High taxes cripple economic growth
Gerard Jackson
Conservatives tend to instinctively realise that tax cuts stimulate savings and production. On the other hand, their opponents fully grasp that significant tax cuts weaken their power to bribe and punish and so they oppose cuts with specious economic arguments.
Public understanding of the relationship between taxation and growth is very poor. Recently a reader seriously referred me to a 1993 World Bank Study that concluded that “growth drives savings rather than the other way round”. Some time ago Brian Toohey (an Australian journalist who works for the Fairfax stable) used the same study, following with another study carried out by two American economists, Christopher Carroll and David Weil, who claimed to have demonstrated that rapid growth in Japan, Hong Kong, South Korea and Singapore had preceded increases in savings.
The dessert was provided by two Australian Treasury economists, Michael Carnahan and Lyn Camilleri, who seemed to find that growth and savings were unrelated. Toohey concluded that these studies clearly indicated that economists who favour tax breaks for savings need to show how these will benefit the economy by expanding savings.
Now those who favour tax breaks should explain their beneficial effects, this should not divert our attention from the reality that these studies only demonstrated how far economic thinking has been set back by Keynesianism. Only the confusion between the alleged differences between saving and investment that Keynes unleashed on economic students can account for such bizarre conclusions.
Before any article on savings and investment can really make sense it must first define what savings and investment really mean. Saving is the process of transforming present goods into future goods. Present goods are consumption goods and future goods are capital goods.
When we save we tranfer purchasing power from consumption to the production of capital goods, many of which will then be used to produce more capital goods. (This is why growth is sometimes called forgone consumption).
Investment in more capital (the material means of production) makes for increased future consumption, i.e., higher living standards. It needs little imagination to realise that taxing savings amounts to taxing future living standards.
What needs to be remembered is that when defined in real terms, investment and savings are (a) always equal and (b) saving is clearly the only means by which resources can be directed from consumption to investment. To put it another way:
The function of savings is to redirect resources from the production of consumption goods to the production of capital goods.
(Some might object that I am labouring the point. Be that as it may, it is a point of such importance that it needs constant labouring lest we get more journalists echoing Toohey’s fallacies).
All of this would be painfully self-evident in a barter economy but, as the classical economists so aptly put it, “money is a veil” that conceals fundamental economic relations, the nature of saving obviously being one.
This is a small price to pay for enjoying the benefits of ‘monetary exchange’. Nevertheless, economists are supposed to be able to see beyond the veil; that so many cannot is a sad reflection on much of what is taught in economic faculties.
This brings us to the egregious fallacy that growth can precede saving, which in turn calls for a definition of growth. Growth is an increase in a country’s capital structure, its productive capacity. By our own definition of saving and investment, the two cannot deviate because by definition they are identical. Nevertheless, the existence of money can and does create the illusion that savings are exceeding investment.
However, this is old hat in economics. This problem was discussed by Malthus in an 1811 review of Ricardo’s first pamphlet. Henry Thornton’s Paper and Credit, 1802, acknowledged the issue; Jeremy Bentham dealt with it in some detail in his Manual of Political Economy finished in 1804 but not published until 1843; Stuart Mill also addressed the subject, as did other economists throughout the nineteenth century.
To these economists, savings in excess of investment was not a mystery to be solved but an issue to be discussed along with its consequences. They fully realised that for ‘savings to exceed investment’ a monetary expansion is necessary. In the words of Malthus:
“Whenever, in the actual state of things, a fresh issue of notes comes into the hands of those who mean to employ them in the prosecution and extension of profitable business, a difference in the distribution of the circulating medium takes place, similar in kind to that which has been last supposed; and produces similar, though of course, comparatively inconsiderable effects, in altering the proportion between capital and revenue in favour of the former.
The new notes go into the market as so much additional capital, to purchase what is necessary for the conduct of the concern. But, before the produce of the country has been increased, it is impossible for one person to have more of it, without diminishing the shares of others [emphasis added].
This diminution is affected by the rise of prices, occasioned by the competition of the new note, which puts it out of the power of those who are only buyers, and not sellers, to purchase as much of the annual produce as before: While all the industrial classes, — all those who sell as well as buy, — are, during the progressive rise of prices, making unusual profits; and, even when this progression stops, are left with the command of a greater proportion of the annual produce than they possessed previous to the new issues.”
What Malthus described here was the process by which monetary expansion can increase investment by forced savings, what Bentham called “forced frugality”. The same process by which consumption is forcefully restricted was discussed at length by Professor Robertson in Banking Policy and the Price Level, 1932, in a section headed Automatic Stinting.
Professor Pigou simply described it as a process by which the banking system transfers purchasing power to business which then uses it to command resources that would have otherwise gone into consumption. This is basically the same process that the Austrian school uses to describe forced savings.
I realise that readers might still find the issue somewhat obscure. As already noted, in real terms investment must always equal savings because they are aspects of the same thing, i.e, the resources being directed into investment are the same resources that would have gone into the production of consumers’ goods.
Therefore, not only are they equal they are also identical. The introduction of money, however, complicates matters. In money terms investment can exceed savings just as savings can exceed investment. But this is only in terms of values. When investment exceeds savings we have inflation and when savings exceed investment we have deflation. These are processes that the classical economists obviously understood, unlike so many today.
Let us take a hypothetical situation in which savings and investment in money terms are equal. In order to expand investment the banks create new deposits for business to draw on. These deposits enable business to command resources that were destined for consumption.
It now appears that investment (capital accumulation) is being created without savings because the money value of investment is greater than savings. This illusion completely deceived the 1959 Radcliffe Committee that erroneously reported “heavy investment in new capital assets” without an increase in current savings taking place.
But as Professor Hutt pointed out (The Keynesian Episode) “savings must have been forthcoming through decisions somewhere.” It follows from this that differences between savings and investment are due to changes in the money supply and not magnitudes. Once again, when investment exceeds savings new money must have been created.
Let us see what these studies mean in real terms. If investment can really exceed savings, this mean that capital goods can be literally created out of nothing! This is true magic pudding economics. But as we have seen you need resources to create resources.
To argue otherwise is to argue that land, capital and labour can be conjured up at will; that economies can grow without ever sacrificing consumption, that farmers can grow wheat without planting seed, that milk can be produced without cows, that a country can increase its productive capacity without accumulating capital and that the Tooth Fairy is a live and well and living with Keynes.
Of course, countries with similar saving rates can, even in the absence of monetary changes, have different growth rates. Again, there is no mystery. Hong Kong on one side and Singapore, Malaysia, Korea et al on the other side provide a graphic example of divergent growth rates.
A 1992 study by Professor Alwyn Young found that Singapore and Hong Kong were very similar to each other and both more or less started on an equal footing in 1945 and both were free trading city states with no manufacturing base. By 1960 their GDPs per head were about equal and from that year both began to grow at about 6% pa for 25 years.
The fundamental difference between them was that Hong Kong adopted a free market approach while Singapore opted for interventionism (industry policy: it sounds better than planning).
The results are remarkable. Hong Kong leapt ahead of Singapore. From 1970 to 1990 output per worker in Hong Kong rose by 150% compared with just over 100% in Singapore. Moreover, Hong Kong’s output per unit of capital was comparatively constant during this period while Singapore’s fell by over 50%. By the mid-’80s Singapore’s rate of return on capital had fallen from about 40% pa to 11-12%, by the late ‘80s and she needed to invest twice as much for the same output as Hong Kong.
Furthermore, total factor productivity (the amount produced by a combination of given factors) in Singapore had fallen by 6% while Hong Kong’s had risen to 56%.
A study by the National Bank of New Zealand showed that Singapore, Indonesia and Malaysia have had negative total factor productivity growth rates for over 30 years. Once again, Hong Kong stood out with a positive total factor growth rate of 2.4 per cent a year. As the report noted, Hong Kong was the only one of the Asian tigers that really approached a free economy. The reason for this marked divergence is quite simple: only the market can allocate resources to the margin, i.e., their most valued use.
This fact was lent further weight by a McKinsey Global Institute study that found American capital productivity greatly exceeded Germany's and Japan’s. (Of course, if Congress had adopted Robert Reich's economic proposals, America's advantage in productivity would have been quickly destroyed).
When politicians, bureaucrats, rent-extracting businesses and other vested interests get their fingers in the savings pie the results are malinvestments, wasted resources and falling productivity. It is only because of the Asian tigers’ high savings ratios that the true cost of their interventionism had not been fully revealed. However, the next economic crisis will quickly reveal these malinvestments
The point of this is that when comparing growth rates with savings rates, one should look beyond the economic magnitudes to the level of intervention in the economy. This, unfortunately, is rarely done. There is also the non-problem of actually defining investment. For example, residential building is defined as investment because houses, flats, etc. are durable. This is economic nonsense.
Houses and flats are consumption goods. The only real economic difference between a house and a pizza is time. To define housing as part of the capital structure on the grounds of durability is absurd. There is also the matter of government malinvestments being classified as capital.
However, to carry this point further at this stage would add nothing to the debate. What we can conclude, however, is that the more a country genuinely saves the more economic growth it will enjoy providing the appropriate institutions are in place.
Suffice to say that the so-called mystery of an economy growing (accumulating capital) at a faster rate than it saves is found to be no mystery at all. It turns out be nothing more than a case of forced savings (inflation).
What is mystifying is how so many of today’s economists can be so ignorant of these matters. These confusions would never arise if most of today’s economists had been properly educated in the first principles of savings and investment.
The lesson of savings should now be abundantly clear: to save is to grow. Therefore anything that hinders savings retards growth. So stark and so simple is this truth that even the most strident critics of tax cuts should be able to grasp it — but only if they want to.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 31 January 2005