The Big Debate:  Productivity or Spending?  

Say's Law and Economic Growth (ECON 272)

In my opinion, the two biggest differences among economists have to do with:

1.  what really drives economic growth and

2.  whether or not government meddling in the economy creates good or bad outcomes.  The two differences are related, of course.

Generally speaking, although this is simplifying things, those economists who believe in Say's Law believe that productivity drives economic growth.  Those who follow Keynesian economics believe that spending drives economic growth.

So - let's first look at Say's Law and some of the theories/policies that follow from it.  Then we will go into Keynesian economics.

These ideas are usually attributed to what is known as the "Classical School" of economics.  But many economists, besides the Classical School, subscribe to the idea of Say's Law and the theories that follow.

This section relates to IMPORTANT CONCEPT READING NINE: PRODUCTIVITY, NOT SPENDING, DRIVES AN ECONOMY

Overall basic ideas: 

• productivity is the key to the wealth of nations (not spending or aggregate demand);

• people acting in markets do not have perfect knowledge, however;

• markets provide signals that help people make good - but never perfect - decisions (signals such as prices, profits, losses, interest rates, etc.);

• the long run is the relevant time period to judge outcomes of markets and also to judge the outcomes of government policies;

• there are always "unseen" parties that are affected by government policies;

• there are also unintended outcomes because of the lack of knowledge (and perverse incentives) that government planners have when trying to manipulate the economy (through either monetary or fiscal policy).

Let's start with the big idea: 

Say’s Law of Markets - also referred to as his theory of markets (la theorie des debouches) or law of markets (loi des debouches).

Supply or productivity must take place before demand takes place -- but why? 

    Jean Baptist Say (1767 - 1832)

In many ways – Say's Law can be seen as essential to any defense of markets – so those who support Say’s Law (some version of it) typically support free markets.  But also can be seen as the way to really understand how markets or the economy actually works.

Most textbooks truncate Say's Law into the phrase "supply creates its own demand" (which was actually first termed by James Mill, not Say). 

The production, or supply, of commodities (and complementary services) in general leads to the consumption of, or demand for, commodities (and complementary services) in general.

According to Say:  "It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products." (J.B. Say, 1803, A Treatise on Political Economy or the Production, Distribution and Consumption of Wealth).

Let's look at our buddy Crusoe again:

So is this true when others enter the picture and we have many people in our economy? 

People really trade production for production.  One must produce first in order to have the means to obtain someone else's production -- and their production enables them to have the same means to consume.

Be careful -- for someone to have an actual demand for a good one must have both the want and the ability to buy.  To Say, the want gives value to certain goods - but one can value something but not have the means to buy it.  Productivity gives people that means. 

Production must be guided by demand - or taste, preferences - to prevent the creation of goods that people will not consume.  This is true - one is not being productive simply by producing something -- they must produce something of value to others if they want to trade and consume.

But be careful - wants and demand are two different things.  Wants drive all of our behavior -- but we do not demand anything unless we have the means to obtain it.  Production provides that means!

In order to drive this home - let's bring in the ideas another French economist writing around the same time as Say,

Frederic Bastiat (1801-1850)

Bastiat built upon Say and said that "value is measured by services rendered, and that products exchange according to the quality of services stored in them."  Here, talking about subjective value as being the reason that people trade and where the value of resources comes from -- the consumer.

He continually emphasized that consumption was the goal of economic activity.  His often repeated triad was:

Wants -

Efforts -

Satisfactions.

Note the similarity to Say's Law. 

Bob wants cookies (that gives value to cookies).  But he doesn't have the means to obtain cookies until he undertakes some effort of producing something of value to the cookie maker so that he has the means to trade for the cookies and satisfy his wants!

Wants are the goal of economic activity, giving rise to efforts, and eventually yielding satisfactions.  Furthermore, he noted that human wants are unlimited, and hierarchically ordered by individuals in their scales of value.

So he said, "it is necessary to view economics from the viewpoint of the consumer. . . . All economic phenomena . . . must be judged by the advantages and disadvantages they bring to the consumer." (1850, Economic Harmonies)

What Say's Law is NOT: 

It is not saying "build it and they will come" or in other words -- we must produce something first before someone can buy it.  That is NOT what he is saying -  although that is obviously true.  How can you buy something that doesn't exist?  But remember, he is talking about obtaining the means to buy what is produced. 

So let's look at the pie again:

If we increase the money supply without increasing the pie -- yes, there might be more demand - but as the demand increases without the pie increasing, all we are doing is buying up what is there.  Once that starts running out (and prices start going up because of that), where are we then?  We don't have the resources to continue meeting this "false" demand that took place because of the increase in the money supply instead of in the increase in productivity (which would give us the means to buy other people's productivity).

The theory of Say's law then would NOT support monetary policy!

Say argued against claims that business was suffering because people did not have enough money and more money should be printed. Say argued that the power to purchase could only be increased by more production. So Say's Law is used against those who want to give an economy a boost via unproductive consumption. Consumption destroys wealth, in contrast to production which is the source of economic growth, according to Say's Law.

It is not the scarcity of money that causes problems in an economy -- it is the lack of productivity.  Money is only a medium of exchange, it is not the object of exchange per se.

"For, after all, money is but the agent of the transfer of values.  Its whole utility has consisted in conveying to your hands the value of the commodities, which your customer has sold, for the purpose of buying again from you; and the very next purchase you make, it will again convey to a third person the value of the products you may have sold to others." (J.B. Say, 1803, A Treatise on Political Economy or the Production, Distribution and Consumption of Wealth).

This theory - that money is not wealth to an economy - has been "formalized" into what is now known as:

The Equation of Exchange or the Quantity Theory of Money:

MV=PQ  (assumed to be true by definition).

M =

V= inverse of the demand for money (remember)

P=

Q=

 If V and Q are held constant, then there is a proportional and direct relationship between M and P.  Money is not wealth for an economy - an increase simply creates inflation.  REAL productivity is wealth.  If V and Q aren't constant, there can still be inflation if the money supply is increased beyond Q (or the demand for money).

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Say's Law and Government Macro Policy Generally

Monetary policy is not the only policy that is detrimental if an economist believes in Say's Law. 

Remember that the other theory - the Keynesian theory - is that spending drives an economy.  And remember from when we discussed the government's measure of productivity in the economy, GDP - how was it measured?  By looking at the spending in the economy.

The four components of spending are:  C + I + G + NX.

So - if the government spends more - then this is seen as an increase in aggregate demand - and production and employment will follow.

So we already know how monetary policy is supposed to increase aggregate demand and help the economy in the Keynesian world (the Phillip's Curve theory).

What about Fiscal Policy?  A change in Government Spending and/or Taxes.

Let's discuss taxes first.

Taxes can be very detrimental to productivity - therefore harming the economy (according the Say's Law economists).  This is especially true of taxes on income or investments in capital because income taxes and capital gains taxes tax productivity.

Let's go back to what Say himself said (these quotations are from A Treatise on Political Economy or the Production, Distribution and Consumption of Wealth):

Regardless of its specific form or method of collection, "all taxation may be said to injure reproduction, inasmuch as it prevents the accumulation of productive capital."

    Remember, capital goods are productive goods.  They help productivity - so:

Therefore, according to Say, "[i]t is a glaring absurdity to pretend, that taxation . . . enriches the nation by consuming part of its wealth."

But what about:  from a statistical standpoint, prosperity and taxation may be positively correlated.  That is, the more prosperous a nation is, the more tax revenue the government pulls in.

Say explains that such assertions commit the error of reversing cause and effect (what is the called the Post Hoc fallacy).

That is, "[a] man is not rich, because he pays largely; but he is able to pay largely, because he is rich."  In other words, Say believed that prosperous nations, if they remain prosperous, do so despite heavy tax burdens, not because of them.

So he concluded that, "[e]xcessive taxation is a kind of suicide."

A more modern version of how or why taxes decrease productivity is known as Supply-Side Economics.

Fiscal Policy and Supply-Side Economics

Supply-side economists focus on incentives -- especially the incentive to work or not (but also to invest or not).  Their main assumption is that people work more if their wage is increased (in general).  Therefore, cutting taxes (increasing wages) will lead to more work effort and the opposite is true.  Increasing income taxes will lead to less work effort and a decline in productivity.  But as always, it depends upon what assumptions are made:

Incentives and work -- which is correct:

Substitution Effect:

Income Effect:

If the substitution effect outweighs the income effect in the economy - then increasing income taxes will decrease productivity.  People will work less.

So as income taxes increase, wages go down, people work less - decreases productivity.

As income taxes decrease, wages go up, people work more - increases productivity.

Also - increasing capital gains taxes will decrease productivity because the incentive to invest in capital goods will decline (the rate of return from investing will decline - similar to the decline in wages as above).

Another part of the Supply Side theory relates to tax revenue:

Cutting income and capital gains taxes (increasing wages and returns) will lead to more work effort and more capital investment, a larger tax base, and therefore, more tax revenue.

Tax Base:

This is based upon the assumptions regarding the theory surrounding the “Laffer Curve.”

The Laffer Curve (the relationship between tax rates and tax revenue):

GRAPH

The Theory Summarized:

If the government increases marginal tax rates, that will decrease additional income that earners keep, thereby affecting output (productivity) for 2 reasons:

1. ­ Marginal tax rate increases, this decreases the payoff people derive from work (for example, when this occurs many with working spouses opt out of the labor force), less work, less productivity (incentives have changed – people choose leisure over work in the labor/leisure trade-off).

2. ­ Marginal tax rate increases, people (including those operating businesses) turn to tax shelter investments to avoid excess taxes (for example, investments that generate paper losses from depreciated assets) or move their businesses to places where tax rates are lower .  Therefore people are spending resources on tax avoidance (or tax evasion) instead of on productive activities. Real productivity is lower than it could be because resources are wasted producing goods that are valued less than their cost of production -- many goods are produced that otherwise would not have been produced if it wasn't for people trying to avoid taxes.  Those resources could have produced goods that actually made peoples lives better off (in absence of the taxes).

Trickle Down: 

Policy Conclusions:

Cut income taxes in order to increase tax revenue (through an increase in productivity and tax collection).

Furthermore, there is an increase in the share of income tax paid by high income taxpayers when the higher bracket tax rates are cut (i.e., the rich end up paying more of the total tax bill).

The "Curve" and tax revenue aside - the supply-side argument can be seen as a long-run strategy to increase economic growth, not a short-run policy tool to deal with a recession, for example. 

A cut in income taxes stimulates productivity - which is what is necessary for long term economic growth.

Supply Side Tax Cuts - Empirical Evidence - Review on Your Own

From History - the U.S.:  Four major income tax cuts in the United States -

Keep in mind that tax revenue collected by the U. S. federal government has typically increased over time.  The question is - does it increase at a higher rate after a major income tax cut.  According to data, it does.  Numbers from the U.S. Budget Office.

1922-1928 (Coolidge Tax Cuts)

When the federal income tax was enacted in 1913, the top rate was just 7 percent. By the end of World War I, rates had been greatly increased at all income levels, with the top rate increased to 77 percent (for income over $1 million). After five years of high tax rates, rates were cut sharply under the Revenue Acts of 1921, 1924, and 1926. The combined top marginal normal and surtax rate fell from 73 percent to 58 percent in 1922, and then to 50 percent in 1923 (income over $200,000). In 1924, the top tax rate fell to 46 percent (income over $500,000). The top rate was just 25 percent (income over $100,000) from 1925 to 1928, and then fell to 24 percent in 1929.

So the top marginal tax rates were cut from 73% to 25% (-48%).

Revenues received by the federal treasury increased from $719 million in 1921 to more than $1.1 billion 1929. That's a 61% increase (there was zero inflation in this period).

Real tax revenue collected from incomes of $50,000 and above increased from $305.1 million to $481.1 million (+63%). Real tax revenue collected from those who made less than $50,000 dropped by 45%.

1963-1965 (Kennedy Tax Cuts)

JFK’s tax cuts were passed in the summer of 1964. The top marginal tax rates were reduced from 91% to 70%. The bottom rates were reduced from 20% to 14%.

From 1965 to 1968, total federal revenue rose by 30%, from $117 billion to $153. 

Tax revenues of the bottom 95% of taxpayers fell from $31 billion to $29.6 billion (-4.5%). Tax revenues of the top 5% of taxpayers rose from $17.2 billion to $18.5 billion (+7.6%).

1981-1986 (Reagan Tax Cuts -- supply-side tax cuts)

Top U.S. federal income tax rates declined from 70% to approx. 33% (and was 28% when he left office).

Tax payments and the share of income taxes paid by the top 1% climbed sharply. For example, in 1981 the top 1% paid 17.6% of all personal income taxes, but by 1988 their share had jumped to 27.5%, a 10 percentage point increase.  The share of the income tax burden borne by the top 10% of taxpayers increased from 48.0% in 1981 to 57.2% in 1988. Meanwhile, the share of income taxes paid by the bottom 50% of taxpayers dropped from 7.5% in 1981 to 5.7% in 1988.

2003-2008 (Bush Tax Cuts - supply-side tax cuts)

Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRAA) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)

JGTRRA accelerated the gradual rate reduction and increase in credits passed in EGTRRA. The maximum tax rate decreases originally scheduled to be phased into effect in 2006 under EGTRRA were retroactively enacted to apply to the 2003 tax year. In addition, the child tax credit was increased to what would have been the 2010 level, and "marriage penalty" relief was accelerated to 2009 levels.

There were also capital gains tax cuts in both.

The Bush tax cuts had sunset provisions that made them expire at the end of 2010. But were extended by a two-year extension that was part of a larger tax and economic package, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

What about Fiscal Policy?  A change in Government Spending and/or Taxes (Part Two)

Now let's discuss Government Spending (we will tackle government deficit spending later).

If you read Say's Treatise you will notice that the discussion of taxes and government appears in the section headed "consumption." This is because Say identifies government spending as "unproductive consumption." Why?

When the government spends money it is not money that was "earned" by "the government" through an increase in productivity.  It is money taken through taxation (either today or tomorrow through deficit spending - more on that later) from the person who was productive.  The consumption by the government has a cost then --

There is always an opportunity cost when the government spends tax money!

Let's look at Bastiat's ideas again:

In his essay, "What is Seen and What is Not Seen," Bastiat pointed out that there are unseen parties and both short and long term effects of government policy (and other economic happenings).  A good economist – to Basitat – is one that can point to these unseen parties and to the long term effects of things.

This is where he wrote the famous Broken Window Fallacy -

"Have you ever been witness to the fury of that solid citizen, James Goodfellow,^*1 when his incorrigible son has happened to break a pane of glass? If you have been present at this spectacle, certainly you must also have observed that the onlookers, even if there are as many as thirty of them, seem with one accord to offer the unfortunate owner the selfsame consolation: 'It's an ill wind that blows nobody some good. Such accidents keep industry going. Everybody has to make a living. What would become of the glaziers if no one ever broke a window?'"

Basically he had three levels of economic analysis:

1. First-level - common sense.  The destruction of property in breaking the window is not good.  So people have sympathy for the store owner.

2. Second-level - sophisticated analysis or what economist Murray Rothbard calls a "proto-Keynesian" analysis.  Destruction of property, by compelling spending, therefore stimulates the economy and has an invigorating "multiplier effect" on production and employment.

3. Third-level - the economist.  Vindicates common sense and refutes the theory of the sophisticated analyst.  Here is where he considers what is seen and what is not seen!

It is basically the best application of opportunity cost analysis that one can provide.

In that essay, Bastiat, by relentlessly focusing on the hidden opportunity costs of resource allocation, criticized the idea that government spending can create jobs and wealth, war is good for the economy, technology destroys jobs, protectionism is good for the economy, etc..

So again, according to Say's Law economists, government spending does not actually create wealth in the economy - it redistributes money and has other economic consequences. 

If the government taxed Bob and then did something more productive with the money than Bob would have done with it, then it would contribute to productivity.  But this is not likely.  Why?

So in Today's World

Those economists who believe in Say's Law would not like "fiscal stimulus" - saying that it doesn't increase real productivity growth.  Also wouldn't like monetary policy for the same reason.

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