The Negative Multiplier Effect and the New Tax Bill: Tanking the Economy

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.

The Lie of Supply Side

I graduated from the University of Missouri with a bachelor with honors in Economics in 1975, the year before Tim Kaine enrolled.  I majored in Economics for the same reason Tim Kaine did – Professor John Kuhlman.  Tim sent a letter to Professor Kuhlman that cited why he changed majors.  “You told our small honors section that you took attendance and that you expected us all to be in class every day, absent emergencies,” Kaine wrote. “Your reason for the expectation was unique and memorable: ‘UMC is a state school. Part of the cost of you being here is paid by the taxes from people all around the state, many of whom will never go to college and might not be able to send their kids to college. You owe it to them to be serious about your studies.’ That statement, and the moral sense that it conveyed, made a significant impact on me, as did your later interest in my progress at UMC.”  The moral imperatives taught in Dr. Kuhlman’s class also stuck with me.

One of those imperatives was that we had to watch our leaders.  Their decisions could have a dramatic impact on the success or failure of our nation.  They could make decisions that would have a beneficial on the overall good of the nation, or they could make decisions that would benefit a few for the short haul but cause sharp decline for the entire nation over time.

Dr. Kuhlman’s specialty was antitrust, and he gave me a passion for it as well. His rationale was simple.  Individuals simply cannot stand up to the power of a large corporation.  Neither can small companies.  When any corporation in any industry gets too big, nobody can compete with it, and there is no competition possible in the supply line.  They will simply suck the consumer dry with their pricing, suck the supplier dry with their ability to dictate prices, and prevent any potential competitors from entering the marketplace.  Worse, they are able to prevent innovation that could move us beyond their products.  We see this now, with the Koch brothers.

Among the things I learned while getting my degree were the demand and supply curve and the multiplier effect.  The multiplier effect refers to the increase in final income arising from any new injection of spending. The size of the multiplier depends upon household’s marginal decisions to spend, called the marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps).  The mpc plus the mps equals one, or the whole after tax income of the consumer.  The multiplier is then calculated using the formula 1/1-mpc. If consumers spend 0.8 and save 0.2 of every dollar of income, the multiplier will be 5.  This means that the money will circulate through the economy enough to generate 5 times as much value as its original. A common example is that when $100,000 is spent on a new road in a community and the wages go to working people with a 0.8 mpc, it generates $500,000 in economic activity in that community.  This is an important concept.  Because, the mps will vary across different segments of society.  Poor people are unable to save 0.2 of every dollar of income, really rich people are unable to spend 0.8 of every dollar.  In a society with a reasonable distribution curve, it would wash out.  But when income is heavily weighted to the top, the result is a restriction of the economy.

It is this principle that makes trickle down economics a sham.  The notion that if the guys at the top get more money, they will spend more and it will work its way down to the little guy flies against all data as well as being contradicted by the math.  There is nothing anywhere in any reality based world that suggests the possibility of trickle down economics working.

Another nonsensical notion is supply side economics.  Supply-side economics is the theory that says the supply of money, labor, and goods or services, creates demand.  In particular, supply-side economics focuses primarily on lowering marginal tax rates to the after-tax rate of return from work and investment, which results in increases in supply. Supply side economics contradicts any models that have ever worked.  There is not a credible business plan out there that suggests that a company would base new hiring on getting a tax cut.  It just doesn’t happen.

Companies base hiring on the idea that the cost of adding one more person to their employ will be less than the added revenue that employee produces.  That added revenue is generated by consumers buying the goods or services offered by the company.  That added revenue is not generated by tax cuts.  It is generated by demand.  Demand is generated by people having money to spend.

So let’s look at what is about to happen.  We already saw, courtesy of the Bush administration, that tax cuts to the wealthy do not generate jobs.  A major reason they do not generate jobs is because they don’t put money in the pockets of those with the highest mpc.  They put money in the pockets of those with the lowest mpc.  In fact, the Bush tax cuts put money in the pockets of financial hoarders.  Now the Trump administration is preparing to take money out of the pockets of people with the highest mpc, the poor and disadvantaged.  These are the people whose mpc approaches 1.  The only economic thing that could result from this action is a tightening of the economy.  As more and more Americans fall into the poverty bracket, there will be less and less ability to buy goods and services.  Elective purchases will be the first to go, and there will be job losses in those sectors, further increasing the numbers in the poverty bracket.  Those currently receiving the most income, more than they can spend, will not increase their numbers.  Meanwhile, even the large corporations, receiving the juiciest tax cuts, will not have people to sell their products to.  They will reduce employment, and the cycle will be complete.  At this point, the large corporations and the wealthy will no longer be able to sell their goods and services, the money that they gained in tax cuts will be more than offset by their losses in sales.

The wealthy and the corporations will still have a stranglehold on the factors of production, thus leading to Corporate Feudalism, which will be the topic of my next rant.