Friday, February 05, 2010

Raising Taxes

The general consensus among economists, left and right, is that raising taxes in an economic downturn is always a bad idea. From Paul Krugman to Milton Friedman, all agree that raising taxes, on anyone, would hurt the recovery. Krugman ranks it as being just as bad as cutting spending. Now I perfectly well understand this with regard to business in a ideally competitive environment. In an ideally competitive environment any increase in costs, taxes or otherwise, can only be made up by producing less stuff. That would entail, in general, laying people off and thus reducing aggregate demand. The taxes collected would be spent on something, but the result would be unlikely to be better than what was being purchased prior to the tax increase, and is quite likely to be worse. That, as I understand it, is the view consistent with standard economic theory.

However, I am puzzled about what happens in a certain non-ideal environment, particularly because I believe that that non-ideal environment applies the the US economy. Let us suppose that John Smith is the proprietor of a gas station under franchise to XYZ Oil, Inc. (fill in the name with your favorite, or most despised, oil company as you please) Among his costs are a franchise fee paid to XYZ Oil. If this fee is at the highest rate the market will support, then everything above applies and any increase in his costs, taxes or otherwise, are likely to force John to contract the amount of work he does, possibly cause him to leave the business. In any case aggregate demand would go down.

I want to consider a situation where the John’s costs are different from the ideal of competition and I’d like to put some numbers on the problem to make it more concrete. So let us suppose that the market price for the franchise fee is $50,000 and that after all other expenses are paid, John can expect to be taking home $60,000 for himself, assuming that he puts in about 60 hours of work each week. Let us further stipulate that this arrangement would be quite satisfactory for John, considering the range of opportunities for work available to him. This then is the state of affairs in an ideally competitive market. Consider then what the situation would be if XYZ Oil, for some reason, were charging him much less than the market value for the franchise fee. The reason is not important, but for some reason it is charging him $25,000 a year, half what the market would support. But given that he can expect to take home now $25,000 more than the market would typically support, I would expect him to work fewer hours. With the reduced franchise fee working 60 hours in a week would bring in $85,000. In this case he could perhaps work only 50 hours in the week and still have $75,000 to spend, more that he would have in the ideal market. Surely, he would rather have the 10 hours in leisure time and use it to spend the extra $15,000 rather than do the full 60 hours of work.

So what happens then if XYZ Oil discovers that its fee is too low. Let us suppose that it raises the fee up to be somewhat closer to the market (it chooses not to correct the error in one sudden jump) and raises the fee from the very low $25,000 up to $35,000. Now if John continues his 50 hours a week his disposable income will be reduced to $65,000 per year. He might keep that level and have 10 hours free time per week now to spend the $5,000 per year, but he is also very likely to choose to work a few more hours each week and increase the amount of stuff done by the station (increasing also the number of people employed and the number of hours these employees work as well as the incidentals purchased by the station) by 5 hours per week. Now he is producing more, working 55 hours per week (still fewer than the market would demand) and earning $70,000 a year. He isn’t as well off as before the price rise, he is working more, but he still has more free time (5 hours per week) and more money to spend ($10,000 per year) than the market would support. The point here is that in this non-ideal situation, raising his costs will not decrease his output and productivity but rather increase it. Contrary to the standard economic theory of an ideal market raising his costs will raise the aggregate demand. Similar arguments could be assembled to show that should XYZ Oil, for some really bazaar reason choose to lower the franchise fee from $25,000 to $15,000 the effect could only serve to encourage him to take even more time off, produce less and reduce overall demand. Note too that this argument has been developed in terms of franchise fees for a gas station and has nothing specifically to do with government and taxes. I maintain that the arguments apply as well to any costs that a business incurs.

Now the reason I discuss this in a post on raising taxes is that I maintain that exactly this kind of deviation from market value applies to the US government and the prices it charges for services such as general security, copyright protection, the guaranteed sole use of radio spectrum, incorporation, etc. If, as I maintain, our prices are too low, we charge far less than what the market will support, then raising prices will not reduce aggregate demand but rather increase it. Raising taxes on those who use these services to generate their income will not discourage production and hiring but rather encourage it.

Consider, for example, the issue of the relative poor state of broadband service in the US compared to other countries in the world. The reasons for this state of affairs is debated, but I propose that at least one cause is that given the low prices we charge for our services the operators of the companies providing these services have little reason to do the extra work needed to provide the better services. Yes they would make more money by providing better services, but the managers would have to do more work and given the pay scales they would rather take the leisure time. Particularly during the past 8 years when a pay raise (via lowered prices charged by the government for services it provided) was guaranteed whether service improved or not. If we would like to see improvements in these services we need only raise our prices. Furthermore this would only be a boost to the economy.

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