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?