Saturday, November 29, 2008

Adam Smith on Tax and Borrowing

William Watson writes in Financial Post (National Post in Toronto, Ontario), HERE:

The Tories' negative stimulus

A still older tradition that we might call Smithian, though I don’t think Adam Smith ever made this case explicitly, might argue that if stimulus packages mean the government’s share of the economy will grow, that may actually cause net economic contraction since government will be much less efficient producing things than the private sector would be. So in fact an apparently contractionary package that reduces the size of government might actually end up being stimulative. This Smithian interpretation is the only one, so far as I can see, that could lead you to conclude the Tories’ Economic Statement is stimulative.

….The government is declining to borrow the monies in question and pay them to people who undoubtedly would go out and spend them. Ricardo, on the other hand, might think it a wash while Smith might see it as a gain

I have no comments on the merits or otherwise of the policies proposed in Canada to deal with the current financial crisis under my standing ordinance of not commenting on politics in countries other than the one I vote in. However, I am free to comment on policies that its proponents or local columnists associate with Adam Smith.

William Watson qualifies his statements with: “I don’t think Adam Smith ever made this case explicitly”, which is absolutely appropriate because it is true. In Smith’s day there was not a great deal of thinking about managing economies, or what we call macro-economics, or the government’s role in these matters.

Political economy had macro elements – the monetary system, the Bank of England (and the Bank of Scotland), the currency (gold and silver, and paper currencies, the individual banks, balance of trade, foreign trade of consumption, domestic trade, taxation, and the annual production of wealth or “necessaries, conveniences and amusements of life”) – but of government directed macro-policy, this was no such a ‘big idea’ at the time.

The government ‘sector’ was relatively small compared to the 20th-21st centuries (under 15 per cent compared to over 35 per cent), and its biggest item was ‘defence’ spending. If activity slackened off, unemployment rose (lost amongst the general destitution of the countryside and the towns), and farms and enterprises experienced bankruptcies, people didn’t look to government for relief.

When a ‘recent’ war ended, Adam Smith noted how, when

a hundred thousand of soldiers and seamen were deprived either of employment or subsistence”, which was “a number equal to what is employed in the greatest manufactures”, that while there was “some inconveniency” suffered, the seamen “gradually betook themselves to the merchant service” and the soldiers ‘were absorbed in the great mass of the people, and employed in a great variety of occupations” (WN IV.ii.42: pp 469-70; Canaan p 436).

It did not occur to him to demand government action; it did occur to him to advise government to move from protected to free trade ‘gradually and slowly’ to allow time for these events to work themselves out with the least direct harm to those affected.

William Watson is appropriately cautious in ascribing views to Adam Smith about situations he did not face, but because Smith considered waste and prodigality abundant features of government spending, with consequent negative affects on economic activity, growth included, Watson makes a plausible case for describing a possible ‘Smithian’ policy of not increasing the budget deficit to allow government deficit finance to ‘kick-start’ a sluggish or declining economy. To the extent that this is a current Canadian ‘Tory’ policy such a stretch of plausible ‘Smithian’ ideas ‘fits' Watson’s analysis in his opinion piece.

However, I am not inclined to go along with this argument, particularly as Britain is in a similar policy quandary. Government expenditure carries with it some degree of inherent waste, but some level of it nevertheless has some level of productive (in Smithian terms) effects; employing labour that covers its costs, including capital, plus a profit. A road, bridge, runway, or sports theatre, built by private companies with government funds, that earns profits adds to economic activity. So some element of that sort of activity is productive and positive, but it is unlikely to be sufficient or timely (big projects take years not weeks or months).

The other side of the argument is strictly Smithian. Taxation reduces private incomes, and though necessary for society at some level for defence, justice, public works and education (and the ‘dignity of the sovereign’), it also inhibits private consumption and savings below that they would otherwise have been.

Where taxes are ‘too high’ (a subjective assessment) and where, in consequence, government-determined choices displace private-consumption choices by depressing consumer demand, and the government choices are ‘locked into’ non-spending, because of ‘non-lending’ (a problem with retail banking at present), it may be Smithian to lower taxation fairly dramatically.

Of course, this would still increase government borrowing and its deficit. But by lowering taxes through removing taxation of all incomes below £12,000 per individual, so that millions of the poorest people pay no tax, and the rest pay no tax on the first £12,000 of their incomes (as recommended by the Adam Smith Institute HERE and HERE), there is more than an even chance that the result would be a fairly certain stimulus to private consumption, which would do more to re-activate the economy, albeit still slow and gradually, but also quicker than uncertain fortunes of big spending projects coming on stream in 12 to 18months, or even longer, from government ‘big projects’.

Smithian economics does not lead to a ‘do nothing’ anti-depression strategy, nor is it opposed to a government deficit. It is the quality of the counter-measures not their use that separates the advocates of big government ‘big fixes’ from Smithian better sense.

Governments do not trust individuals to do what is right; they prefer the visibility of big projects, not least for their photo-opportunities – and if that is too cynical they only have themselves to blame from their habits of a lifetime.

It seems to me that such a policy as the Adam Smith Institute proposes is compatible with any good government, Tory or otherwise.

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