DANGERS OF THE FISCAL CLIFF ANALYZED THROUGH ADAM SMITHS IDEOLOGIES

Jonathan P. Sherman History of Economic Thought University of Connecticut November 26, 2012

Adam Smith was one of the most influential economic

thinkers of all time. Smith wrote several books on the ethical values of life as well as economic theory. His most famous writings were The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations. It is with these two writing Smith developed the idea of his famous invisible hand. Smith was as much of a philosopher as he was an economist. Through his idea that humans act in their own selfinterest but by doing so also benefit all participants, he rationalized the idea of free markets, division of labor, and the right for the capitalist and land owner to receive interest for capital or land lent to the borrower. Today there is a major debate within the United States in regards to taxes, the inequality between classes and the outsourcing of jobs to foreign countries. Through the use of Smiths ideologies this paper will search to explore and demonstrate why some of todays proposed economic policies may hinder our economic growth rather than encourage it.

Smiths invisible hand is widely interpreted as,

self-interest consistent

individuals beneficial

whose

actions for

are all

with

results

participants.

This can be explained with the simple idea involving two individuals such as a farmer and a weaver. The farmer himself can produce all the food he and his family needs to survive. However, he lacks the skill and time to weave clothes for he and his family. The weaver on the other hand, suffers from the lack of ability to grow food. But, he can produce more clothes than he and his family require. It is through both these individuals acting in their own self-interest that a trade of food for clothing and vise versa would occur. This trade benefits both parties in the sense the farmer as well as the weaver can now feed and cloth themselves and their families. This principle can be applied to all aspects of economic trade. However, this example is rather primitive since the invention of money, which, Smith viewed as a result of self-interested behavior. The invention of money effectively eliminated the inconvenience of bartering. The invention of money also allowed individuals to build capital which could be held or invested at the owners convenience. Prior to this one could build their capital but if said capital could spoil, for example food, the farmer may lose

all of his capital in a matter of days. Thus, the profits of his labor would diminish. Smith further proposed an innovative way to produce more capital in less time, thus growing the economy.

The division of labor is among the most accredited and

widespread ways of producing better quality goods at a faster rate. Take the weaver for example who uses the cotton grown in the field to weave his clothing. Included in this process from virgin cotton to clothing is the dyeing process. If the weaver himself must pick the cotton, deseed the cotton, dye the cotton and then weave it, it will take the weaver many hours to produce one shirt. However, if we apply the idea of division of labor to the process, at each stage there is an individual whom specializes in either picking, deseeding, dyeing or weaving. This division of labor and specialization reduces the time it takes to produce one shirt. Further more, the picker over time may develop a more efficient way to pick the cotton thus producing more cotton in less time. The deseeder also develops a faster way of deseeding the cotton and so on and so forth with each stage of production. This division of labor also allows a less educated individual to find work in certain fields where no formal training is needed, such as the cotton picker. It is with the division of labor that more people are able to produce a

greater quantity of goods then they would otherwise be able to on their own. Above all of these workers is the capitalist who does not partake in any stages of the production. Rather, the capitalist is responsible for providing the capital required in the production of the good. The capitalist himself may or may not benefit from the risk in providing the capital. But, when the capitalist does benefit, he usually benefits far more than any of the workers used in the production of the goods. From this comes the division of classes, a highly discussed and argued topic in contemporary United States politics.

The capitalist, as mentioned before, invests or lends some

of his capital to a borrower with the expectation the borrower will return the initial investment plus interest. In Smiths time the capitalist may have been one who purchases the looms for the weaver but in return the weaver must pay the capitalist with some of his profits. Capitalist may also start their own manufacturing company and employ workers to produce clothing. The capitalist initial investment in the looms, cotton and dye is perceived as a risk, should he not be able to sell any of the products he produces he will have lost much of the initial capital he invested. In order to produce clothes he must also employ workers who will work for a wage. As products are sold

the capitalist brings in revenue. Once costs have been deduced from the revenue, the capitalist realizes his profit. From this profit he uses some of it to pay his workers, some to support himself and his family, and reinvests the rest back into his business. Ultimately, the capitalist will make more in profits than the worker will whether or not he exerts the same amount of labor into the final product as the workers do. This difference in profit between the worker and the capitalist leads to the division of classes. The capitalist with time will fall into the upper class due to his huge profits, and the worker into the middle or lower class. However, the division of labor and the resulting division of classes benefits society as a whole by raising living standards for all involved. This is because without investments and the division of labor, the economy would become stagnant.

The accommodation not always exceed

of the European that of an

prince does and

industrious

frugal peasant as the accommodation of the latter exceeds that of many an African King. (An

Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith)

This quote demonstrates that while a worker may not live as a capitalist, the of a king worker could easily be who society does not living have a

lavishly as above the

standards

division of labor and classes. While it is incorrect to say those of the to lower class have nothing pay to and complain living about in

relation

inequality

of

their

standards

compared to the upper class, it should be realized that without the division of labor and classes, a societys living standard as a whole be much less. This is due to the fact without the division of labor there would be a reduction in jobs and a reduction in output. These reductions in both jobs and output cause a reduction in spending and investing. Further more this would lead to an economic recession which harms society as a whole.

To

investigate

the

use

of

Smiths

ideologies

in

contemporary America, one must first understand the differences between our modern society compared to society during Smiths time. Some of the difference tax include various on types of and

capitalists,

differing

brackets

based

income,

globalization just to name a few.

Lets

first

look

at

the

various are

types

of

capitalist owners,

in who

todays

society.

First,

there

small

business

invest much of their own money into their business. There are also shareholders, who buy a stake in a company in hopes they will make a profit as the company generates profits. Then there is the venture capitalist, who takes huge financial risks in providing funds to a start up company. This is different from the capitalist in Smiths days where stocks were rarely sold and traded and the term venture capitalist was not yet coined. The capitalist in Smiths days were more of the business owners and a job makers. Today the term has changed and we have many

different types of capitalists. Smiths ideas of not taxing the capitalist for the reason that they are the job makers is no longer relevant to our modern society. Further more, all those who work in todays society whether the owner of the business or the minimum wage worker must pay some portion of their profits in taxes. In todays society many of those who fall into the top tax

bracket are capitalist and investors. However, not everyone in the upper most tax bracket is a capitalist or an investor. Some capitalist such as a small business owner may not fall into the highest tax bracket. The same goes for shareholders. Those who

do fall into the upper most tax bracket should be paying 35% federal income tax, granted they do not utilize tax deductions and loopholes. In 2013 the projected income of those who will fall into this bracket are those making over $398,350 whether married and filling jointly or filing single. (Forbes) However,

there are many other taxes one must be aware of, which will effect people of all different income levels.

One such tax is the the tax on unearned income. As stated

by the IRS, unearned income is any income received from taxable interest, ordinary dividends, and capital gain distributions. It also includes unemployment compensation, taxable social security benefits, pensions, annuities, and distributions of unearned

income from a trust. (IRS Publication 501, 2011) These taxes affect every level of income earners from high income earners to the lowest of income earners. Lastly, to further understand the difference between our contemporary society and Smiths we will look into globalization and its competitive advantage.

With the invention of the internet people and businesses the globe have become for increasing an connected. in This

around

increased

connectivity

allows

increase

competitive

advantage for businesses. During Smiths time much of the hiring

of employees was done very locally and within the community a business operated in. Today however, a product that is sold in the United States by an American company is vary likely to have been made in a different country. The reason for this is the competitive advantage a business receives by outsourcing jobs. The biggest contributor to the increased competitive advantage a company receives is the lower wages they must pay to workers in another country. Within a specific market the company who

produces at the lowest cost can either sell its product at a reduced price compared to its competitors, or they can sell at the same price and make a larger profit than their competitor. This allows businesses an competitive edge over their

competition. Which if all other factors remaining equal will allow the company to grow at an increased rate in comparison to its competition.

The outsourcing of jobs is a double edge sword. While it

allows companies to bring in greater profits, it also eliminates many of the once available jobs domestic workers are able to fill. However, there are benefits some domestic workers receive by outsourcing jobs. While not all workers receive the benefit of a 401(k) plan from their employer, those who do usually have mutual fund holding within their 401(k) plans. As the company

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outsources more jobs, they effectively reduce costs and increase profits. This increase in profits can be rewarded by rising

share prices and mutual funds with those shares increase in value. With the knowledge of how our contemporary society is similar and different from Smiths, we can investigate and

analyze how Smiths ideologies can be applied to contemporary U.S politics.

Following the 2008 financial crisis the Unites States debt

has grown dramatically largely due to the governments efforts to avoid a serious economic depression. With the economy

recovering, much of this emergency spending will end. However, over the long run it is projected that our deficit will continue to outgrow our GDP. (CNN) To counteract our growing deficit many politicians and citizens are turning to the wealthy to

contribute more in terms of tax increases. Smith was a large proponent of not heavily taxing the capitalists. This was due to the fact that the capitalist during Smiths times were the

business owners and in turn the employers. Smith argued that by reducing the profits the capitalist received by the means of taxation would reduce the incentive for the capitalist to

reinvest more of his capital than he previously had. In todays society the capitalist is no longer just the owner of the

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business.

As

discussed

before

the

capitalist

of

today

are

shareholders, small business owners and venture capitalist.

With the fiscal cliff coming January 1, 2013 politicians

are in debate about what to do. The fiscal cliff is the sunset of the 2001 and 2003 tax cuts as well as the expiration of other provisions and the reduction in payroll taxes which was enacted earlier this year. Should the government allow the top two tax rates to increase along with an increase in taxes on dividends and capital gains there could be serious economic consequences.

If the current provisions are left unchanged the top two

tax rates will increase from 33% to 36% and 35% to 39.6%. The top tax rate on dividends as ordinary income will increase from 15% to 39.6% and capital gains from 15% to 20%. Limitations on itemized deductions for high income earners will also be

reinstated. Further more, those who fall into these high income tax brackets will also face an increase in Medicare tax, which will increase from 2.9% to 3.8%, which will also be applied to unearned income such as interest, dividends, and capital gains. The possible increase of each of these taxes coupled with the reinstatement on limitations on itemized deductions will

increase the top effective marginal tax rate from 35% to 40.9%.

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The effective tax rate on dividends will rise from 15% to 44.7%. (Ernst & Young) These figures however do not even include state tax rates which further increases the tax rate. The increase in the top two tax rates are not only a

concern to wealthy individuals but also to many flow-through businesses, which employ 54% of employees working in the private sector. (Ernst & Young) As these businesses are forced to give up larger portions of their profits it is likely that the

business owners will decide to hire less employees, leading to fewer jobs. This reduction in employment due to the increase in taxes is exactly what Smith conceptualized in regards to higher taxes on the capitalist of his day. To make matters worse the reduction in profits caused by increased taxation reduces the incentive for capital investment. The combined result of less hiring and less capital investment leads to slower growth of the business. While Smith argued that an increase in taxes on the capitalist would slow economic growth, we can apply his theory to those individuals and firms which fall into the top two tax rates. As noted before a large portion of flow-through business, which employ 54% of those working in the private sector, fall into these top two tax brackets. Knowing this, it becomes

obvious the negative impact increased rates would have on the

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economy. However, the impact on businesses becomes worse when an increase on dividend and capital gains is added to the mixture.

Should the tax rate of dividend and capital gains increase

the incentive to purchase dividend paying shares of a company decreases. The problem with this lies in the ability of a

company to raise capital through equity financing to further promote their growth. If this occurs company must raise funds though debt financing. However, there are two major problem with this is. One, it could lead to a bad debt-to-equity ratio which further turns off investors from by investing a firm in a company. the

Secondly,

increased

borrowing

increases

possibility of financial distress should the economy weaken. The reduction in take home pay after taxes from working and the reduction on returns from saving and investing after taxes will slow our economic growth.

As

Adam

Smith

stated,

the

increase

of

taxes

on

the

capitalist will harm an economy. Using his idea coupled with our understanding of modern society it becomes obvious that by

increasing taxes on business owners, shareholders, and venture capitalist our economy will slow. The effects of the tax hikes and the looming fiscal cliff should the provisions remain

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unchanged will effect every individual in the United States and our overall economy.

Referring

back

to

Smiths

ideologies,

self-interest

individuals whose actions are consistent with beneficial results for all participants, the division of labor and the resulting division of classes and not raising taxes on the capitalist, we can understand how these provisions effect each of these. The division of labor and the resulting division of classes and income inequality has led much of the middle and lower income earners to believe raising taxes on the wealthy is the answer to solving our deficit and providing funding to ever increasing entitlement programs. However, the tax increases on mentioned

our modern capitalist will cause lower investment and saving. It will reduce the amount of employees a firm hires and retains. Lastly, those who would otherwise act in their own self interest by investing in hopes of gaining a profit and in return provide funding for a business will no longer have the incentive they once did. All of these factors will not help our economy like some believe, but instead it will hinder our economy.

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References:

Carroll, Robert, and Gerald Prante. Long-Run Macroeconomic Impact of Increasing Tax Rates on High-income Taxpayers in 2013. Rep. Ernst & Young, 2012. Print. Landes, Luke. "2013 Federal Income Tax Brackets And Marginal Rates." Forbes. Forbes Magazine, 01 Nov. 2012. Web. 25 Nov. 2012. <http://www.forbes.com/sites/moneybuilder/ 2012/11/01/2013-federal-income-tax-brackets-and-marginal-rates/>. "Obama's Economy: A Snapshot." CNN,Money. Cable News Network, 7 Nov. 2012. Web. 25 Nov. 2012. <http://money.cnn.com/galleries/2012/news/economy/1206/gallery.Obama-economy/ 12.html>. "Publication 501 (2011), Exemptions, Standard Deduction, and Filing Information." Publication 501 (2011), Exemptions, Standard Deduction, and Filing Information. Internal Revenue Service, 2011. Web. 25 Nov. 2012. <http://www.irs.gov/publications/p501/ar02.html>. Rima, Ingrid Hahne. Development of Economic Analysis. 7th ed. New York, NY: Routledge, 2009. Print. Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations. Chicago: Encyclopedia Britannica, 1955. Print.

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