Government Finance | Basic Economics by Thomas Sowell | Ch. 19

Now on the 19th chapter of Thomas Sowell’s Basic Economics, we take a look at how governments take their share of the national output and put it to use.

If you want to take a look at my previous summaries and thoughts on this book, please click here. Otherwise, let’s get into government finance!

Chapter Summary

Governments today generally have two main ways of financing what they want to do. The first way is to take from the national output in the form of monetary taxes today. The second is to issue government bonds (debt). If taxes are used to cover all of its spending, then the government budget is considered balanced. If taxes exceed government spending, then the budget is considered to be in surplus. If taxes cannot cover everything the government wants to do, then it is in deficit. The accumulation of such a deficit over time is called “the national debt”.

Government spending pays for many things, including things that would be used in the current year a budget is determined (e.g. utilities, military or civilian pay, etc.) as well as things that would be of benefit to the public for the future (e.g. highways, dams, etc.). Some of these activities are considered better supported through taxes, while others are considered better supported through issuing bonds.

Government Revenues

The main assumption behind tax rates is that, the higher the tax rate, the higher the revenue the government receives. However, because of various other factors, this is not necessarily true. For example, people generally move away from a heavily taxed jurisdiction. Thus, when the local government raises taxes, people move away, and the revenue doesn’t actually increase. In fact, it might decrease.

The opposite happens as well. When the US federal government lowered its capital gains tax from 28% to 20% in 1997, it actually gained revenue (almost 2 times, in fact), as the lower taxes incentivized more people to increase their investments, which gave more return than bonds. This shouldn’t be surprising, actually, given that businesses themselves often make more money by charging lower prices. And it’s not a phenomenon only occurring in the United States.

This gets more complex as we dive into looking at who bears the financial burden of paying taxes to the government. There’s this idea of “taxing the rich” in society, so that they bear more financial burden in taxes. However, oftentimes, the wealthy can take advantage of various financial instruments to keep themselves from paying those higher taxes. The same such financial instruments are often not available to the normal person.

Furthermore, there is often more sales tax than tax on investments. People of lower income tend to spend a higher percentage of that income on consumer goods, which means that they spend a higher percentage on taxes than higher income people.

The same goes for things like Social Security. When an employer must consider the taxes paid for Social Security, they must front the cost when hiring a new worker. While a worker might not necessarily see a reduction in their own paycheck, in reality, they are missing out on the money that their employer had to pay to Social Security. Such taxes on businesses are thus almost always passed down to the consumer to pay for.

This is why the discussion of taxing the rich and poor is irrelevant, because taxes often fall more on income than real wealth. People who are wealthy may not work at all, and so experience very little of the taxes that the ordinary person has to pay. A “progressive” income tax, one which taxes higher income earners more than lower ones, actually prevents hard working people from earning much at all, while leaving the truly wealthy untouched.

So what if we increased taxes on those capital gains? The issue, of course, is that capital takes time to pay a return, if it even does so. However, just because a piece of capital has increased in value doesn’t mean that, in itself, has allowed its owner to earn anything. Valuation has many aspects, and changes through time and circumstance. Not all of those will increase earnings. Thus, doing so will often keep investors away from the capital, causing a massive drop in productivity and employment, destroying an economy.

The power to issue bonds also extends to local governments, which use them to finance local building projects. This may sound like a good use of government resources, but the reality is more complicated. For example, when a government acquires land from other owners to ‘upgrade’ or ‘redevelop’ the property, it does so under the guise of progress (a favorable way to gain votes). But because the acquisition is forced, it does not take into account the real market value of the properties. Thus, resources are artificially allocated for the acquisition and redevelopment at a rate under the real cost. The consequence of this is a higher rate taxation that would then be put on future owners of that development.

Government bonds aren’t free. They are simply the government borrowing money to be repaid through future government revenues.

Thus we come to national debt. National debt isn’t always what it is said to be by the public. As an example, if a union worker is in debt by thousands of dollars, that might seem like a lot. But a millionaire can easily step in and pay that debt. Thus, national debt must be compared to national output or national income to have any sort of meaning. In the same way that someone who builds more credit card debt than they are able to pay off will send him or her into massive financial issues, government debt must be understood in the context of current expenditures, and what the future tax payers will have to bear.

Complexity is again added when people outside of the country buy into the nation’s bonds. When such a thing happens, those outside of said country are basically collecting wealth from the future generations of that nation, as the tax revenues must go to those nations. Even if all bonds are held inside the nation, it still is a tax burden the present is making on the future. This doesn’t necessarily mean that the public doesn’t benefit from the use of those bonds. After all, highways and other government funded utilities are very much beneficial for the public. However, that doesn’t erase the fact that the money being raised to fund these public goods and services will still need to be paid for by future generations.

In addition to taxes and issuing bonds, governments can also sell goods and services, such as land or surpluses of other goods (e.g. military equipment) that it owns. The sale of such often has a different impact on the economy than a normal private business, and as such, the prices paid for them are also quite different. This is because it isn’t just a monetary transaction, but transferring real resources that affect, en mass, the efficiency of allocating resources.

For example, it used to be that private businesses in the United States were responsible for much of the public transportation. However, as the local governments clamped down on how much fares could be charged, most of these services passed their ownership to governments. However, since there was no incentive for government to raise the prices back up (it would be unpopular to do so), instead government tax revenue was allocated towards it. In other words, rather than letting the market determine whether it was worth using the service, resources from other sectors were used to prop it up, and thus inefficiently using resources that have other use-cases.

This is a big problem with government-run things. Since local services are paid for by national tax revenue, there is no incentive to charge for them based on how well cared for the local service is. So from things like national parks, which are underpaid, to bridges with tolls, which are often overpaid, the price structure does not reflect the real cost.

Government Expenditures

There are things that the government must pay for, and then other ventures which are more voluntary. Many government services are officials who decided to voluntarily create programs or departments for, while other things like unemployment insurance are things it must pay for because of pre-existing laws. In this way, though we blame current government officials for the problems of today, in reality, sometimes its more due to pre-existing laws which they have to obey. Such is the case with things like Medicaid, Medicare, and Social Security.

In any case, government spending has repercussions on the economy as a whole. For example, in an economic downturn, the government collects less taxes because people are making less. However, they must spend more at the same time, as more people become reliant on unemployment insurance and other such things. This cushions a nation’s decline in output, and the government can give a lot of purchasing power to the economy. If an economy is doing well, the government is taking more while giving less, thus taking purchasing power from the public. While it may be ideal that the government always spends the money it is given, this is not reality.

When looking at the cost of government expenditures, it’s important to understand the difference between the cost to the government, and the cost to the economy. A government agency forbidding building of infrastructure in a certain location may cost very little as a law to keep, but may be devastating on the economy as a whole, as the real estate would be unused to create value by the public.

We can see this in the examples of criminals and prisons. While many may argue that the cost of creating prisons and locking up criminals for a long time is a lot, the cost of allowing such criminals to freely roam in public may be greater.

Are there benefits of government expenditure? There are certainly things that everyone would consider desirable, but each individual may value those beneficial things differently. This becomes entangled in politics when people who are not willing to pay a higher price for a certain product outnumber those who are. Politically, it’s convenient to define the higher price as a problem, thus gaining popularity among those who number more and want to make things more ‘affordable’. The government then forces the price down, but must subsidize that cost through tax payer dollars. Thus, the reality becomes that everyone has to pay for that product, rather than only the market for which it was designed.

The problem is that we often don’t see the little costs along the way. For example, it’s pretty normal that a huge sports stadium is built in cities where there is very little maintenance on roads, highways and bridges. This is often because it’s quite costly to actually repair all those potholes and things, while a sports stadium not only looks good to the public (i.e. great ribbon-cutting ceremonies for the officials), but is often cheaper to build as well.

Government Budgets

Government budgets are predictions of what it will spend in the future. Because of this, there is a lot to be said about the underlying assumptions of these predictions. If the predicted costs and payments of the future are based higher rates on the income of the past, it may be that lawmakers predict a rise in revenue, when in fact the opposite will happen.

As explored before, a reduction in tax rates often leads to a gain in tax revenue. Thus, when “tax cuts for the rich” happen, oftentimes, there is an actual increase in revenue from the same people. Yet, the public is often inundated with the idea that increasing tax rates for the rich will help alleviate the financial burden of those in with lower income.

And so, while many may believe congressional budget committees are non-partisan, the opposite is in fact true. Assumptions that politicians have about growth rates, rates of return, and other factors underly much of politics, so much so that even the budgetary arm of the government can become hyper-partisan, given the right assumptions. Such assumptions can prove disastrous when the money government owes to the public is misunderstood or miscalculated.

My Thoughts

I believe more and more that thinking about governments as just another form of business, albeit one which can often create the rules it wants to abide by, is a more effective way to understand them. And it is because they can create the rules they want to follow that we must always limit government in any and all capacities.

After all, most people trust that their own decisions are, by and far, better than those of others. Such a belief becomes amplified in groups, where those in the group believe that their collectively agreed upon decisions are greater than those of others. When such an entity gets to create the rules everyone must abide by, including themselves, it leaves out the word and information of the minority and the competition.

Interestingly, I think it’s easy to understand this phenomenon even outside of the arbitrary categorizing of ‘public vs. private’ or ‘government vs. businesses.’

In this case, we can assume government represents an arm of utility that must be rigidly followed, whereas the other side (i.e. private or business) represents where the rules are malleable, depending on the desires of the public. If we apply this idea to the growth of the digital tech industry, the results are basically the same.

Imagine an era where the computers you used could only be typed on, and all commands and programs were done through the keyboard. There is no mouse, no icons, no graphics of any kind. Such was the world prior to the Macintosh. In this world, the users had to bend to the will of the hardware designers and programmers, people who had no interest at all in helping them use computers for their own needs.

Then Apple comes along and takes the idea of the GUI from Xerox and puts it on a publicly usable computer. And of course, we know what happened after that. History was made as computing became a roaring industry that has global ramifications today. And programmers and technicians all over the world have benefited from it.

The analogy, here, of course, is that when the public could choose the set of rules it wanted to abide by in computing, the revenue from and for all programmers and developers spiked up, not down.

I believe that, in the same way, if governments are forced to compete to see which of its rules are actually the best for the public, then the best rules will rise to the top. The problem, of course, is that governments aren’t incentivized to compete, but rather to monopolize and expand. I touched on this idea, and the possible solution, in the previous chapter analysis. But given that its unlikely that governments would attempt to downsize and limit themselves, I think there may be other solutions that we can look towards to form a better governance system.

The Crypto Perspective

The advent of blockchain and cryptocurrency has, I believe, allowed the world of the Internet a second chance to decentralize and introduce market forces into governance. Blockchains are technologies, and interestingly, just as Web 2.0 forced governments to reckon favorably with the nascent social internet of the time, as blockchain grows, and its power to transform and benefit societies does as well, governments will need to learn to cooperate and compete well with them, or be left behind.

Governance is clearly the next phase of blockchain. Even Vitalik Buterin agrees. And it’s actually already started, most recently with France already using Tezos to vote on a local project. But it may not be blockchains replacing political elections and other utilities that is going to revolutionize governmental systems. Instead, the fact that these blockchains in themselves aren’t local to any government will actually prevent them from being subservient to any national authority. Furthermore, there are so many blockchains, many which actually replicate the utility of each other, in addition to all their differences, that blockchain governance will be nearly impossible to keep down. Governments will be forced to cooperate, or be left behind in the dust of progressive technology.

There is a problem, of course. Namely that most governance systems for blockchain rely on democratic voting to make changes on it. While this is great for small nascent communities (as most blockchains are now), as participants grow on the chain, this may become messy. There are many failings with democracy, as I pointed out with a previous post, the most important of which is the mob mentality that it tends to devolve into.

We must remember that decentralization and democracy, though having similar traits, are not exactly the same. Both have the roots in allowing the public to make governmental decisions. However, democracy concentrates (i.e. centralizes) those governmental decisions to impact all of society. On the other hand, the root of decentralization is giving the smallest group or entity the ability to make decisions for itself. Thus, while democracy can certainly be helpful, if a blockchain ever reaches more than a small nascent community, that democracy may actually be a detriment to its system, just like any governmental system. As it gets bigger, the minority opinion actually gets suppressed, even if it’s a better idea.

Thus, it may be a good thing that multiple blockchain systems are being developed. From Ethereum to Tezos to Kava to XRP, each of these systems have their own way of governance, as well as utility. As they compete and jockey for positioning, the ideal way would be that many boats rise with the tide of mass adoption. And as they do, people will be able to use these new financial instruments and invest where they feel free to.