Dynamic model of tax transfers may see effective demand as an attractor state
A comment by Arne in a previous post raised the idea that a tax transfer from capital to labor would raise the effective demand limit. So a video was made using the dynamic model for the circular flow to test his idea. As it turns out, the model shows that the natural real GDP equilibrium level would rise… holding other variables constant.
(Click on title of post to open up post and see videos.)
The video says that the effective demand limit would rise. However, that statement was made too fast. We have to take into consideration other variables that would change too. For example, two other variables would not stay constant, namely capital’s marginal propensities to consume and invest. If capital had to pay a higher effective tax rate, they would invest a little less and consume at a lower rate. So the following video was made to show that small changes in those variables could bring the economy back to the original natural level of real GDP.
The natural level of real GDP is associated with the effective demand limit. Historic data show that the effective demand limit stays fairly constant through the business cycle. Here is a sample graphic to show the constancy of the effective demand limit. You can see adjustments that return to the trend line and eventually lead to the projected meeting place of real GDP and effective demand.
So due to the constancy of the effective demand limit in setting a natural level for real GDP, the idea arises that the effective demand limit may be some sort of attractor state for macroeconomic adjustments. (An attractor state is a state to which a dynamic system will tend to return to.) If you were to change one variable, the other variables would adjust to maintain the dynamic equilibrium determined by the effective demand limit. The effective demand limit is based on a relationship that the combined utilization rates of capital and labor will not exceed an effective rate for labor share of income.
One of the statements I was commenting on was that fiscal policy would be ineffective. This result shows that it can be effective depending on the impact on consumption and investment. I would suggest that a forced redistribution (fiscal policy) would look very like a voluntary increase in labor share. Changes in labor costs will impact consumption and investment similar to changes in tax costs.
I also wonder about the investment impact. Investment decisions are made on the basis of predictions about future demand. If firms see that consumers have more money, will they not invest more even though their taxes have also been increased? (with the caveat that they are still profitable)
All of this also takes note of the assertion that we are below “optimal” labor share. If the money in consumer’s hand is sub-optimal, then (almost by definition, certainly by intuition about other dynamic systems) giving them more will create a more optimal result.
A transfer like you talk about is best put in terms of disposable income which is the income after net taxes. You simulate a rise in labor share by raising disposable income.
Will business invest the same, more or less with an increase in taxes? Then will they invest more when consumers have more consistent money over time?
You would see in the model in the videos that labor consumption will in effect increase, but that increase would be offset equally by downward changes in capital’s propensity to consume and invest. Thus real GDP would not change like you say. Consumers may have more money but overall real GDP will not increase its equilibrium level.
The economy has entered into a new equilibrium from low labor share. The dynamics of the economy have somewhat “solidified” around that.
My research into effective demand tells me that labor share will not increase, because it is already anchored into the dynamics of the economy. Labor share had the same anchor from 1975 to 2001. It has shifted downward since then. It will be very hard to get it back up.
“For example, two other variables would not stay constant, namely capital’s marginal propensities to consume and invest. If capital had to pay a higher effective tax rate, they would invest a little less and consume at a lower rate. -”
Well certainly this is a standard assumption in classical economics, and a whole lot rides on it, not least every supply side argument ever made. But is it true? I mean is there actual historical evidence that shows this relation to hold?
Because it assumes that investors are motivated by rate of return and accumulation making the goal in life to GET richer. As opposed to the desire to LIVE richer. But from the stanpoint of a former historian this seems all backwards in the context of history north and south, east and west except maybe for the limited time and space that comprised Northern Germany, Holland, England and Scotland in the 18th to 19th century. This locus rightly are wrongly has been associated by Weber and others with a specific type of Calvinist Capitalism that rather ostentaciously shunned the kind of show consumption they associated with the Church, the Monarchy and the Landed Aristocracy. Which in turn looked down on money grubbing bourgeois merchants. After it was into this century that the old adage that Gentlemen didn’t engage in Trade fell into abeynce in Britain, and of course through much of Christian history the advancing of money with the expecation of returns with interest was considered a mortal sin best left to Jews.
On the other hand over that same span one of the prime virtues was considered to be Hospitality which was normally demontrated by conspicuous consumption. To appeal to another adage common among the landed rich until very recent times, A Man is Known by His Table. And this meant sharing the ‘good stuff’ rather than hoarding it for private consumption. There has been no time in at least Western history where being a niggard or miser were admirable chracteristics. And yet chasing return and maximizing accumulation is precisely what the miser does and so risking falling into the mortal sins of Avarice and Greed.
Returning to the point, what if we posited that Homo Oeconomicus was actually motivated by targeted consumption and display and gaining the admiration of others through that? As opposed to having the biggest bank account? If so the standard notion that increases in taxation (by hurting rate of return) will lessen intensity of investment and a turn to consumption instead. But this implicitly assumes that Homo Oeconomicus will simply adapt to the lower level of consumption commesurate with those lower levels of return. On the other hand it H.O. is truly motivated by PRESERVING his level of consumption the effect of increased taxation will be to INTENSIFY investment so as to be able to afford the consumption target. On the other hand this would suggest that lowering taxation would allow the wealthy to maintain the same level of consumption with a lower level of investment intensity.
Which frankly is a much better fit with the actual reality of the Reagan Supply Side revolution. What we have seen over the last thirty years is a truly obscene increase in conspicous consumption by the rich and particularly the New Rich. On the other hand we have not seen the intensification of investment that the standard model suggests we should.
Exactly where in history is the evidence that lower taxation EVER has led to lower consumption? And there is all kinds of evidence against it. For example one reason that Europe is relatively overrun with heriditary aristocrats (Le Comte de This and Graf van That) compared to even Britain is that patents of nobility whether granted from service to the monarch or via heridtary military service (Nobiliity of the Robe vs Nobility of the Sword) has been that such awards almost always came with a tax exemption. And the direct effect of that exemption was the tendency of each new noble to live up to the consumption habits appropriate to his new class in dress, food, drink and housing. And the LAST thing most were likely to do was to take that opportunity to engage in un-gentlemanly and below his station trade and banking. Oddly even true among those members of the New Nobility was fortunes were gained in trade and banking.
So where is the counterargument against me extracting this little Ginga piece from the Economic Theory tower? Because there is no ‘of course’ associated with . “If capital had to pay a higher effective tax rate, they would invest a little less and consume at a lower rate.”
Says who? Some tight ass late 18th century Scotish Moral Philosophers and the 19th century founders of the Manchester School of Economic Theory?’ Sure the virtues of Thrift were obvious to them, that is after all what they had preached to them from the pulpit every Sunday. But why should Catholics listen?
(Classical economists seemed baffled at the idea that the French would just willingly embrace the 35 hour week and 7 weeks of paid vacation. Why don’t they know what that does to your potential bank balance compared to working 60 hour weeks? Well maybe they aren’t motivated by that-no matter what your theory says is ‘natural’ for H.O.)
I think Arne is on the right track. We have to keep in mind that the overwhelming constraint on growth , both in the U.S. and globally , is deficient end demand . Over-capacity is the norm. Dividends and buybacks have replaced “investment”.
Capitalists’ propensity to invest would increase , not decrease , as the income of their customers went up. The propensity to consume of the capitalists ( i.e. rich people ) might go up as well , as confidence arising from increased demand for their goods and services counteracts any ( likely small ) effect of the marginal tax hike.
In your model , labor share is a proxy for income inequality. Any means of moderating inequality would work to address the demand imbalance , as long as it was persistent. Raising labor share is one way to do it , but not the only way.
I like the video format btw.
“You would see in the model in the videos that labor consumption will in effect increase, but that increase would be offset equally by downward changes in capital’s propensity to consume and invest.”
I watched the video before I commented. I saw that you made a choice to model that the increase would be offset by changes in capital’s propensity to consume and invest. It was clear enough when you made the video that those were guesses.
I gave you a rationale for investment to increase instead of decrease and Bruce gave you one for consumption to not decrease. These are guesses on our parts as well.
But again I ask, since these changes in behaviour of capital are caused by changes in the balance sheet, would it matter whether the change comes from becoming educated about effective demand and deciding to pay workers more or from being taxed the same amount?
I am not advocating the tax (as I am just guessing about the real effects). I am just asking about the model.
I will propose an idea… The equilibrium of the dynamic model is established at the very beginning when income is divided between labor and capital. Labor’s share establishes the equilibrium of the economy.
How might the MPI of investment decline? It could be mathematical. If consumption rises as a % of real GPD, the % of something else must decline. Either investment or net exports, because government spending is held apart from this.
If net exports as a % of real GDP does not decline, then investment as a % of real GDP would have to decline in the model.
I agree with Arne too. More money in the hands of consumers would stimulate investment.
It is interesting to note that capital used to be taxed much more than labor. Now their effective tax rates are much closer. The effective capital tax rate used to be twice as much until 1998 when it started to change.
How much did the lowering of the effective tax rate on capital contribute to the fall in labor share? And then, would a rise in capital’s effective tax rate eventually lead to a rise in labor’s share?
That seems like one place where one could go with this.
It sounds like you are framing the same question differently.
There is a % battle going on between the variables of real GDP, consumption, govt spending, investment and net exports. Together they must add up to 100% of real GDP.
When you say, “I gave you a rationale for investment to increase instead of decrease and Bruce gave you one for consumption to not decrease.” you are saying that investment % is rising, and consumption is not falling. Then what is falling? Either govt spending or net exports has to fall as a % of real GDP. It is hard to know what will happen because govt spending and net exports are decided exogenous to the model.
I assumed that since consumption rose as a % of real GDP, investment would fall from 16% to something lower. If you raise consumption and investment as a % of real GDP, most likely net exports will decline, and they did in the video, but we can’t be sure how much they would. Govt spending would probably decline as a result, but we can’t be sure.
Yet, the effective demand limit follows a determined trend line business cycle after business cycle. The variables of real GDP are aligning themselves to make that happen or they are aligning themselves in response to it.
“Either investment or net exports, because government spending is held apart from this.”
Another accounting identity that is held to apply to the real world based on nothing at all that I can see.
For example it would seem that this particular equation always assumes that government spending is never an investment. Because ‘definition’.
It seems that the main thing that divides economics from physics as being sciences is that at some point physicists recognize that their basic axioms have to have a close enough approximation to empirically established reality that they are justified in going forward with their models.
Economists? Not so much. “Assume a fully informed market”. Well apart from a sheep trading fair in the Tyrolean Alps that seems to be the starting point for both Austrian and Chicago economics at what point have any brand of classical economic schools been willing to put EMH to a real falsifiable test? Even where economists like Akerloff have been given Nobel Prizes for demonstrating that many markets are based on asymmetrical information (“Lemon used cars”) and the entire history of financial markets has been marked by insider trades of one type or another. Which in the late 19th century was not actually illegal or considered by most market participants illegitimate. I mean on what other basis does the concept of “Stock Market tip” even make sense?
But you see this over and over, mostly from the right but also from the Brad deLong types (who as an historian of economics often shows he really knows better). For example we have the argument advanced by some that the New Deal did not really create employment because by one measure the U.S. lagged newly Nazi Germany. Well this turned out to be that the metric placed volunteer WPA and CCC workers in a category that would have them not ‘really’ be employed yet counted Nazi slave laborers assigned to private industrial planst as being so employed. Because ‘private enterprise’ vs ‘dead-weight government’.
Well I am sorry but two lines drawn on a whiteboard in an Econ 101 class does not constrain analysis for everyone else in the world. It is not enough to cite axioms, there is a need to justify them.
In previous posts and comments I have called this the problem of “Word to World Fit” vs “World to Word”. Less charitable labeling would have it be “Procrustean”, lop a limb here, stretch one there and wow! a fullly justified model!
“If capital had to pay a higher effective tax rate, they would invest a little less and consume at a lower rate.”
That’s demonstrably false. When the US had high corporate tax rates in the 50s & 60s companies tended to invest more, since investment, that is, spending on capital goods and capital enhancing services, was deductible. At a 50% rate, for example, it was common to consider the deduction a 50% (100%-x) subsidy towards capital spending. Cutting oneself a check, the usual modern executive course of action, would have meant paying 80-90% to your government partner, so it was less attractive.
This attitude was not just a business school thing. It permeated the popular culture. For example, watch the James Garner, Lee Remick classic The Wheeler Dealers. The movie may be a bit hard to follow. Not only have the sexual mores changed, but the tax structure as well. It was generally recognized that high taxes were a push towards investing in one’s business. (The taxi lease back deal might seem to be gibberish, but it actually made sense under the tax code then. It’s like the Franklin’s Tale in which Chaucer seems to be playing the bamboozle, but is actually describing exactly how the tides were calculated in the 14th century.)
And reinforcing Kaleberg.
Stockholders didn’t revolt because of the simple fact that unrealized capital gains were not taxed. As such their interests were mostly aligned with those of the executives who were looking to minimize taxation on the corporate side, reinvesting served to increase both the overall value of the company AND the allocated share of that which accrued to shareholders and all without tax consequence at the point of value earned. Now of course those taxes would could due at point of gain realization. Unless of course you had a good estate lawyer and/’or some method of borrowing against those assets. Which most wealthy folk do and did. Which is why people like the Rockefellers and Kennedy’s are incredibly wealthy even though in theory their estates have been triply or quadrupably exposed to nominally high estate tax rates over the last century. Because there are always ways to preserve capital.
On the other hand once you break down the barriers that make capital preservation the only way to keep the taxman from taking 90% of your loot, e.g. by lowering the marginal rate to start with, then why not buy that yacht. Sure it might take a 15% penalty because you cashed out ‘long term’ gains or as much as 36% if you were foolish enough to pay it with current income, but it beats the hell out of only getting value to the extent of a dime on the dollar like yacht purchases might cost you back in 90%+ marginal rates.
We could call it (and maybe they already do) the marginal cost of consumption. Higher tax, higher marginal cost.
You write, “When the US had high corporate tax rates in the 50s & 60s companies tended to invest more…”
But here is a graph of investment as a % of real GDP since 1951, data from national accounts.
Investment was lower back then. (BTW, investment as a % of real GDP is the marginal propensity to invest without an autonomous amount.) But as the corporate tax rates have fallen, investment has risen over the years, especially since 1995 when capital tax rates started moving closer relative to labor income tax rates.
So it is not far-fetched to lower investment as a % of real GDP if capital tax rates rise. That would simulate reversing the trend during the boom years.
Nice graph. But maybe we could use the definition of ‘investment’ in question.
Because if it includes such things as plowing money back into various financial derivatives or pure plays on the movements of interest rates then it is really no more ‘investment’ than that of Gilded Age millionaires spending the winter at Monte Carlo and Biarritz in the Grand Casinos.
I am willing to grant your case. But you don’t make it by throwing up the label ‘investment’ as one axis on your whiteboard. What is included and what is excluded from your term? Are these apple for apple comparisons of investment in actual material productive goods such as machine tools and production facilities? Or does any play that involves capital assets qualify?
I’ll grant that there are trillions of dollars of financial transactions sloshing around the world’s markets on any given day that even in constant dollar terms way exceed those we saw in the fifties. Maybe because they didn’t have the computers needed to make those transactions in micro-seconds rather than sending a telephone call to a trader in a funny jacket waving his hand down on the floor of the New York and Chicago Exchanges. But how much of that new micro-second driven activity is anything more than high-tech rent seeking/skimming?
Maybe there is really more actual investment in productive capacity than before. And certainly we no longer measure all production by the ton, after all many, many goods are in the final analysis just electrons and photons moving over one transmission channel or another. But anyone can draw a squiggly line on a whiteboard and label it. And that is okay if everyone accepts the label as representing something real and agrees that the line properly represents it. But a .png doesn’t make it magic.
P.S. Ed here is a hint. A good way to shut me up, at least for a little while, is to give a year, a page, a title and a table number for that ‘Data from National Accounts’. Because otherwise you are in the position of somebody proclaiming ‘So Sayeth Leviticus”.
Hmm. Which verse? Because I got access to the Bible. And those National Accounts. And am not afraid of doing my own exegesis.
The discussion taking place above is a perfect example of why it is that economic theory and/or modeling should never be used to determine tax policy. Note the number of times the word “assumption” is used in the comments. Note also that even references to past economic history does not make reference to the multivariate nature of the topic itself, taxation, GDP, consumption, etc. It is simply assumed that any one variable has an effect on the others, but the extent of each variables contribution to an end result is then grossly uncertain. So why then does government allow economic theory/models to be used as a tool in determining tax policy?
Wealth controls the conversation once theoretical concepts rear their ugly heads. Theorists are always available for sale and are generally indistinguishable from theorists who believe themselves to be unbiased in their study of the issues. Look at the governing boards of most universities. Those bios are full of corporate America. Chicago Univ. wasn’t funded by John D. and Marshall Field for purely altruistic reasons, and the scholastic descendents at the Chicago School have never forgotten their benefactors. Look at the governing structures of all of those “think tanks.” Even worse than are the controllers of university thought. What was the last truly scholarly paper produced by the “scholars” of the American Enterprise Institute?
And the point? Taxation is for the purpose of funding government activities. Taxation is not for the purpose of directing economic activities.
Tax wealth and income and the economy will take care of itself. That statement includes one big assumption. That being that the government make certain that all economic activity runs within the bounds of legal and legitimate purposes and that the tax laws are impartial to wealth.
I hope this doesn’t shut you up.
But here is the link to the post on where I get the data for the circular flow.
Click on the links to “source”.
And the type of investment effects the long-run. Many times beyond the business cycle into the next cycle. China is investing heavily, but many talk about investing that is frivolous and that will have consequences down the road.
I understand your point that there are many variables interacting. That is why I end with the thought that the variables tend toward an attractor state because the effective demand limit stays stable on trend line. So if we start changing one or two variables, the constant effective demand limit implies that all the other variables adjust over time to bring the equilibrium real GDP back on trend line.
When I have time, I will look back and observe how the other variables changed.