Monday, March 07, 2005

Taxes, Growth & Economic Freedom

In 1776 Adam Smith’s Wealth of Nations was published. The economic models advanced by Smith ushered in the market economies that dominate the globe today. This seminal work ended 25 centuries of economic systems characterized by mysticism, superstition, and cronyism. The market economy outlined by Smith, and later refined by Marshall and Friedman, replaced then anachronistic systems of feudalism, mercantilism, and familial systems such as the Greek Oikis.

Several tax reform proposals before Congress this session depend on an assumption that has never been empirically observed. That is, pay people less by taxing them more and they will not reduce their level of work. To put it simply, “take from the rich and give to the poor and the size of the economic pie will remain the same.” To the contrary, by achieving greater income equality, such action will shrink the overall size of the economy leaving both the rich and the poor with less.

Almost two centuries ago, Malthus observed that increasing the wages of the Irish laborer resulted in less work since they use the extra money to indulge in drunkenness to the point where they actually work less. David Ricardo, also a British economist, showed that this assertion was empirically invalid. In economics speak, Malthus was arguing that there exists a backward bending supply curve for work. That is, pay a person less by taxing them more results in the same level of income for society. In fact, by taxing the more productive, or rich as suggested by some, there will be less for us all—rich and poor.

The system or paradigm that generates testable or falsifiable hypotheses as demanded by Popper is one that is framed by individual utility maximization. I, along with most economists, assert that by encouraging the industrious and more highly productive by not taxing them in a punitive manner, the overall economic pie is larger with higher economic well-being for all. While the shares are unequal, the shares for each are larger in this system. It is an overused, but accurate economic maxim, that you tax what you want less of. Many big government liberals advocate taxing the industrious and productive more heavily. If done, society will end up with fewer industrious and productive just as was observed in the Soviet Union and Communist China. We must understand that the poor, along with the rich, have benefited from the work of individuals like Bill Gates of MicroSoft and Sam Walton of WalMart.

I argue that the current system, even without tax hikes on the rich, negatively affects economic growth. In the U.S., the top 20% of income earners are paying the lion’s share of taxes while more and more of lower income earners are being removed from the tax rolls. This certainly places unusual stress on the system as low income individuals see few problems associated with higher and higher tax rates since they pay little if any of these rising tax burdens. This of course leads to electoral misbehavior as higher income individuals are punished by their populist elected officials.

Ernie Goss, Ph.D.
Professor of Economics
Creighton University


Robin said...

Although I have always considered myself somewhat of a liberal, this particular blog brought a lot of interesting thoughts to mind. If only there was some way to only reward and encourage true ingenuity and productivity(such as that of Gates and Walton) and not just any wealthy person who became wealthy through corrupt practices or a trust fund.

Ed Morse said...

I suppose the problem is identifying what is "true ingenuity and productivity". Markets do this pretty well. When governments start to do this, their favorites prosper and others end up in the gulags. You get the corruption, which I gather you don't like.

I agree with you that corruption should be addressed. This seems an appropraite area for government to intervene to enforce the rules of the game. Thanks for commenting, Robin.