We’ve covered quite a bit on why a consumption tax might not be the best way to go in this short series. We have one more reason, and it might not be one that occurs to most people simply because it is highly technical and gets into economic and financial theory.
|Consumer demand drives the economy.|
It is a basic rule of taxation that if you want to discourage a form of behavior, you tax it. This is why most of the price of cigarettes and alcohol isn’t profit to the seller or the cost of manufacture, it’s taxes to the government.
So, logically, if you want to cut consumption, you tax it. And that creates a BIG problem.
You see, it’s demand for consumption goods that drives any economy. If there is no demand for widgets (economists always talk about widgets), then there is no demand for widget makers. If there is no demand for widget makers, there is no demand for widget making machinery. If there is no demand for widget making machinery, there is no demand for machines or people that make widget making machinery . . . .
And so on. In the end, it’s the consumer who drives everything in the economy, one way or another. If you divert consumption income away from consumption and into taxes or reinvesting, then you’ve reduced consumption and thus the reason for producing in the first place, and thus eliminated jobs (and more consumption income) from the economy, reducing demand even further.
This is where the problem comes in. Mainstream economists, especially Keynes, insisted that new capital can only be financed by restricting consumption below production levels (“saving”).
|Dr. Harold Glenn Moulton|
Dr. Harold G. Moulton, president of the Brookings Institution, however, pointed out something that contradicted Keynes’s assertion about cutting consumption in order to save being essential to finance new capital formation. It creates what Moulton called an “economic dilemma”:
The dilemma may be summarily stated as follows: In order to accumulate money savings, we must decrease our expenditures for consumption; but in order to expand capital goods profitably, we must increase our expenditures for consumption. . . . [W]hen the managers of modern business corporations contemplate the expansion of capital goods they are forced to consider whether such capital will be profitable. . . . Now the ability to earn interest or profits on new capital depends directly upon the ability to sell the goods which that new capital will produce, and this depends, in the main, upon an expansion in the aggregate demand of the people for consumption goods. . . . if the aggregate capital supply of a nation is to be steadily increased it is necessary that the demand for consumption goods expand in rough proportion to the increase in the supply of capital. (Harold G. Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 28-29.)
In short, no producer will invest in additional capital until and unless there is an increase in consumption to warrant and justify the investment. Instead of a decrease in consumption prior to new investment in order to provide the financing, what Moulton found for the preceding century was an increase in consumption accompanying every period of significant investment in new capital. As Moulton concluded,
The traditional theory that an expansion of capital construction and consumptive output occur alternatively . . . finds no support whatever in the facts of our industrial history. . . . We find no support whatsoever for the view that capital expansion and the extension of the roundabout process of production may be carried on for years at a time when consumption is declining. The growth of capital and the expansion of consumption are virtually concurrent phenomena. (Ibid., 47-48.)
|Investment banks help "float" new issues of stock|
This finding raised another question. If periods of rapid capital expansion are not preceded by periods of saving to finance new capital instruments, but instead by dissaving to finance the increase in consumption, how is new capital financed, especially on such a vast scale? The answer is, By the proper use of the commercial banking system (invented for just that purpose) backed up with a central bank:
Funds with which to finance new capital formation may be procured from the expansion of commercial bank loans and investments. In fact, new flotations of securities are not uncommonly financed — for considerable periods of time, pending their absorption by ultimate investors — by means of an expansion of commercial bank credit.” (Ibid., 104.)
If, therefore, all current income is used either for consumption purposes, or to retire loans made out of expanded commercial bank credit for capital formation, production and consumption will be in balance, and there will always be enough effective demand to purchase all production. If, however, income that should be spent on consumption is diverted to reinvestment, there will be insufficient demand to clear all the goods and services produced.
The bottom line here? Cut consumption, and you kick the economy in the teeth. A consumption tax is a direct incentive to cut consumption, and therefore is harmful to the functioning of a sound and sustainable economy.