Taxes, Stimulus & The Broken Window Fallacy

A couple of days ago I received an e-mail from a friend directing me to a video snippet entitled “the broken window fallacy”. Its story line is that a hooligan throws a brick through a baker’s window and the baker has the glass replaced. The glassier replacing the glass now has a job and can buy more grain from the farmer who can use this money to buy something else etc., etc. Following that argument more hooligans doing more damage would be even a better economic stimulus. On the other hand, if the baker did not have to replace the window he would buy a suit from the tailor who would spend his money on produce thus also providing money to the farmer. In the later case, however, society would have gained a suit whereas in the former it was a zero-sum game with the farmer’s gain being offset by the baker’s loss. The snippet ends by reminding the viewer that to pay for a stimulus or a war, money is taken from people in the form of taxes thus reducing the amount spent and causing the loss of jobs.

I found the choice of a hooligan throwing the brick as a comparison to stimulus a very interesting if not too subliminal a political message. The economic argument could just as well have been made using, say, a limb from a tree broken by a storm breaking the window. The logic would work just as well without introducing political bias. But I guess it is hard not to make political hay given an opportunity when there is an underlying agenda to an argument. That’s the case for most of us (including myself).

If I got the gist of the message right, it is an argument for cutting taxes to increase business and get the economy out of a terrible slump instead of pumping money in through public works. In the current economic downturn there have been several tax cuts under the previous administration and one under the current one which did not turn into spending (a new suit for the baker) but resulted in increased savings (good stuff but not simulative). The examples in this video were at a level of consumer. There is a similar argument on behalf of the investor that increased taxes on the wealthy, through repeal of the “Bush tax cuts” will stifle investment and thus prevent a recovery. This is the current dialog.
There is an assumption here I think that money collected in taxes somehow is removed from the economy. The fact is quite the opposite. Government has a propensity for spending as conservatives rightly point out so the taxes go back out into the public in one form or another facilitating commerce. One can argue whether it is spent in a most productive way but it is spent. To put another spin on the snippet in the case of a stimulus going to the glassier, the money gets to the farmer in either case. The question is does the $30 dollars to repair the window move from the baker’s pocket and get to the farmer through the government or does it go to the farmer through the baker. The same $30 dollars gets to the farmer either way.
The “broken window fallacy” puts defense spending into the same bucket as the stimulus (must be a Libertarian cite) but the same can be said for money spent on defense. It is used to pay soldiers who or their families use it so buy stuff. (even overseas it is used in military stores to buy goods available at home). The making of uniforms, armament and munitions employ people in well paying manufacturing jobs. Much of foreign aid is military with the recipients using the moneys to buy weapons made in our factories.
Other foreign aid spending, though small, still leaves a significant portion of the money in the US economy. I saw Bill Clinton addressing a philanthropic convention where he related a story about the government donating $100 million to feed the hungry of a third world country. $75 million of the $100 went to US consultants paid to figure out how to distribute the food. He mentioned that that was not a criticism of the Bush administration because he suspects the same went on in his. At some level, as with the case of the window that didn’t brake, money was made available to businessmen that could be invested in job creation. The government spends the taxes. The question is to whom does the money go and will they spend it in a way that improves society?

In the 35 years I ran the company I spoke to about 50 different organizations interested in acquiring the enterprise. They ranged from venture capitalists, private equity enterprises and large public companies. These were all people looking to make an investment. It is interesting that not one of them ever asked how much tax we pay. I wonder if that suggests that how much taxes may not be an important consideration in their investment decision. However, every single one asked about where the customers are going to come from and how are we going maintain their demand along with what advantages can we create and maintain over others in our industry.

Expecting that my experience can be applied to other businesses, I can’t imagine a restaurateur hiring another chef or waitress without customers lined up at their door regardless of how low the tax rate is. Nor can I imagine, because the tax rate is too high, them not hiring when they are turning customers away. An appropriate influx of money into an economy creates more customers. I also cannot imagine an investor forgoing an opportunity for increasing profits regardless of how much of it they have to give up to taxes. More profit is always better. The tax increase, though fought vehemently before the fact, after the fact becomes just another reality and as long as all in an industry pay the same rate, none are advantaged and life goes on. Aha! What about international competition? Don’t taxes make one less competitive? Competition from lower wage countries creates competition and lowers profits, often to the point where there are no profits. Profits are taxed and enterprises struggling for survival from fierce competition or an economic downturn have no profits and thus no concern for taxes on them.

I realize the above is an oversimplification and does not go into all the nuances of hidden taxes and taxes, such as employment taxes, which reduce the profit and are part of the expense of struggling, as well as profitable businesses. An enterprise buying a commodity that it will transform and resell, does not pay a sales tax on that commodity. When arguments are made on the full amount of taxes paid, they often and correctly point out that included in the price, beside the cost of producing the item, is the profit and tax paid on the profit it generates and this goes on multiple times as things are bough, transformed, sold, bought, transformed, etc., etc. The taxes I have most often herd debated however, are the income, estate and capital gains taxes. This discussion is focused on these in particular because they are coming up for a vote soon.

One can further pick at the window example. For instance, there is a difference
between the glassier, out of work, buying bread and a backer still in business buying a new suit. But I digress. That gets into a whole other discussion. Who should get what and what, if any, is government’s role in that decision. In the spirit of oversimplification, I offer the following, also an oversimplification and open to many complex discussions. If I made $100 profit and paid $30 in taxes, but now have to pay $40, what is left is $60 in my pocket instead of $70. However, if I can make $110 in profit, though I now keep only $66 whereas I would have kept $77 before, I have a $66 profit that is still $6 better than a $60 one. The only reason I would not take an opportunity to make a larger profit from an investment is that I could invest the same money and get more profit from something else. Even there, if the amount I give up to taxes remains the same, taxes do not enter into that decision.