Adam Smith and the Republican Presidential Candidates

In the 1980s Reagan Republicans were fond of wearing Adam Smith neckties. (I personally still have two hanging in my closet that hail from that era.)   Adam Smith, of course, was the 18th Century Scotsman who wrote An Inquiry into the Nature and Causes of the Wealth of Nations, a book considered by many to be the founding work of modern economics. Wearing the Adam Smith neckties was intended to display fidelity to Smith’s ideas and, in particular, fidelity to free markets.

One does not see many Republicans wearing these neckties anymore. Perhaps this loss of ubiquity is to the good, however. After observing the large crop of Republican presidential candidates over the past several months, I can only conclude that none of them is particularly well informed by Smith’s ideas. Indeed, I suspect that few, if any, have ever read The Wealth of Nations. Some of the candidates indeed display an extraordinary degree of economic illiteracy.

The central thesis of The Wealth of Nations is that a nation’s economic well-being is measured not by its store of gold (or other financial assets), the amount of goods it exports, or the number of jobs that exist within its borders, but rather a nation’s economic well-being is determined by the quantity of goods and services available for consumption by its populace. In the book, Smith makes the point that the ultimate purpose of all economic activity is to satisfy human wants and needs. That is, the reason that economic activity takes place is so that people can consume. Work and production are means to that end, but not ends in themselves. They are properly considered costs, not benefits. Put another way, in a world in which resources are scarce, employment of human labor and other necessary factors of production are what a nation must give up in order to consume.

Thought of in this way it becomes clear that if a nation can reduce the number of labor hours (or the employment of any other resource) required to maintain a particular rate of output of consumer goods and services, those freed up resources can then be used to increase the output rate even further, thus allowing the nation to become wealthier. One way by which such an expansion of wealth might occur is through the adoption of new technology that increases productive efficiency. The efficiency is manifested in higher labor productivity and potentially an increase in the productivity of other resources as well. Technological innovation may also yield higher quality products, or the introduction of entirely new goods and services.

Another way by which a nation’s wealth can increase is by trade with another nation that has a comparative advantage in the production of certain goods. In this case, both nations gain by taking advantage of each other’s relative productive efficiencies. The trade consists of one nation giving up some of its wealth by exporting goods produced out of its scarce resources in exchange for imports of higher-valued goods from the other nation produced out of that nation’s scarce resources. Each nation sacrifices some of its wealth in order to obtain something in return that it values higher. The result is that each nation becomes wealthier.*

As Smith taught, exports then are a cost to a nation; imports a benefit. When a nation exports, it is using up its scarce resources for the benefit of another nation’s consumers. When a nation imports, it is enjoying the consumption of goods produced from the scarce resources of some other nation. Properly considered, exports are the goods that a nation must sacrifice to pay for its imports.

The principal lesson here is that a nation that can become more efficient in supplying consumer goods to its people becomes wealthier. Whether that efficiency comes about because of new technology or because of international trade, the savings in resource use, including labor, permits an expansion in the nation’s wealth through redeployment of those resources to the production of still other goods and services. **

Regrettably, none of the Republican candidates for president evinces much awareness of this basic lesson from The Wealth of Nations. What they say instead are repeated promises to “create” jobs and artificially promote exports, presumably beyond that rate required to pay for imports. In other words, they promise that, if elected, they would make America poorer.

To be sure, individuals want jobs because they know that they have to work in order to have income to obtain the consumer goods and services that they need and want. They must exchange their labor for those goods and services.  This necessity is a fact of life in a world of scarcity.

But political leaders who respond with promises to focus directly on creating jobs, including jobs derived from exports, will largely fail to keep those promises. Bearing out Smith’s ideas, economic history and experience show that job opportunities expand most when a society focuses first on increasing efficiency over time. The proven mixture is technological advancement, free trade, and minimal government-imposed burdens on entrepreneurship and other economic activity. These factors along with other necessary conditions such as the rule of law are the recipe for a growing and ever wealthier economy. More jobs are, in turn, the byproduct of this process of economic growth.***

It would be refreshing if at least one of the Republican candidates for president evinced an understanding of these tested principles and could articulate them in a compelling manner. Instead, we get empty promises to create jobs and pursue programs that hinder trade with other nations. It is indeed appropriate that none of them wears an Adam Smith tie.

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* In the modern global economy, trade of course takes place multinationally and is not goods for goods but rather is financed by means of international currencies and other monetary instruments. This permits nations to trade indirectly with each other. It also means that settlements need not occur instantly but can take place over time. So, for example, one nation may export in one period, but rather than import in the same period simply hold claims on another nation’s goods to be redeemed in a later period.   Nonetheless, the basic wealth-creating principles of trade as discussed above continue to hold.

** For a notable illustration of this principle, simply consider how technology has improved agriculture and thus permitted the expansion of non-agricultural production.   Were we still to employ the agriculture technology of 1900, many more people would still have to be working on farms instead of producing the variety of consumer goods that we enjoy today. In other words, advances in agricultural technology throughout the 20th Century freed up the resources, including labor, that permitted the development and supply of that century’s wide-ranging new industries, products, and services. Indeed, a politician who his dead set on “creating” jobs could ensure full employment simply by outlawing the use of tractors. It would not be a situation that most of us would want to endure, but it certainly would create full employment.

*** For example, over time new labor saving technology most often actually expands total labor employment. It does this in two ways. First, in that area where the new technology is applied, the increase in labor productivity reduces per unit costs, and thus consumer prices. With lower prices, quantity demanded increases and more output is sold. Although labor hours per unit of output are fewer as a consequence of the new technology, the higher output rate often means that total labor hour employment grows. Second, the increase in labor productivity in one area frees up resources for expanding output rates, and hence labor employment, in other areas, including new and developing industries where job opportunities may increase dramatically.

Paying One’s “Fair Share” of Taxes

I have always been puzzled when I hear politicians, particularly Democrats and others of the left, talking about people needing to pay their “fair share” of taxes.  Most recently, Vermont Senator Bernie Sanders, Independent Socialist and candidate for the Democratic presidential nomination, has made this claim in most, if not all, of his campaign speeches.  What he and others mean by this idea is that those earning higher incomes should pay more in taxes than they already are, notwithstanding that income tax rates are already progressive, i.e., marginal rates increase with income.  Rarely, however, do proponents of raising marginal rates on high income earners say exactly what a “fair share” of taxes is or, more precisely, what exactly those marginal rates should be.  Even more vague is their philosophical basis, either in ethics or economics, for what constitutes “fairness” in this context.

It seems to me that Senator Sanders and others of similar views have the tables turned upside down.  In fact, rather good philosophical arguments can be made from both an ethics and an economics perspective that, if anything, high income earners are already paying well more than their fair share of taxes and that their absolute tax payments or marginal rates should therefore be reduced.

Taxes are the cost of financing government.  In our democracy, every qualified voter is afforded one vote, no more and no less.  Just as this political shareholding is allocated equally among citizens, it would seem intuitively fair that the burden of the cost of government should similarly be allocated equally.  That is, everyone should pay the same amount in taxes in the form of a simple per capita tax.  This way, each person contributes the same amount toward the cost of government, much like dues assessments in a club.  At the least, it would be interesting to ask Senator Sanders to explain, from an ethics standpoint, why his income tax proposals are more fair than a per capita tax.

Of course, as a practical matter, given the current size of government, an equal per capita tax would necessarily mean that many, if not most, taxpayers would owe more than they earn or have in savings and, in some cases, likely much more.  Such a tax thus would be unworkable unless government were shrunk substantially.  The cost of government would have to shrink at least to the point where the per capita tax would be affordable by each taxpayer, a goal unlikely to be shared by Senator Sanders.  Even so, the size of government and the practical ability to have fairness in the tax code would seem to be inextricably linked.

Admittedly, I am uneasy to render judgments on purely ethical grounds about whether the amount of taxes a particular taxpayer pays is fair for that taxpayer.  I do, however, claim some expertise in economics.  Drawing on that expertise, I think that there is a reasonable argument on economic grounds that, in the alternative to a per capita tax, a regressive income tax is fairer than a progressive one.

The argument rests on the idea that whenever there is voluntary exchange, every transaction creates wealth.  A voluntary transaction will not take place unless each party becomes better off as a result of the transaction.  It follows therefore that, so long as high income earners obtain their income through voluntary exchange of their labor, services, or other resources, each dollar of that income is the product of a wealth-creating transaction.

Significantly, however, the high income earner does not keep all of the created wealth, but only a fraction.  The rest of the new wealth necessarily accrues to everyone else with whom the high income earner engaged in voluntary exchange, either directly or indirectly.  Thus, the higher the income of the high income earner, the greater the earner contributes to other people’s wealth.  It follows then that high income earners benefit society more than lower income earners before any taxes are taken out of those earnings.

Based on this reasoning, one possible way to measure tax fairness would be on the basis of relative additions to aggregate social wealth.  Under such a definition, people who contribute less to social wealth would be required to make up for the deficit by paying more in taxes, while those who contribute most to social wealth would be rewarded by lower taxes.  Put another way, fairness would require that high income earners be taxed less than low income earners.  The former have already made a disproportionate positive contribution to social welfare.

Of course, as with the per capita tax, a regressive income tax would require considerable downsizing of government.  Such a tax simply could not finance the current government.  Once again, the size of government and the practical ability to have tax fairness are inextricably linked.  But that practical consideration aside, a fairness argument for a regressive income tax that rests on economic reasoning, unlike Senator Sanders’ fairness arguments, at least has an analytical grounding.  It would be interesting to learn how Senator Sanders would respond to the argument.

In that regard, I will volunteer one glitch in the reasoning. Regrettably, many high income earners today derive their high incomes not from contributing to aggregate wealth but rather by using the machinery of government to expropriate the wealth created by others.  Rent seeking can be very lucrative.  Thus, if “paying one’s fair share” in taxes is inversely related to one’s contribution to social wealth, these high income rent seekers should be taxed at a 100% marginal rate.

Hillary Clinton and Trickle Down Economics

Few utterances in public life over the last 30 years annoy me more than the term, “trickle down economics.”  I know of no economics textbook, treatise, or journal article that even mentions TDE, let alone discusses it as a recognized economic theory or school of thought.  Yet, in her recent speech outlining her economic plan for the future (see here), Democratic presidential candidate and former Secretary of State, Hillary Rodham Clinton, invoked the term several times, asserting that she is not only opposed to TDE but, moreover, would most assuredly not return to that policy as president.  Mrs. Clinton’s opposition to TDE is not new.  It has been a theme in her public utterances for some time.  See here.

I wonder, however, just whom Mrs. Clinton has in mind when she implies that TDE is a policy that her political opponents, specifically the current crop of Republicans running for president, would implement if elected.  I know of none of these Republicans who has said “elect me and I will pursue a policy of trickle down economics.”  Nor, for that matter am I aware of a period in which TDE was the reigning policy of a Republican administration, a period of time to which Mrs. Clinton does not want to return.  Indeed, to my knowledge, only Democrats use the term.

Certainly some of the current Republican candidates have advocated for reductions in marginal tax rates and the elimination of unnecessary regulations on businesses in order to incentivize work, productivity, and saving.  Perhaps policies of this sort are what Mrs. Clinton has in mind.  Yet, the economic theory underlying such supply-side policies is quite different from the description that Mrs. Clinton and other Democrats give to TDE.  According to that description, TDE is about giving more money to the rich in the hope that the rich will immediately spend that additional money on yachts and the like, which eventually will stimulate economic activity that trickles down to the lower income classes.

Supply-side economics, however, is not based on spending.  Quite to the contrary, it is based on the idea – long observed in economic life — that encouraging more work, productivity, and savings results in both immediate increases in aggregate wealth and increases in future wealth.  Future wealth comes about because additional saving provides the means to expand the capital stock.  Economic growth is the end result.  All income classes share in that growth.  Whether or not there is more spending by the rich on yachts is wholly irrelevant.

Milton Friedman was fond of saying, “there are only two kinds of economics — good economics and bad economics.”  Good economics teaches that, if you want growth and rising incomes, the capital stock must increase over time in order to make resources, including labor, more productive.  Increasing the capital stock, in turn, requires saving by those in the best position to save and also that the government exact as little of that saving as possible.  It is not a particularly difficult concept to grasp.  Perhaps even Mrs. Clinton will grasp it someday.

Hello World!

Welcome to Liberty & Markets, my personal blog site.  I hope that you enjoy my commentary on legal, economic, and political issues of the day.  If you would like to know more about me and my background, please click on the About page on the opening screen.  Theodore A. Gebhard.