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Contrary to popular belief, incentives to cut consumption and save do not encourage investment and spur economic growth. By diverting consumption income to investment, the investments themselves are made less financially feasible for the simple reason that when people save instead of spending, producers do not sell.

The idea that capital can only be formed (investments financed) by cutting current consumption and saving, then investing is fixed into U.S. tax policy, largely due to the influence of John Maynard Keynes, the economic architect of the New Deal. It was Keynes' unquestioned assumption that, "The immense accumulations of fixed capital which, to the great benefit of mankind, were built up during the half century before the war, could never have come about in a Society where wealth was divided equitably. (John Maynard Keynes, The Economic Consequences of the Peace, 1919, Chapter 2, Section III.)

In 1935, in response to Keynes' influence on the New Deal recovery programs for the Great Depression, Dr. Harold G. Moulton of the Brookings Institution in Washington, DC, investigated the claim that it was only possible to form capital by saving, then investing. By tracking consumption and investment from the 1830s to the 1930s, Dr. Moulton discovered something surprising. If capital could only be formed by first saving, then investing, he should have found that periods of increased investment were, in each and every case, preceded by periods of greatly decreased consumption.

On the contrary, what Dr. Moulton found - in each and every case! - was that periods of increased investment were preceded by greatly INCREASED consumption! That is, instead of savings being accumulated then invested, savings were being depleted.

Where, then, does the money come from for the increased investment?

Dr. Moulton pointed out that the money for the increased investment had been created by the banking system, using classic techniques of banks of issue and central banking. That is, a borrower with a "sound" productive project obtained a loan from a commercial bank. The money to purchase the note was created by the bank, which took the note on the project (and some collateral) as security. The borrower took the money, invested it, and when the project began to pay off, used the income to repay the principal and interest on the loan (and afterwards to spend on consumption). The bank would take the interest as its profit, and cancel the money, thereby avoiding both inflation and deflation. This process is described in Dr. Moulton's book, "The Formation of Capital," in which he published his findings in 1935.

Taking Dr. Moulton's findings into consideration, cutting consumption in order to invest is therefore contrary to a sound policy of creating money as needed through the banking system. It is also contrary to the best interests of the economy as a whole - spending less in order to save then invest means that producers (and thus investors) will not make as much income ... if any.

Consequently, taxing capital gains, dividends, and every other form of income, however derived, at the same rate is the only just method of taxation - given a reliance on bank credit rather than past savings to form capital.

Changing to a program such as "capital homesteading" away from the current reliance on existing accumulations of savings (which should be spent to encourage economic growth, per Dr. Moulton's findings) would go a long way toward encouraging investment and promoting economic growth. The alternative is to continue to rely on financing growth in ways that actually inhibit growth, and cut off the greater part of the American (or any other) people from participation in the economic system as both workers and owners.

Learn more about this author, Michael Greaney.
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