Tuesday, August 4, 2009

The Law of Pies

Let's say you have six people over for dessert, and you have a delicious cherry pie. You slice it up into six pieces, serve it up with coffee and everyone is happy. Now let's say six more people suddenly drop by. You can slice up the existing pie into twelve tiny, unsatisfying pieces where nobody is happy, or you can bake another pie for the six newcomers. You have now bumped up against the Law of Pies.

Apparently, lawmakers do not understand the Law of Pies. You cannot satisfactorily feed six more people unless you have additional pie. You cannot just redistribute the pie you have to more people, you need more pie. The same is true for government spending.

Whether or not you agree with the spending on TARP, Auto Bailouts, Stimulus, Cap and Trade, ObamaCare, and the countless other spending priorities of the liberal agenda, there can be no doubt in anyone's mind that there is insufficient Federal revenue to slice up to handle all of these new and expanded spending programs. There just ain't enough pie.

Liberals would say that the answer is simple, "Let's tax the taxpayers more and increase the Federal revenue." Nice try. There is a glaring problem with this approach, the Law of Pies stands in the way.

By taxing more, are we really increasing the size of the pie? Show me one main-stream economist (liberal or conservative) that does not agree with the proposition that if you take disposable income from people in the form of taxes, they react by investing and spending less money. The decrease in spending results in a decrease in the national GDP (the overall measure of the value of transactions in goods and services). So, while the Federal pie gets bigger, the GDP pie gets smaller at approximately the same rate. The size of the overall pie remains the same. Remember the reason for wanting the Federal pie to get bigger? It was so more people can eat the Federal lemon meringue. And like our example above, we end up trying to feed 12 people at the Federal dessert party with an overall GDP pie that formerly served six.

In the 1970's, Art Laffer proposed that "[t]he basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect." Simply stated, the arithmetic effect says that as tax rates go down, revenue goes down, and as tax rates go up, revenue go up. Superficially, this seems to make sense to everyone and it is the primary justification used by liberals when establishing tax policy.

Laffer's breakthrough is the concept of the economic effect. Laffer explained that if tax rates are lowered, people will act in their best self-interest. They will earn, invest and spend more money since the government would not be raking it in the form of taxes. This growth in consumer wealth, under the right conditions, increases the amount of money subject to taxes and, under the right circumstances, may actually INCREASE the amount of revenue to the government. The overall GDP pie gets bigger, and government receipts go up. Laffer's theory has been tested three times in modern history. Tax rates were lowered in the mid-20's, the early-60's and the mid-80's. All three intervals were times of significant growth in government revenues. Only profligate spending by legislators cause problems resulting in a deficit and its cousins, inflation and recession.

In 1993, Kurt Hauser, a San Francisco economist, offered an idea now known as Hauser's Law. Based on decades of data, Hauser observed that no matter what the tax structure, no matter how high or low the tax rates are, Federal revenue is about 19.5% of the national GDP.


Not really. The rises and falls in GDP correspond to the rises and falls of the amount of money subject to taxation. If more money is available to be taxed, the government will have increased revenue, as the GDP falls, government revenue falls. This observation is way more than just a restatement of Laffer's ideas.

Hauser's Law sends a strong message to legislators. It doesn't matter what the tax rate is, the government will generate revenue of about 19.5% of GDP. If legislators choose policies that decrease GDP, there will be less overall Federal revenue. If they choose policies that increase GDP, there will be more Federal revenues (Let's not even talk about fiscal policies of spending more than you receive, or the priorities of those expenditures.).

The long-standing economic assumption of Laffer and others is that people act in their own best interests and that GDP will rise and fall as a function of the environment established by the government. It is clear that the more money that remains in people's hands results in more money available for government to tax, and the higher the available Federal revenues. If spent wisely, sufficient revenues are available for the necessary operation of government.

People like investors, and businessmen, entrepreneurs and inventors create wealth. It is these people, spurred on by innovation and consumer spending that control the size of the pie. Government does not create, it redistributes. Government does not bake pie, it slices up what is available. Government consumes pie, and consumes it with a voracious appetite.

Legislators must realize that no matter what the tax rate, they will have only about 19.5% of GDP in Federal revenues to spend. Any policy (on taxes or other priorities) politicians make that reduces GDP (like the Nixon Wage-Price controls and the Obama Cap and Trade proposal) shrinks the pie and ultimately hamstrings politician's ability to push their political agenda, no matter what it is. The bigger the agenda, the more revenue needed and the more economic growth must be stimulated. Our lesson here is that if you want government to spend money, you must want the government to create an environment of incentives that spur economic growth.

There is absolutely no evidence that Obama and the Democrats in Congress have an understanding of these simple economic concepts.

Democrats are feasting on a large menu of their own creation (whether or not you agree with the selections), and it would seem they demand a piece of your pie for dessert. They obviously don't know they need to get in the heat of the kitchen and bake more pie. They need to limit the amount of people at the party, as well as institute pro-growth initiatives. It's the Law of Pies.


Frank Linn said...

Economic theory is confusing and endlessly arguable but everyone understands not enough pie! . . . everyone but liberal politicians, that is. Great article. As for me, I'm for more pie!

jenniferw said...

I think they are going to take my pie whether I want them to or not (I don't), and I think they are also going to take my stores of flour, shortening, salt, sugar, cornstarch, and cherries ... so I won't be able to make another pie even if I am so inclined. I do believe I will go now and hide the Hershey bars where they cannot be found.