was complaining about the PPACA costs per employee, the cost increase amounted to an ~ 10 cents per large pie. What is the pay back for such an increase? Fewer people going to the ER for unreimbursed hospital costs from the user (we pay it). The payback for higher wages is greater consumption.
Jerry,
Exactly… Lower profits in short term steadily and carefully, then demand builds, then sales build, then profits stabilize, then more workers employed, then slowly prices will stabilize at or above 2% inflation… The increase in wages is slow and steady. Too fast and the system will over-react.
The benefit from more employment in the domestic market would more than make up any competitive disadvantage in exports. If we try to lower wages to be more competitive overseas, we just constrain our economy more.
How does the model react if I increase benefits to the unemployed (regardless of whether they currently are getting unemployment benefits) and maybe even put the recipients to work on useful projects that need to be done? This increased government spending increases labor share and would be going to people who most need money for consumption, right?
PJR,
Benefits to the unemployed would lower net taxes, since net taxes are taxes minus transfers. It would be similar to a business tax cut. Labor consumption would rise. But it still does not change the effective demand limit.
The government would increase its borrowing to meet its expenditures. This would lower business borrowing (when the economy is not in a liquidity trap). Ah yes… the liquidity trap.
I must say that in the model above, i did not make enough adjustments. Net exports should have changed some. Capital saving should have changed some.
The system really does move like water.
I have gone back and made a flow for 1stQ 2011… and the marginal propensity to consume for labor was 88.1%. It has risen only slightly since then. Capital MPC was 61.4%. It has gone down some since then.
So I think there is a problem in the above flows. Labor MPC would not decline as much as the model shows. But there would need to be an offsetting adjustment somewhere due to the effective demand limit.
If I hold labor MPC constant in graph #2, the fall in capital income taxes goes straight into capital saving to be used for investment.
If I hold labor and capital MPC constant in graph #3 (raising govt spending) then the MPI (marginal propensity to invest) goes down to 15.6%.and capital investment will drop.
I just updated the post above taking into consideration that the MPC should be held constant in these scenarios.
Ed I have a few questions that I struggle with.
One, is that do businesses really factor in taxes on how they treat labor or investment? In my experience staffing and wages depend on demand for your products. Higher demand means more investment, possibly more hiring if you need the extra labor, and wages depend on the tightness of the job market.
Two, I do not feel that Government spending crowds anything out – especially deficit spending that adds to net private savings. Thus Kalecki profit equation shows that deficits drive profits. Without deficits to add net financial assets then the following happens: All the new money created is bank from lending. You only get a stable system over time if all that bank money is spent. Any saving will create demand leakages that that knock potential supply and effective demand out of whack thus underperformance.
This is the Kalecki formula I use here:
Gross Profits = (Investment) + (Government Deficit or surplus) + (Net Exports) – (Savings)
Can this model show economic growth? I get the impression that the total output is fixed, so whatever parameters you change, you get the same grand total. This would imply that the growth of any one sector would have to be balanced by shrinkage in another.
I imagine any growth model would have to include time using differential equations, rather than be a simple constraint system. Your model just solves a set of static equations, so we can see what the various equilibrium states are, and that is amazingly useful. Drawing all those silly curves reminds me of those geometry fallacies (e.g. all triangles are isosceles) that are based on cleverly flawed drawings.
If you publish a version of your model, I could dump it into an equation solver and generate some simple graphs of parameter versus parameter, ceterus paribus. I’m guessing I’d mainly see sloped lines.
Edward,
You are confirming what many people have been saying all along – demand drives the economy. If your goal is to improve the economy you must put more money in the hands of the people, not the businesses. Putting money in the hands of businesses simply increases profits, not the overall economy.
Matt,
One, In payroll expenses, you have to figure in payroll taxes. Then it all gets bundled as labor expense that affects the bottom line.
Two, I agree with. If a business wants to invest, the bank can just create the money. There really is no crowding out. How does deficit spending add to net savings? because the government consumes more?
Your Kalecki equation is interesting. The result turns out to be capital net saving. Kalecki then called gross profits… capital net saving… That is interesting.
Kaleberg,
The idea is basically, the parameters lead to an equilibrium. Thus, would the same parameters always lead to say $16 trillion in real GDP? Well, no… There is a mystery in a recession, where as the economy inflated it is actually growing within the parameters to the next higher level of equilibrium GDP. You found the mystery. I too had to think about that, but I want to see it in action. I want to run some numbers and see how the economy warps reagl GDP growth into the parameters.
I keep thinking about that moniac machine. The circular flow moves so much like water.
How can I publish a version of the excel spreadsheet online for you? You can email me off my blog… effectivedemand.typepad.com
Then I can email you a version of the circular flow.
I will post tomorrow a cleaner correct version of it.
Ed, Private Savings = (G-T) + (X-I).
G is Gov spending
T is taxes
X is exports
I is imports
Mechanically the following happens. Government deficit spends buying a $1000 widget. A checking account gets credited $1000. A $1000 bond is issued and another checking account is debited $1000. In the end you still have $1000 in reserves, and the $1000 bond (plus the interest it throws off). The latter is a $1000 net asset addition to the economy thus private saving gets a positive.
Two questions, and I know there’s an additional post (at http://angrybearblog.strategydemo.com/2013/08/been-tinkering-in-the-circular-flow-laboratory.html) clarifying some of this. I was not sure which place was better to post my questions. I thought people would “land here” first, so I chose this spot.
(1) There’s a notion I’ve seen from time to time that government spending has effects upon business spending or household consumption presumably by raising the cost of money. Given that the debt market is large and fluid, why is government spending singled out here? Should the effect be considered by the aggregate borrowing in that market on the part of all brokers and borrowers in it, corporate as well as government?
(2) It would be useful to see these “flows” described as differential or difference equations rather than as a bunch of qualitatively described relationships. Is that documented anywhere?
Thanks,
– Jan
I can answer (2) from a mathematical, not economic, point of view. This current model is a steady state model, hence any differential equation is equal to zero. (No change with time.) To make it a dynamic model (time dependent – showing us how fast money flows from one element to the other – is a whole lot more complicated requiring much more data and a much more sophisticated method of solution.
Jerry,
It is not difficult to do a time dependent model. I have been doing one here with solver and goal seek from excel. You do not need sophisticated mathematics. You only need a model that is set up right.
I now have two models for the circular flow. One sets GDI always equal to GDP. One sets GDP greater than GDI and can only be solved by finding the equilibrium point between GDI and GDP. The equilibrium point is found instantly with basic excel functions.
@Jerry,
So, presumably, it is a statics, all-in-equilibrium kind of model. So, it there the equivalent of a forcing function? That is, the equivalent of an out-of-system driver?
@Edward,
“… can only be solved by finding the equilibrium point …” … Does that mean that the states outside of a neighborhood of equilibrium don’t make semantic sense and the equilibrium is only relatable to “the actual economy”? Or are excursions away from equilibrium also economic conditions?
If they do correspond to economic conditions or state, wouldn’t the time-dependent oscillations (assuming they oscillate, depending upon eigenproperties) be of interest as well? Wouldn’t these give insight into responses to various shocks?
If states which correspond to excursions away from equilibrium are not actual economic states, how do you know (what’s the proof for, in other words, in the maths sense) that the equilibrium is an economic state?
I’m not trying to be a pain … Just coming at this from the perspective of someone who knows something about coupled differential systems and their numerical solution, and nearly nothing about economics.
Edward,
I would be interested to see how you do that with solver and goal seeker.
Jerry,
but I already explained it in a previous post.
GDI leaves firms as income and flows through the economy. There may be an extra injection of lending from banks that result in more money returning to firms as GDP.
The higher GDP now leaves the firms as higher income to be used by households. This results in an even higher level of GDP. The flow goes round and round until GDI reaches equilibrium with GDP.
Goal seek does it so easily. You just make goal seek increase GDI until it equals GDP. Goal seek will then start to increase GDI internally in its function. GDP increases with each step that goal seek takes. You can quickly watch the process as the numbers change. It’s like watching the time sequence pass by in a fraction of a second. Ultimately goal seek finds the equilibrium where GDI will equal GDP. It will do the actual rounds of money flowing through the economy, round by round. The actions of goal seek functions exactly match what actually happens in the economy. I prefer to do it that way.
Edward,
OK. I see what you are doing. That is not what I think of as a time dependent, dynamic calculation. But at this point it does not matter because you are not talking about the dynamics of the the system, just how the equilibrium points change. (Of course, I don’t think our economic system is ever really in equilibrium. Too many things are constantly changing.)
Goal seeker starts with a guess, goes through the series of equations, ending up with a new guess, and starts over again. It continues the calculation until the goal is reached. (In your case, GDI = GDP) The numbers change as it calculates and it looks like, but is not, a time series of calculations. There is no time component in the calculation. For example, the calculation does not tell you how long (days, months, years?) it takes GDI to equal GDP, just what the GDI and GDP figures are. In other words, there is no “velocity” component to the “money” as it flows through the system.
@Edward,
I presume all the equations are linear, lest the caution described here
http://support.microsoft.com/kb/100782/en-us
apply. Otherwise Excel Solver is required, per
http://support.microsoft.com/kb/82890/EN-US
but even its Generalized Reduced Gradient algorithm won’t deal with multiple minima or maxima.
Jerry,
You got it…
Jan,
That’s right. You have to give solver numbers that are actually close to the solution. So if you give numbers from one business cycle, the solution generated will apply only to that business cycle. If you give numbers for a different business cycle, the solution will change.
Did you read that part about hills and valleys as solver finds a solution? So you need to start with different numbers in the adjustable cells for various possibilities to see if the solution changes. You also need to make sure your constraints are complete.
Edward,
I applaud your diligence and discipline at checking all these things. As I’ve said, I know little economics so I don’t know what’s typical in these models and I have not seen the coupled system of equations.
However, in my experience, it’s better to use an algorithm which is not do dependent upon correct human set up. For example, people once provided analytical derivatives to power Newton type methods of root finding and optimization. They later realized this was error prone so secant methods were devised that did not need explicit derivatives.
Additionally, something that might concern me, were I doing something like this, is to be sure that the function surfaces are smooth and consistent so there aren’t hops and ripples. This could happen if data arts from different adjacent quarters weren’t properly adjusted or interpolated onto a common reference frame, or if they were affected by statistical fluctuations or other effects.
But, as I said, I don’t know the field or application.
Jan,
You are right about those hops and ripples. They can make solver stop before the best and true solution is found. The key is to make sure the constraints are thorough and complete.
I posted today an explanation of the circular flow chart I use. i did that because I have determined the constraints for the chart. And I want to establish the model before I show the charts.
I found one variable that had wide swings. It caused capital’s consumption of imported goods to go irrational, like from 20% to 90% of income. I determined a way to stabilize that variable which also had the effect of stabilizing household savings. I had to make an assumption. I had to assume that capital income consumes on average 20% more imported goods than labor income.
That assumption stabilized the model. And from what I see, that 20% cannot change very much.
Now I will prepare those charts for posting later.