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In the beginning God created Adam Smith,
And Adam created an invisible hand,
And every man pursued his own self‑interest,
And labor was divided,
And nations became wealthy,
While the invisible hand worked together for the good of all,
And thus did Adam create economics,
And God saw that it was good, but naive.
So on the second day, God created Ricardo,
And Ricardo tasted the forbidden fruit of income distribution,
And the population increased rapidly,
And the wages of workers stagnated,
And people demanded more food from the marginal land,
And the rents of landlords increased greatly,
And the returns to nations diminished,
And God saw that it was dismal.
So on the third day, God created Marx,
And labor created all that was of value,
But labor was denied this value by greedy capitalists,
And capitalists increased their surplus by exploitation,
And thus was created the reserve army of the unemployed,
And labor was united,
But the potential for social revolt became great,
And God saw that it was upsetting.
So on the fourth day, God created Keynes,
And there was a Great Depression on the land,
And the reserve army of unemployed suffered from sticky wages,
And Keynes saw that there was insufficient aggregate demand,
And the invisible hand did not work,
so Keynes sent the government to replace the invisible hand,
And the government tried to represent God's goodness on earth,
But God saw that it was depressing.
So on the fifth day, God created Friedman,
And Friedman tried to rediscover the invisible hand,
And he called it the constant growth of the money supply,
And he decreed that the demand for money would be stable,
And this decree made the velocity of money stand still,
And Money determined everything,
And thus Friedman determined the power of money,
But God saw that money was the root of all evil.
So on the sixth day, God created Laffer,
And Laffer also tried to rediscover the invisible hand,
And he called it lower marginal tax rates,
And workers were going to work harder,
And households were going to increase savings,
And businesses were going to increase investment,
And supply was to come forth,
But God saw that it was marginal.
Then on the seventh day, God would have created Zachary Smith,
And God would have imparted to him the truth,
And Zachary would have used this truth to build a model,
And this model would have unified economists,
And all would have been one.
But it was the seventh day,
So God rested in equilibrium,
Leaving economics in disequilibrium.
More Accurate Graphical Multipliers
Mark Zupan,
Many students memorize and believe that the autonomous spending multiplier is always 1/[1‑b] and the tax multiplier is always ‑b/[1‑b]. I avoid this problem by emphasizing that the spending multiplier in the simple Keynesian model is always 1/[1 ‑ slope, AE curve] while the tax multiplier is ‑b/[1‑slope, AE curve]. This helps them to see that when components of the AE curve other than consumption depend on Y, all the multipliers change.
I draw the AE curve shown in Figure 11‑1 to show the basis of the general formula. I also, as a test, ask students when the multipliers would be smallest: when slope = 0 and multipliers = 1 or ‑b (tax multiplier). This occurs when no form of spending depends on Y and when any change in exogenous spending (intercept) will change by the identical amount since it produces no reverberations.
Figure 11‑1
The Irreversibility of Fiscal Drag
David Jones,
Students often mistakenly get the notion that automatic stabilizers reverse the sign of the multiplier, rather than merely lowering its size. Thus, they conclude that if an external shock causes income to fall, automatic stabilizers will slow the income decline and then reverse it, causing income to return to (or at least move back towards) to its original level. A simple analogy overcomes this misconception. Automatic stabilizers are like dragging your feet. They slow your slide, but they don't reverse it!
Louis H. Henry,
Depression: Depression may be explained in terms of inadequate spending in the nation's economy. Let's say that level B in the tub (Figure 11‑2) is the correct amount of national spending that would insure jobs for all those who want them. Depression hits when the tub level falls to C. We have three ways to raise the level in the tub: faucet 1, household spending; faucet 2, business spending (investment); and faucet 3, government spending. The spending flows have to overcompensate for two leakages: savings 4 and taxes 5.
The malady of economic depression usually begins by increasing the leakage of savings 4. But, instead of flowing directly into the investment faucet 2, the sinister valve of hoarding 6, is opened, and the leakage fills hoarding tank 7. (Through lack of confidence or other reasons, people and businesses would rather hold cash than spend. This attitude could be illustrated by imagining the pump on the table slowing down.)
Fiscal Policy: To raise the level in the tub, the government could cut taxes (close the valve at 5) or increase government spending (open the valve at 3). The tax presumably causes increased flows from 1 and 2 because individuals and businesses now have more after‑tax. Government spending at 3 is itself a direct spending injection. Either technique results in a deficit for the government budget; that is, leakage at 5 is less than addition at 3. Where does the government get this extra money to spend? By simply running to the bond market (pump 8) and borrowing the hoarded money from tank 7. Up goes the level. All is wonderful.
Ever hear of the multiplier effect? Let's say that the difference in spending between level C and level B is $100 billion in new spending through any of the three faucets. Every time a dollar is spent, it becomes someone's income and they spend part of it, which becomes another's income and so on until a full dollar leaks out in saving or taxes. In the meantime, that initial dollar made for increases in several people's incomes. So if we add, say $40 billion of new spending to the tub, the multiplier effect (outboard motor 9) churns the level up by $100 billion. It also works in reverse‑‑an initial small drop in spending results in a large drop in the tub's total spending level.
Figure 11‑2
Inflation: Demand‑Pull inflation is caused by too much spending ‑moving the tub's level to bathtub ring A. To offset the spending spree of the private sector, government reacts by increasing taxes (open the valve at 5) thereby reducing the flow from household faucet 1 and business faucet 2. Or the government could turn down the valve for 3 reducing its own spending. More out, less in, and the level drops back to level B. Once again, all is simply wonderful.
Stagflation: The statistics and the description of stagflation (simultaneous recession and inflation) suggest that we are strangely enough, at both levels A and C. What seems to have happened is that with inflation problems, policy makers react by opening the drains thus dropping the economy to a recession level below B but the bathtub ring of inflation remains. Why? It's a different kind of inflation called cost‑push and it is not the old demand‑pull variety of too much spending. Obviously we cannot have levels A and C at the same time (too much and not enough spending). Manning the pumps and valves will not cure stagflation‑‑unless of course, we almost drain the tub into depression. That's a cost we cannot endure in order to reduce the rate of inflation. Other, more direct policies are less costly in human terms to attack cost‑push inflation. (The plumber's hat must be removed in the fight against stagflation.)
Monetary Policy: In addition to the fiscal hydraulics of the government, we also have monetary policy as practiced by the Federal Reserve System. This time, the tub levels are adjusted up or down by flushing more money into the economy from tank 10 or by reducing the money supply by opening valve 11. These techniques are also ineffective in combating stagflation but may be useful in the battle against recession or demand‑pull inflation.
Ronald A. Siltzer,
The Umbrella Theory Approach can be an excellent tool as students begin to build an economic model. It can expand their thinking skills by encouraging them to evaluate the secondary effects of a theory as well as the primary effect.
Suppose the theory is to reduce the federal deficit by raising personal income taxes. As all the effects of this decision are examined, note the secondary ones in particular. (See Figure 11‑3).
The primary support of the umbrella compares to the primary effect in the model; the prongs or secondary supports correspond to the secondary effects of the theory. If the secondary effects support or uphold the theory, the umbrella will continue to be open and usable. On the other hand, if the secondary effects prove negative or do not support the model, the theory (or umbrella) will collapse. This approach can be used in other disciplines in addition to economic theories.
Figure 11‑3
"To Reduce The Federal Deficit By Raising Personal and Income Taxes"
A Flat‑Tax Consumption Function
Paul G. Coldagelli,
This exercise is especially helpful given the renewed
interest in "flat rate" tax for the
In each of the following cases, draw taxes as a function of income. Then draw an "after tax" consumption function, with consumption a function of gross income. Compare this with a "before tax" consumption function drawn on the same diagram.
a. No taxes: C = $500 + .9Yd (Yd = disposable income)
b. Taxes = $300, independent of income (a lump sum tax)
c. Taxes = .2Y (Y = gross income, tax = 20 %)
d. Taxes = .1Y for income < $5,000; (10% marginal tax)
Taxes = .3Y for income > $5,000; (30% marginal tax)
What is the average tax rate if Y = $12,000?
e. Income below $5,000 is not taxed; Taxes = .25Y for income exceeding $5,000. Does the marginal tax rate rise? Does the average tax rate? Write a formula for the average tax rate.
f. Taxes = .0715Y for income < $50,000.
Calculate total taxes at income of $26,000. At $37,000. What are the marginal tax rates at these incomes? (This reflects the Social Security tax.)
By
While most non-traditional college students have good first hand experience with the impact of taxes on economic decision-making, most traditional students have only vague images of taxes as a "four letter" word muttered by parents every spring.
Students tend to know little about taxes but they are quite interested in the subject. As a means to involve students I give them an assignment to interview two taxpayers. I suggest that they interview these people separately and ask the following questions:
"What types of taxes do you pay?" (not amounts)
"Which tax do you consider the fairest? Why?"
"Which tax do you consider the most unfair? Why?"
"If you got a $100,000 raise, how much of it would you really receive?"
Sometimes I add an additional question about a current issue or proposed tax such as reducing capital gains taxes.
The first questions shows students how many taxes exist and which levels of government use different types of taxes. Most people only name four or five taxes, frequently missing excise taxes. Someone will ask whether or not FICA is a tax.
Responses to the fairness questions differ but lead easily into discussion of ability-to-pay versus benefits received principles of taxation and then into discussion of progressive versus regressive taxation.
Responses to the $100,000 raise question will always vary but I show students that full-time workers probably receive between $500 and $800 depending on their income level and state and local income taxation. The whole concept of marginal analysis becomes meaningful to students when applied to taxation and income. Next I show students how being offered $5000 more per year to work in a major city doesn't mean you will have $5000 more to spend. Finally I explain why economists at my university, recognizing marginal taxation, are the least likely business faculty to teach summer courses!
Classical Stability vs. Keynesian or Marxian Instability?
Ralph T. Byrns
You might introduce this chapter by reminding students that Classical economists perceived the market system as intrinsically stable, and recommended laissez faire policies. Contrast this with the Marxist view that capitalism is dynamically unstable, using blackboard graphs such as Figure 11‑4. Then indicate graphically that Keynes perceived capitalism as unstable without government intervention, but that full employment with price level stability could be secured through proper fiscal policies.
Figure 11‑4
Gary Galles,
A discussion of the effect of IRAs on saving is a useful way to focus student attention on marginal incentives during a supply side economics lecture. I begin by explaining that IRAs allowed individuals to place up to $2,000 a year tax‑free (this year, as the IRA deposit is subtracted from taxable income) into an account that would compound with interest (also tax‑free, and it is this tax‑free compounding that makes the biggest difference, which I use a numerical example to show) until retirement ("substantial tax and interest penalty for early withdrawal"), at which point it is paid out as taxable income (at, hopefully, lower tax rates, due to lower post‑retirement income).
I point out that the effect of an IRA is to substantially lower the effective tax rate on that form of savings. Then I ask whether IRAs are likely to increase savings much, due to their higher after‑ tax return. Most students indicate that it would. I then point out that there was almost no effect on the savings rate when IRAs were introduced and that the reason could be seen by focusing on marginal incentives. First of all, I explain that there was no change in the marginal incentive to save for those already saving in excess of $2,000 a year, since the last dollar saved would not be in an IRA, getting preferable after‑tax rates. These people, who tended to be high income and high tax bracket individuals, did build most of the IRA accounts (having the most to gain from deferred taxation and having more liquidity in their assets), but the funds put in IRAs had been previously saved in some other form, leaving no net effect on their savings rate. Lower income and tax bracket individuals, who weren't saving $2,000, were also unlikely to have significantly better marginal incentives to save. First, they had less to gain by the tax deferral than higher tax bracket savers. Second, they had fewer liquid assets and, with lower incomes, less certainty that they wouldn't have to withdraw the funds prior to retirement and hence be subject to the interest and tax penalties for early withdrawal. Third, since retirement income is highly correlated with pre‑ retirement income, lower income individuals are likely to want to set aside less money for retirement than higher income individuals (especially with Social Security as a separate system.) However, note that the post‑retirement income cap after which Social Security becomes taxable would act as an added tax on higher income retirees with IRAs. Finally, even if people in this group started IRAs, the relevant question is whether the marginal dollar saved went into an IRA or whether inframarginal dollars saved were just shifted from other forms of saving. Given the desire for liquidity, it is doubtful that many in this group put their marginal savings dollars into an IRA, and thus questionable whether their savings rate would be raised. Finally, remember that some people borrowed the money to start IRAs, which does not represent net savings at all.
In summary, I conclude that the effect of introducing IRAs was primarily a tax subsidy to relatively high income groups with very little of the claimed intention of increasing savings.
Elasticity and the Laffer Curve
Robert Schenk,
The idea behind the Laffer Curve‑‑that a decrease in tax rates may increase tax revenue‑‑is an interesting application of the concept of elasticity. The Laffer Curve points out that the government faces a "pricing" problem much like the one a business faces. If a business raises the price of a product, buyer behavior will be affected and revenue will rise or fall depending on the responsiveness of people to the change. When the government raises the cost of an activity by taxing it more, it will also affect people's behavior. As in the case of the business, if people are highly responsive to the change in cost, revenues will decline. In fact the major difference between the "pricing" problems of business and government is that business should avoid inelastic portions of the demand curve while the government should avoid elastic portions (unless the purpose of the tax is to discourage undesirable behavior rather than raise revenue).
Edward D. Lotterman,
One analogy for explaining the Laffer Curve is to compare taxing to shooting. This may be most useful on campuses where there are a significant number of ROTC cadets, reservists or just plain militarists among the student body. In my experience it is a very good analogy to use for people with some shooting experience, but may completely mystify others, so caution is urged.
In shooting rifles, tank guns, and
16 inch cannon on the battleship
A howitzer can be fired at all angles from below the horizontal to nearly straight up. Firing below 45 degrees is called "lower register" firing, that above 45 degrees is called "upper register" firing. A howitzer crew has to know that when firing in the "lower register" an increase in barrel elevation will increase range, but that as the 45 degree angle is passed, further increases in elevation will begin to decrease range. When the crew gets a call from a forward observer to shoot at a target farther away, they have to know whether they are in the lower or upper "register" in order to make the correct adjustment to the angle of the tube. If they make a mistake they will at best miss enemy and at worst wipe out their own troops!
The Laffer
Curve argues, in effect, that Federal tax policy is analogous to shooting a
howitzer. Raising tax rates (the gun barrel) from zero will raise tax revenues
(range of the weapon) up to a certain point, but that continuing to raise rates
after that point will decrease revenues (range)! Pointing the weapon straight
up will prove disastrous to the crew, just as progressive property taxes
approaching 100% on English manors after WWII were disastrous for U.K. property
tax revenues. Fiscal policy makers must know what "register" they are
in just as howitzer crew members must. Supply‑side economists who argued
that lower tax rates would not hurt government revenues implicitly believed
that the
The Laffer Curve and Physical Exercise
Geriant Johnes,
The following game may be used to explain the shape of the Laffer curve. Offer five students 25 cents for each press‑up (or sit‑up or some other painful physical exercise) they can do in a minute. Explain to the students that the income earned by one of them will be taxed at a rate of 100 percent; the other four students will be taxed at rates of 75, 50, 25 and zero percent respectively. Five more students may be employed to count the number of press‑ups completed by each of the athletes. At the end of the minute the point can be made that the student being taxed at 100 percent did not complete many press‑ups because he lacks the incentive to do so. Hence a Laffer curve can be drawn. Occasionally students will behave irrationally and will work hard when heavily taxed; the game still makes it easy to explain why this would indeed be an irrational response.
Gradualism and the Laffer Curve
Ralph T. Byrns
Discuss Arthur Laffer's contention that the phasing‑in of the tax cuts of 1981‑83 actually reduced current investment and income because investors and workers postponed productive activities until the full cuts were in effect. For example, a person might have considered working and saving to finance a college education. The postponed tax cuts may have induced some to borrow to attend school during 1981‑83, so that their earnings would be taxed at the lower rates of 1984 and beyond.