Modern economic debate is dominated by demand side economics. The tenets of Keynesian economic theory have so pervaded the spheres of politics and public discourse, that consumption is everywhere touted as the driver of economic growth – and as a corollary, saving is disparaged as, a threat to economic growth. J.M. Keynes himself coined the phrase “the paradox of thrift” to describe the phenomenon where individuals increase savings during a recession, adding to a fall in aggregate demand which in turn is thought to deepen the economic downturn.
Following this logic, tax cuts for the rich are deemed to pose a danger to the economy, as money is saved rather than used for consumption, and in the tax-avoidance debate money saved from the tax authorities is presented as a loss to society which disappears from the public purse and therefore might as well not exist. Better to tax and use the money for an expansive fiscal programme from the government. The criticism of allowing people to keep their money rather than hand them over to the tax authorities doesn’t end with the indictment of thrift as a threat to economic wellbeing, of course. Enraged by (allegedly) starved public services and (perceived) inequality, extravagant investment in for example art or property is chastised as a waste, with money better spent on the less fortunate – “how many people could you feed for the price of a that villa?”
There are, however, severe flaws in the logic which would lead those easily persuaded to accept such arguments as valid. Henry Hazlitt taught us Economics in One Lesson when he said: “the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups” (Economics in One Lesson, 1946). And the lack of pursuing effects beyond those immediately apparent is indeed responsible for the misconceptions around the dangers of cutting taxes; for everyone, but in particular for the vilified “rich”.
Some of it is trivial. Investment in cars, houses, art and other luxuries are of course not the equivalent of flushing wealth down the drains: millions of people make their living off money spent frivolously by the “rich” on luxuries, even if many see such consumption as unnecessary. Wealth spent by the rich flows to the less well off as compensation for the goods and services they provide. And of course, if you see the economy as demand-led, any old consumption keeps the wheels turning. There really is no controversy here, and from a macro perspective, economists do not differentiate between various forms of demand depending on whether it is for basic or luxury goods.
So far so good. Much more interesting is the question of whether there really is a “paradox of thrift”? Is saving a danger to the economy?
In fact, the paradox of thrift is not attributable to Keynes; it has been around much longer. The theory can be traced all the way back to economists of the 18th century, and it was the theme of William Trufant Foster and Waddill Catchings’ 1920s article The Dilemma of Thrift. F.A. Hayek, the Austrian economist, posed his alternative theory in response to Foster and Catchings’ book, and there is much we can learn from Hayek’s thinking, which he set out in a 1929 article entitled The Paradox of Saving.
Foster and Catching had proposed that additional investment would increase supply which consumers would not be able to buy, because an unchanged money supply would leave them with nothing further to spend. If prices were falling in response to the increase in supply (as they would), the problem would magnify as firms would be forced to sell below the cost of production.
Hayek saw it differently. He argued that additional savings are channelled to firms as Capital (the Austrian concept of Capital is broad and covers the chain of goods and processes used to produce consumer goods), which results not in a replication of existing production processes, but in increasing productivity. New investment makes firms more effective and reduces their production costs, allowing them to make a profit when selling more goods at lower prices, which is what allows consumers to buy more goods even if the quantity money remains unchanged.
So, there is no “missing purchasing power” as a result of savings. Workers who have additional Capital at their disposal are more productive, their real wages increase, increased supply leads to increased demand. Instead of collapsing into a recession, the economy finds a new equilibrium at a higher level of savings with labour and capital; prices and quantities; production and consumption all at new levels. Initially, increased savings are at the cost of a reduction in consumption, as new production methods are implemented, but as a result of the reorganisation and transformation of the structure of Capital, production costs are lowered, prices fall, and as a consequence real wages increase. Hayek’s insight shows us how savings are merely the cause of a temporary drop in demand for consumer goods, but at the same time they are the necessary condition for an economy to advance, through investment, innovation and effectivization of production processes.
What this all tells us is that when people complain about tax cuts for the rich there is no steady foundation for their criticism. Tax cuts puts money in the hands of the people, which is what allows the market to find equilibrium between the amount of money available for investment and the demand for new Capital (this is the core of Austrian Business Cycle theory, which we explain here). In other words, there is no economic reason to oppose cutting taxes – for rich or for poor – and any attempt to do so is merely a disguise for a political agenda.