To tax the rich or the poor? I think it is supply vs. demand

September 16, 2008 at 10:43 am | Posted in tax | Leave a comment
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I always hear of taxes on the rich as taxing the hand that feeds us all – these are the guys who pay for everything. They create jobs and they set up businesses and they get manicures and pay for fancy meals and consume luxuries. I don’t disagree. But – what do they do at the margin? What would you do if you made a million dollars? What would you do different if you made another thousand on top of the million? Whatever your answer was on the first million, I bet you’d save most of the extra thousand. And thats how I would like to see the debate about whom to tax framed. Because not every tax is equal. Taxing different people has a different impact on the economy (and I’m still talking about income tax, the whole sales tax / fair tax issue is an entirely different matter).

So: here goes…

Lets say you cut taxes by giving someone an extra dollar back from the IRS. You could have kept the dollar and had a smaller deficit. But you gave it back. Why? Is it to encourage people to save and invest, or to spend and stimulate? And why do you care what the recipient does with the money?

Because if you give the dollar to some average working class Joe, the dollar goes to buying a new pair of shoes for the kids, or fixing the roof, or eating out, or maybe a weekend getaway. Its spent. And the business that receives the dollar from Joe spends it too – on payroll, on product, on services. 15 cents on payroll, 10 cents on rent, 5 on utilities, 50 on product, 20 on profit. The employee spends the 15 cents somewhere else- food, clothing, a movie. The manufacturer of the product spends their 50 cents on raw materials and payroll and overheads… their employees and their suppliers employees shop at Macy’s and Wal-mart and eat at Chili’s and McDonald’s.

The dollar has created demand for goods and services, perhaps 4-8 dollars worth of goods and services before its done. The business owner would do well to supply the extra goods and services to meet this new demand, and the surplus profit from the transaction can help increase the supply.

On the other hand, give the dollar to someone making $250k, and what happens? Maybe a little bit of the windfall goes to getting an additional latte at Starbucks, or to spend more on a trip to Europe. But most of it gets saved and invested. They already have all the clothes, food and other consumption items they want. Maybe some of it is spent, but, at the margin, the dollar is saved and invested. Which is great for the economy because that is what creates jobs – if there is the demand. This is a supply side situation.

So what do you want to do? A tax cut on the poor and working class stimulates demand while adding a small amount for supply (via profit and the incentive to borrow / invest more). A tax cut on the rich stimulates supply by encouraging investment (and demand a little bit because the rich do spend some of the windfall – just not all of it).

Both approaches have merits. Both approaches tend to balance out eventually – demand and supply find an equilibrium in a free market. But one may be more effective than the other at different times.

Raising taxes is exactly the same thing in reverse – if you had to collect another dollar, would you rather take it from someone who would have spent it, or from someone who would have invested it? DO nothing on taxes (but, as government, spend exactly what you would have anyway), and you will have to take the dollar from somebody in the future anyway. Will the future America be better able to afford that dollar?

I think America has under-invested in recent years. But what is the real problem right now? Where will the extra dollar do most good? The US consumer is cutting back on spending wherever possible. You give her a dollar, and she will use it. Give the business owner a dollar, and he will not create a job. Not today. He will sock it away to reduce debt or to tide him through the tough times he sees coming.

Giving him the dollar may not save his business. But sending him a customer with a dollar in her pocket just might.

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