What Happens When You Get a Dollar?

© Dennis York 2008

That depends. If you are poor you might spend it all. If you are rich you might save part, spend part, and pay taxes on part.

If you spend the dollar you get the benefit of products and services it purchases. The people that provide you these products or services get your dollar. Then they can spend, save and pay taxes with it. The people that they pass portions of your dollar to also spend, save and pay taxes on it. Each time your dollar changes hands its impact on the economy is multiplied. A dollar does not disappear when you spend it. Instead it swims through the economy and has impacts far from its initial release point.

If you ‘save’ the dollar in your mattress nothing much happens. If you ‘save’ the money in a bank you are really loaning it to others to spend. They will buy goods and services with your money and pay you a tribute for the privilege of using your money. If you ‘save’ your money as a stock or equity in a company, the company spends the money with the intent of making a profit and paying you a portion of that profit. Again, they buy goods and services with your dollar and its impact is multiplied.

When a business spends a dollar, the business is expected to create a dollar or more in wealth (asset) in exchange. Businesses that do not do this experience Economic Darwinism and go bankrupt. For instance, a business that pays a software engineer one dollar in salary must receive code from that engineer worth more than a dollar. This is wealth creation. The dollar has passed from hand to hand. It still exists but it left more than one dollar behind in its wake. This generation of wealth is a simple miracle called capitalism.

In almost every transaction, some portion of the dollar is taxed. That is, the government takes a share. Like a private entity, the government may spend or save its share. Unlike a private entity the government pays no tax. The government seldom spends the dollar efficiently. The $12,000 airplane toilet seat and the bridge to nowhere are example of grossly extravagant government spending. But even the most frugal and well managed governments are inefficient compared with citizens and profit-making corporations. Governments can print money or raise taxes so they don’t go bankrupt. Thus, they need not create an asset equal to or greater than the dollar spent and they seldom do. Economic Darwinism is almost irrelevant to governments.

The portion of the dollar that is taxed is key to its impact on the economy at large. Let’s assume that none of the dollar is taxed. Then every dollars swims free in the economic sea forever. It can pass through an infinite number of hands and buy an infinite supply of goods and services over time. It can create and infinite amount of wealth in its wake. The more dollars and the faster they jump from hand to hand, the larger the economy. Each jump adds a dollar to the gross domestic product of the economy. Adding a dollar to this sea raises the ‘wealth’ of the sea by a factor proportional to the average rate of spending. But in this case the government can only provide goods and service by printing new money. If the government prints more money, the value of the money is devalued proportionally and the economic sea is ‘taxed’ through inflation.

If each transaction is taxed, the swimming dollars get smaller on each exchange. If the average tax rate is 50%, after five exchanges only three cents are left of the original dollar. If the tax rate is 10%, sixty cents are left after five transactions. Thus, the dollar ‘decays’ do to taxation. A small change in tax rate can have a large impact in decay because money changes hands frequently.

But as the tax rate increases the rate of exchanges decreases. Imagine going fishing. If you get to keep all the fish you catch you are enthused. If a lame Grisly, too sick to catch fish for himself but fit enough to catch you, sits next to you you may feel obliged to feed him part of your catch. If he only takes 10% you may keep fishing. If he demands 90% you may find another hobby. The higher the tax rate the less people participate in the economy, the fewer the transactions and the lower the gross product of the economy. We might call this 'participation aversion.'

The combination of ‘dollar decay’ and ‘participation aversion’ cause a paradox. An increase in tax rates almost always reduces tax revenue. Conversely, when tax rates are lowered tax revenues rise. This is why the Kennedy, Reagan, and Bush tax rate reductions resulted in huge tax revenue increases. This is why Singapore, with a 15% corporate and personal tax rate (compared to about 35% in the US and higher in much of the rest of the world) is an economic dynamo with large government tax surpluses year after year. The Singaporeans know how to care for their fish.

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