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The Henry Hazlitt Series: Taxes Discourage Production

The Hazlitt Series

This latest stewardship post is a continuation of our monthly exploration and modern application of the economic writer  Henry Hazlitt, and his seminal work, Economics in One Lesson. This work draws heavily upon the insights of the great French economist Frederic Bastiat.  His key insight was to look at that which is not seen.  So, for example, do not simply look at the benefits of a trade restriction of say wool, but also look at the costs to the rest of the economy.  Hazlitt updates this insight with a more modern take to look not just at the short-run effects on a small group, but also the long-term effects for the whole economy.  Hazlitt then applies this lesson to a variety of topics.  Each installment will pay homage to this superbly clear economic thinker and writer by applying each of his applications to our world today.

Taxes Discourage Production

Last month we looked at the fact that public works means more taxes.  This is true of all government spending regardless of how financed or what it is spent on.  This month, however, we will turn to the phenomenon that taxes discourage production.

As Henry Hazlitt explains, the fallacy is that taxation is a mere bookkeeping transaction.  It is looked upon as simply transferring money from A to B as if there are no effects.  In the parlance of economics, the claim is that taxation is, or can be neutral.

Hazlitt points out that this is, of course, completely in error.  Taxes are not neutral in their effect.  I would point out that they never can be, as the subjective valuation, and particular circumstance of those taxed are different, so the effects will be different.

Hazlitt’s main point here, however, is that most of the income tax burden is borne by a small percentage.  This is confirmed by the data regarding the current burden of the federal income tax.  According to this report the top 25% of income earners pay 56.6% of the federal income tax, and the top 50% pay 97.7% of all federal income tax.  Not quite what you may have read.  Of course, the government gets income from other sources, as well.  This would include the corporate income tax, as well as various excise taxes, and import taxes (tariffs).  We will look at some of the effects of corporate taxation shortly.  The point is that this unequal burden of taxation will affect the behavior and the incentives of those so burdened.

Taxes Affect Behavior…Who Woulda Thunk It?

It should not at all be controversial that taxes affect people’s personal behavior.  This is the whole rational behind so-called “sin” taxes on products like alcohol and tobacco.  There are reams of data, and I am sure personal anecdotes of people moving because of the tax burden.  Not just from US state to US state but from countries to countries.  Let’s think this through under the tutelage of Henry Hazlitt and see what this might mean to the production of goods and services.

Let’s start with business taxes.  Hazlitt makes the great point that is a business risks losing 100% of an investment that it makes but only gains 60% of any gains it achieves then its policies are affected.  It will not expand operations or expands only those operations that are of minimal risk.  Newer machinery and newer products are developed more slowly than they would be otherwise.  This prevents consumers from getting more and better, and less expensive products.  This then has the effect of holding real wages down, as real wages are determined by the amount that each worker can produce.  The more you can produce, means the more goods you can take into the marketplace, which means the more goods you can exchange with others, which means more that you can consume, voila, rising real wages.  This does not change by using money as a medium of exchange.

Personal taxes have the same effect.  If an individual loses 100% of their investment but gains only 50% of their earnings, then they will avoid risk.  They will place their investments in lower risk vehicles and/or they will save less to begin with.  Either way this discourages capital formation, and wealth creation.  Therefore, there will be less goods and services produced than would otherwise be the case.

If the Government Taxes, Can’t It Invest as Well?

In a word, no.  First, the government never invests.  Investment is geared toward what the consumer wants, not what the entrepreneur desires.  The government, however, is directing money flows to what it (or the political process) wants.  Thus, it is acting like a consumer.  Next month’s Hazlitt essay will focus attention of the distortions caused by the government directing capital to specific areas.  For our purposes here, it is important to understand that the government will always act as a consumer of goods.  If they are consuming scarce resources, then that means you, the consumer cannot.  This is because the investor who is trying to discover what consumers really want is muscled out of the marketplace for the use of these scarce resources.

We are now at a point that Hazlitt did not make in his excellent book.  I know he understood it, it’s just that it did not fit easily with what he was trying to accomplish.  Yet, it is important to bring up here in the face of the question posed by the heading of this section.  The issue is that the government cannot rationally allocate scarce resources across unlimited wants absent freely set market prices.  This is known as the “socialist calculation problem”.  The government cannot possibly know how to allocate scarce resources in an economy, particularly one as intricate as a modern western economy.  There are simply too many moving parts. 

So, even if the government could assemble as much capital from taxation, they would not know what to do with that capital to produce goods as efficiently as profit seeking entrepreneurs.  But we know they cannot raise the same amount of capital because of the changes in behavior outlined above.  All resources that flow to the government must come from someone else’s productive activity, there is simply no other alternative.  This is why taxes discourage production in the first place.  What the socialist calculation problem illuminates is that having the government take control of the entire economy via taxation and spending is a recipe for complete disaster.

Is There Proof of This Phenomenon?

In a word, yes.  We know that government spending is higher than it has ever been in both real terms and as a percentage of the economy.  Think about that; the government spends nearly as much as a percent of GDP as it did during WWII!  All this spending, and therefore taxation, has been a crucial part of the stagnation of savings, capital formation (tools to build things) and ultimately income.  The inflation created by the Federal Reserve is also a part of this (inflation being a form of taxation), but Hazlitt deals with that in a different essay.

The chart below shows the damage that excessive taxation (that includes inflation) has done to the national savings rate.  The rate was over 10% from the 1950s to the 1980s, a rather solid period of economic growth.  Other than the made-up money binge of the pandemic stimulus it has not consistently been as high since.  It is currently careening toward zero.

fredgraph

This lack of savings bleeds through to stunted levels of capital formation and investment.  The chart below shows the level of real (inflation adjusted) level of net private investment as a percentage of the economy.  The level is lower than it was in the year 2000.  This means that the US is engaging in capital consumption.  This is the financial equivalent of eating your seed corn.

Real Net Private Investment GDP

The last piece of evidence I will offer is real median family income.  As the chart below shows, the rate of growth has slowed significantly.  Between 1953 and 1973 Real Median Family Income grew at a 2.8% per year rate.  Since the year 2000 that rate has slowed to .59% per year.  The previous rate was 5X larger.  We can see this severe slowing in the growth of real family income as the necessary result of the lack of capital formation driven by the drop in savings which is the result of taxes (fueled by spending) discouraging production.

Real Median Family Income

None of what has gone wrong the past 50, and especially the past 25 years is unfixable.  It will take work and some rather painful adjustments to return the economy to a path of sustainable growth driven by a free and honest marketplace.  As always, good stewardship starts with being clear eyed about the nature of the problem.  We should have faith enough in God to use the reason He gave us to fix this problem.

Praise Be to God

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