by Joseph Palazzo

Created on: June 04, 2009

I am completely sympathetic with people who are unsatisfied with the implementation of our taxation system. You could use many colorful words to describe it, the nicest being bloated and the worst would get me banned from here. I can understand why different people would use different logic as to why taxation out to be based upon service or upon sacrifice (if you dont receive any benefit from the lighthouse why should you pay for it). Sadly though a basic understanding of economics is lacking within our society, and the implications of taxes upon it.

The purpose of taxes is to raise demand in the aggregate economy. Every nation has a certain MPC (marginal propensity to consume), meaning for every extra dollar that you get how much of it are you going to spend. The reciprocal of MPS (marginal propensity to save) or 1/(1-MPS) gives us our fiscal multiplier. It works like this i have a dollar so i buy a candy bar from you. You save ten cents and spend ninety on a pen. The owner of the pen saves nine and spends eighty-one on chewing gum. etc etc. The total expenditures created from the one extra dollars worth of demand that was introduced into this economy was (1/(1-.9)*1= 10 My extra dollars worth of demand created 10 dollars worth of consumption and work. Yep people working pay check to pay check is good for the economy.

There is more to it then this yes you will save money and that is bad for the economy but at the same time money is being spent elsewhere to compensate for your selfish saving habits. That is capital investment by big business. Their big money projects like new office buildings, new plants, research projects etc. serve to offset the money you don't spend. The problem with this is that in mid recession when were tightening our belts so is big business. Leading into one big downwards spiral.

This is where fiscal and monetary policy come into play. Monetary policy is what the federal reserve does and fiscal policy is what the government does. So that now when things get out of hand there are active tools to get things back in check. In order to get capital investment spending to go up the fed can lower interest rates now projects that were once unprofitable become profitable through lowered interest expense, investment spending will go up. In order to get consumer spending to go up you can lower taxes. The government can also decide to adjust its own spending.

That really is the purpose of taxation is to spend money that we would not, in order to raise the average propensity to consume. That is why a flat tax is counter productive. It makes no sense to tax someone who is living pay check to pay check when they would have spent everything anyways. It makes much more sense to tax someone who makes 1 million a year for 400 grand because he would have saved a whole lot more now the government can spend the money that he was not willing to, and that 400 which is now spent created more than 400 grand worth of wealth through the fiscal multiplier effect described above.

A flat tax will only serve to hurt the person who cant bear a tax in the first place and ensure that the wealthy will not be taxed enough for the economic well being of the nation.

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