Friday, January 28, 2011

What Are They Teaching in Our Schools?!

-- Posted by Neil H. Buchanan

A friend of mine is enrolled in a certificate program at a top-10 U.S. business school. This friend recently sent me an email, the pertinent part of which reads:
The instructor [in the "Investments" course] is a very handsome young man, in his mid- to late-thirties. He has the well-dressed, privileged, but sweet look I was used to on Wall Street in the 80s. The kind of young man so beloved by his fraternity brothers, his trust fund advisors, and his Brooks Brothers tailor that he is secure and happy and isn't even aware he might be a little outside the mainstream of American workers.

So anyway--at last week's class, he made some passing comment about how tax cuts for the rich stimulated the economy more than tax cuts for the poor.

I perked up because I was pretty sure that was the opposite of what I usually hear, and I wanted to make sure I had heard him right.

I raised my hand and said, "But isn't it true that lower-income people spend a much higher percentage of their income, so extra money in their pockets means more money poured into the economy? While well-off people already have their needs covered so more money flowing to them just means they invest or save it?

He said no.

He said rich people are always spending. They go on vacation even when times are tough.

He also said that poor people have so much credit card debt anything extra they get just gets plowed into debt payments and doesn't really stimulate any new purchases.

And finally, that rich people just have so much more money than poor people, that anything affecting rich people has a much bigger total effect on the economy.

So I ended up puzzled. I did not think I was saying anything controversial. It's not even something I've thought a lot about. I just thought I had always heard that lower-income people spend incrementally more of whatever they get.

But the professor made me think about it. It's true that rich people have more money than poor people so they spend more money. So maybe it's true that anything rich people do has a more significant effect on the overall economy . . . ?

Am I missing something?
I have to give my friend credit for being open to new evidence and arguments. It turns out, however, that what the professor said is simply wrong -- although it is wrong in a few interesting ways. As I am not a regular consumer of opinions from the editorial page of The Wall Street Journal or Fox Business Channel, I understand that these beliefs might be held more widely than by one ill-informed (or ill-motivated) business school professor. In any case, this certainly seemed a worthy topic for a blog post.

Professor Privilege made three points, each of which I consider presently:

(1) "He said rich people are always spending. They go on vacation even when times are tough."

This is a true statement that simply does not support the argument to which it is being applied. Recall that Professor P offered this as a reason to believe that "tax cuts for the rich stimulated the economy more than tax cuts for the poor." That rich people spend a large amount of money, and continue to do so during recessions, tells us nothing about how tax cuts will be spent. The reason that rich people go on vacation even when times are tough is that they have more than enough money to do so. They are not spending-constrained, which means that they can keep doing what they would normally do, even when other people are pinched. That means that any weakness in the economy shows up, if at all, as a reduction in their savings. (Of course, we know that the current recession has not even cut into the overall incomes of many of the wealthiest Americans, making it possible to maintain their lifestyles while increasing their saving and net worth.)

If the rich receive a tax cut, therefore, there is no reason to expect them to use that to buy themselves yet another vacation (or anything else). In technical terms, Professor P's error is in confusing total consumption with "marginal propensity to consume." Wealthy people spend a lot in absolute terms, more than the poor (though not as a percentage of their income -- and, as a group, probably not even as a percentage of total spending, although I have not checked the numbers recently). They do not spend much (or any) of the "next dollar of income," which means that they do not spend tax cuts. Giving the rich tax cuts will not, therefore, stimulate the economy.

(2) "He also said that poor people have so much credit card debt anything extra they get just gets plowed into debt payments and doesn't really stimulate any new purchases."

From the standpoint of someone who has more than enough money to spend every month, this probably seems like it simply must be true. It is just good money management, after all, to use additional income to pay down existing debt. Of course, this simply ignores the financial reality of not only the poor but the middle- and even upper-middle-classes in this country. Even if people would dearly love to be in a position where they could "plow" money into repaying debts, they are not. Giving them additional spendable money through tax cuts gives them money to spend immediately on items that they have had to do without or have cut back -- medicines, clothes, food -- because of their tenuous financial conditions.

For many, that paycheck-to-paycheck reality (with personal debt levels rising or, one desperately hopes, barely holding steady) predated the recession. The Great Recession and its aftermath -- continued high unemployment, stagnant or falling wages, costs of health care shifted onto workers -- have only increased the number of people who have no hope of being able to use a tax cut to pay down personal debts.

Again, Professor P's technical error is in not understanding marginal propensity to consume. Most of the non-rich at this point will spend nearly 100% of every dollar they receive (in tax cuts or otherwise). That stimulates the economy. It also, as a passing matter, slightly improves the lives of millions of people living on the edge.

(3) "And finally, that rich people just have so much more money than poor people, that anything affecting rich people has a much bigger total effect on the economy."

It is certainly true that rich people have more money than poor people. (As one of my favorite movie lines puts it: "Does the word 'duh' mean anything to you?") Being a big part of the economy does not, however, mean that rich people's spending is necessarily a driver of the economy. Again, this is an error about marginal effects. Consider an analogy: Even though there are many more people over 25 than under 25 in this country, offering subsidies for higher education is going to affect many more young people than old people. Being "big" does not make something a "change agent" (to use an ugly buzzword that would surely be ever so welcome in a class like Professor P's).

I wish that I could say that I am surprised by my friend's story. One would hope that professors of business would know better than to spout such nonsense. It is possible, of course, that the professor in question actually knows that he is lying, but chooses to do so for ideological reasons. There really is no reason, however, to think that he has ever learned the basic economics necessary to understand this. Being good at, say, describing the relative advantages of debt and equity in a client's portfolio does not require any knowledge of macroeconomics.

And every other incentive in such a person's life pushes him in the direction of believing that which is reassuring: helping poor people is neither necessary nor useful. Nothing that penetrates such a person's consciousness will ever allow him to believe otherwise.


Phil Lange said...

Since the extra money (from tax cuts or "stimulus" spending by government) in the hands of consumers/taxpayers is not the result of additional production of goods or seems to me that the first and most important effect on the economy will be HIGHER the additional dollars are circulating in the economy, bidding on or chasing the existing supply of goods and services.

These higher prices erode the spending power of all consumers and the future value of their savings, too.


Neil H. Buchanan said...

The extra money in the hands of consumers/taxpayers results in additional production of goods and services. Businesses are currently operating nowhere near their productive limits -- which is what it means to be in a recession. The point of stimulative spending and tax cuts for the non-rich is to give firms sound reasons to expand their production -- by giving them customers who otherwise would have had nothing to spend.

And as we've seen, inflation has stayed near zero, notwithstanding stimulus packages, Fed money creation, etc.

michael a. livingston said...

I think there's a cultural issue here with respect to law and business schools. At law schools distributional issues tend to be taken seriously by both liberals and conservatives. I'm less sure of this at business schools . . . or pretty sure they aren't.

egarber said...

The idea that the wealthy spend more of any tax cuts than the poor -- either individually or aggregately -- seems belied by this fact:

The top 1 percent of Americans control more wealth than the entire bottom 90 percent.

This is a pretty clear signal that at the top, a tremendous amount of income is invested and reinvested. And the relative lack of investment wealth below indicates that any associated income is spent directly within the economy.

That reality is why we have a progressive income tax code. Since the poor spend more (or all) of their income on basic needs and not wealth generation, it's most efficient to keep their rates lower.

Jeff Pickering, CPA said...

I agree that tax cuts for your typical trust fund kid are wasted. But I think that what is missing from your post is the answer to a fundamental question. Who creates jobs? Also, who is most efficient with scarce resources? The answer is the entrepreneur. Reductions in taxes motivate the entrepreneur to take risks. They mobilze the resources of our economy when there is an economic incentive for them to do so.

egarber said...

Hi Jeff,

There's little to no empirical evidence that moving the tax scale a few points correlates with predictable hiring behavior. If there was a strong relationship, we would have seen extensive hiring during the W years after his massive cuts -- but job creation was pretty anemic during his run, and real median incomes went down. Further, if the idea is that available cash stimulates hiring, how does one explain the dearth of job creation right now, amid the record cash sitting on corporate books?

Entrepreneurs hire when demand drives the need for production. And as we've discussed, tax cuts near the bottom -- along with other investments in social and physical infrastructure -- spur that demand. That's the core reality underpinning my advocacy of "stability up" economics (my term), which stands in direct contrast to trickle-down thinking.

Neil H. Buchanan said...

I completely agree with egarber's response to jeff. To put it a different way, jeff's comment ends with the statement that entrepreneurs "mobilze the resources of our economy when there is an economic incentive for them to do so." The economic incentive that they need most is potential customers. Tax cuts for middle class and poor citizens, along with spending by any level of government, provide those customers.

Doug said...

"Reductions in taxes motivate the entrepreneur to take risks"

Entrepreneurs (the kind that make huge new businesses) are the type of people that quit a good job and risk all their assets on a venture that might or might not succeed. A risk taker who does something that might leave you deep in debt or fabulously wealthy isn't exactly going to change tack because of a minor tax change.

Think about any recent massive business success - any at all - where the entrepreneur wouldn't have gone in if taxes were higher. Would Facebook not have happened had tax rates been slightly higher? Microsoft? Apple? Cisco? Research in Motion (Blackberry)?

They wouldn't have happened if there weren't enough educated and creative people to pull it off (which the US and Canada have). Think about more other businesses (law practices, restaurants, research-based pharma companies, trucking companies, etc.) - for some tax rates would have a marginal impact on how fast they grew but for most of the risk takers it wouldn't make that much difference.

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