I have read a lot of articles about how the new tax bill will impact people in this country and our economy.  But I have read none that include the multiplier effect.  That is probably the scariest aspect of the new tax bill and we had better understand it. I ran the model of the multiplier effect on this tax bill, but I only had old data, when our income inequality was not nearly as great as it is today.  Even those old data indicated that the tax bill will constrict our economy by at least 15%, but with today’s income inequality numbers, the model probably understates the constriction. It won’t be just bad, it will tank our economy.

In order to understand the multiplier effect, you first need to understand the marginal propensity to consume vs. the marginal propensity to save, which I explained in a diary some time ago, here. The multiplier is the increase of money that arises from any injection into the economy.

Many models use a single marginal propensity to consume (hereafter MPC) for the aggregate economy. However, that is not accurate. The MPC is different at different levels of income. It is easy to understand why.  People who are at the bottom of the economy are deciding among necessities. When they receive extra funds, they have necessities that they have had to do without, and they spend the entire amount of extra funds they get. People at higher income levels have been doing without niceties but not without necessities might save a little and spend the rest. People at the top income levels are already buying everything they want to buy, and will probably not buy more just because they get more. So while the MPC of the person at the bottom (and probably lower middle) will have an MPC of 1, people at the top will have an MPC of 0, and those in the upper middle somewhere in between. The multiplier will be around 5 when the MPC is 1, and around 0 when the MPC is 0.

So how does the multiplier work?  Let’s say Ben (not his real name) is in the lower bracket. He has been putting off buying clothes and shoes for his kids and repairing the car in order to pay the rent. He gets $1000. As soon as he gets it, he goes and repairs the car for $800, and gets his kids the shoes and clothes they need, costing him $200. The repair shop has also been in tight financial circumstances, so they spend $500 on equipment maintenance and $300 on paint. The shoes and clothing store hires another person. The equipment maintenance company spends some on tools, etc. etc. etc. By the time the $1000 is circulated, it has generated $5000 worth of goods and services. As you can calculate, this is 5 times the initial cash infusion, thus the multiplier of 5.

Tom is in the next bracket. He has his basic bills paid, but has been wanting a new coat. He gets $1000, saves $200, and buys his coat for $800. The coat dealer saves a bit and spends a bit. It circulates to generate $4000 in goods and services for the $1000 injected into the economy, thus multiplier of 4.

Pete is in the top bracket. He has been buying all he wants, and has a lot stashed away. He simply adds that $1000 to what he already has. The injection of $1000 into the economy yields nothing in goods or services, thus a multiplier of 0.

This tax bill proposes to TAKE money from the bottom most extensively, and give it to the top. As a result, we will run into the negative multiplier.  How does this work?

If we take $1000 from Ben, he will have to make even harder choices and do without more things. This will mean he has to somehow figure out how to not spend $1000 that he would have been spending. When he doesn’t spend, the places where he would have spent receive less income. They have to cut costs. They can either cut their purchases or their staffs.  The reduced purchases and staff lead to other companies having to cut back. In the mean time, Pete is receiving more money, but he is not spending it. So no other companies have a reason to hire or buy more, Pete is doing nothing to increase demand. The economy constricts. The irony is, the large corporations and wealthy who are getting the most benefit from this income redistribution will also suffer. When people can’t buy goods and services, the wealthy have no place to generate income.

Using really old numbers, I calculated a multiplier of -15. It could be worse, depending on when and if the downward spiral is stopped.  Unfortunately, there does not seem to be an equilibrium where it will stabilize. We did not see an equilibrium in the Great Depression, because of the New Deal efforts by FDR, and the world war. Had those not happened, who knows how far it would have gone?

I invite any economists who may read this to do their own calculations, hopefully on newer data. Do you find the same result? I don’t know how anyone could support this farce.