August 20th, 2015
Have A Question?
Theory is just that—theory. In other words, based on deep analytical thinking, and using history and judgment as a guide, one creates what he or she BELIEVES would happen given certain dynamics. In The Future of Your Wealth, I discuss economic models and theories. Regardless how sound a model or theory may appear on paper, there are limitations to it when it comes to real life.
Often these models make assumptions that do not hold true in the real world. While economics is useful to try and understand the human incentives that make the world go round, economics is not a science like physics or chemistry, where your can predict real-world outcomes on paper with formulas and equations.
So for all of us in the real world, I have found that applying some common sense and observation to economics can get you a long way in determining what works in life. So let’s dig into something that affects all of our lives: Government Spending and Taxes. After all, it is now over 25% of our economy, incomes and expenses (taxes).
The main economic theories and models that have been used since the Great Depression, say that government spending is a positive thing for us. For every dollar of spending, the economy (which is, remember, the sum of all of our incomes and consumption) grows by more than one dollar. This is called a “multiplier.”
If a multiplier is greater than one, then we get a bigger bang for our buck. Makes sense? Let’s dig deeper. The multiplier for government spending is thought to be large, because the models assume all government spending translates into income for consumers (either through wages from working for the government or from money given to consumers by the government).
On the other side of government spending are taxes. Over time, taxes must equal the amount of money a government spends. If spending is greater than taxes, Uncle Sam has to borrow money and will need to eventually tax us more in the future to pay back the loan. Likewise, if taxes are greater than spending, the government can either pay back borrowed money or accumulate surplus funds, so it can tax less in the future.
The theory is that taxes have a multiple of less than one, because people do not spend 100% of their incomes (they save some of it). Therefore, if the government raises taxes by 1 dollar, this will take less than 1 dollar out of the economy (which is, remember, the sum of all of our incomes and consumption).
So there you have the prevailing economic model. And what does it suggest? It is clear from this theory that it is better to have higher government spending and higher taxes, because the benefits from the spending is greater than the cost of the taxes.
Now, let’s apply some common sense and real-life observations. First, the empirical evidence. Decades of economic research shows that government spending has a multiplier of LESS THAN 1 and taxes have a multiplier of GREATER THAN 1! This is the exact opposite of what the above theories predict. How can this be? Well, some common sense suggest why:
So, applying some common sense and real-life observation, we know that government spending hurts more than it helps; higher taxes hurt more than they help and lower taxes help more than they hurt. If common sense is not enough to convince you, send me an email and I will direct you to the data which supports these conclusions. Government spending and taxes have a big impact on the future of your wealth, so make sure you think about them the right way.