This is the third in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.
Here we take a closer look at the economy from the income side, considering the various uses of income and how they interconnect.
Gross National Income (GNI)
Because the discussion centers on income received by residents of the United States, the focal point will be Gross National Product and income instead of Gross Domestic Product, as in the previous post. Don’t let the distinction concern you too much, since the two are very nearly the same, both around $20 trillion dollars a year. But to be precise, we need to adjust GDP by adding Foreign Net Income (FNI), including income that Americans earn from investments overseas and excluding income that foreigners earn here. Currently Foreign Net Income is positive, and that makes GNP a little larger than GDP.
GNP = GDP + FNI
Using the components of GDP covered in the previous post (Consumption, Investment, Government Spending and Net Exports), we can also describe GNP this way:
GNP = C + I + G + NX + FNI
The combination of NX and FNI is also known as the Current Account Balance (CAB), which is the difference between money flowing into the country and money flowing out of the country, taking into account both trade and investment income. So it is also true that:
GNP = C + I + G + CAB
In macroeconomics, output equals income, and so Gross National Income equals Gross National Product.
GNI = GNP
These equations describe where the national income comes from, but where does it go?
Allocation of national income
Income can be used in three basic ways: to pay taxes, to consume goods and services, and to save.
GNI = T + C + S, in which:
- T = Taxes net of transfer payments. That includes all sorts of taxes paid to government, minus any payments from government like Social Security checks or veterans benefits.
- C = Household spending on goods and services, as before.
- S = Private sector saving, whether by households or businesses. Businesses account for about three-fourths of it.
Consumer spending uses about 68% of GNI, about the same percentage it contributes to GDP. The next largest use is Saving (19%), followed by Taxes net of transfers (12%).
I have already been using the concept of Disposable Income, which is simply income after taxes and transfers, or GNI – T.
I have also discussed the Marginal Propensity to Consume (MPC or c), which is the portion of each additional dollar of disposable income that is devoted to Consumption. Its counterpart is the Marginal Propensity to Save (MPS or s). Although we are often interested in the average propensities for the economy as a whole, households at different income levels have different propensities. Wealthy households can afford to save more of each additional dollar, while poorer households need to spend more of it.
Leakage and injection
Although Gross National Income = Gross National Product, we have separate formulas for them whose equivalence is not obvious. Let’s see what happens when we try to reconcile the income side (GNI) with the spending or output side (GNP):
GNI = T + C + S
GNP = C + I + G + CAB
Well, C in the first formula is C in the second formula; that much is clear.
Let’s assume that T goes into G, since taxes go to the government.
Then we encounter an apparent discrepancy. We might like to think that all of Saving goes into Investment. But the Investment category in national accounting only includes real assets like plants, equipment and new inventory. Some of saving goes to acquisitions of financial assets (cash accounts, stocks, bonds) that are not financing new acquisitions of real assets. Currently S is about $4 trillion, but I is only about $3.4 trillion
Another difference is that the GNP formula includes the Current Account Balance (CAB), which is currently negative because Americans spend more on imports than foreigners spend on our exports. (Foreign Net Income from investments is positive, but it isn’t large enough to offset Net Exports, which is a big negative.)
So some of the national income in GNI isn’t showing up in national spending in GNP. The gap is about $1 trillion, attributable to the excess of Saving over Investment and the negative Current Account Balance. The text calls these “leakages” from GNP. In order for GNI to equal GNP anyway, there must be some offsetting “injection” of spending. That is, there must be some other form of spending going into national product and income, but not coming from national income. And of course there is; it’s the deficit spending by government.
What makes everything balance is that government spending exceeds taxation. G is greater than T by an amount equal to the missing $1 trillion. Most of that is the federal deficit, although G and T take into account spending and taxes at all levels of government. The sovereign government uses its unique position as the issuer of currency to create money when it spends, and that increases national output and income. The deficit spending helps drive the economy, accounting for about 5% of GDP and GNP.
The consequences of trying to balance the federal budget should now be even clearer. It would require some combination of spending cuts, which would reduce national output and income, and tax increases, which would reduce disposable income. Either way, consumption would be negatively impacted to a degree governed by the marginal propensity to consume. The negative impact would be compounded by the consumption multiplier discussed previously. After the multiplier effects ran their course, the economy would find a new equilibrium, but at a lower level of national output and income.
As long as hundreds of billions of national income are going into financial assets but not investments in real assets, and additional billions are going to buy imports instead of American products, the country relies on deficit spending by government to sustain national output and income. The alternative is recession. And in fact, the authors report that balanced federal budgets have usually been followed by periods of recession.
Paradoxes of thrift and spending
Most people consider thrift a virtue. In his classic The Organization Man, William H. Whyte described it as one of the three traditional values of the “Protestant Ethic.” (The other two were hard work and self-reliance.) But in the aggregate, too much saving can be a problem. Not all saving is matched by investment, and what isn’t is a drag on current GNP. Keynesian economists call that the “paradox of thrift.”
If all households would start being thriftier at the same time, consumption would drop, forcing businesses to scale back production and employment. Saving would increase, but not all of the increase would go into the acquisition of productive assets. In fact, investment would likely go down, since businesses see less profit in investing in new plants and equipment when consumer demand is falling. A lot of the new saving would go to buy financial assets, especially safe ones like cash accounts and bonds. The bottom line is that households would ultimately be punished for their thrift by a decline in their own incomes as the economy contracted.
On the other side of the ledger we have what we might call the “paradox of excess spending” (my term). What might be considered a vice on the individual level actually helps sustain or increase output and income on the aggregate level. The sovereign government is the entity with the power to make that happen.
If deficit spending is so good for the economy, then “why not just eliminate taxes altogether?” the authors ask.
One reason is that the power to tax is the main thing standing behind the currency. If people didn’t need to pay their taxes in dollars, the demand for dollars might fall, weakening its exchange value on currency markets and its purchasing power.
Another reason is that the public and private sectors are somewhat in competition, especially when the economy runs at higher capacity. If taxes go too low, private consumption goes too high, commanding too many resources, especially labor. If all the most qualified workers are comfortably employed in the private sector, government agencies have trouble finding talented people. Taxes divert spending from private to public uses, enabling society to create public goods and services. “Taxes create real resource space in which the government can spend to fulfill its socio-economic mandate. Taxes reduce the non-government sector’s purchasing power and hence its ability to command real resources.”
A related reason is that by reducing private-sector spending, taxes also help control inflation. Disposable income is now about 88% of Gross National Income. If taxes would move closer to zero, disposable income would move closer to 100%. The increase in aggregate demand could put a big strain on supply, pushing prices up.
The conclusion is that deficit spending is economically useful, but so are taxes.
An additional effect that government has on income is to redistribute it. One way it does that is through mildly progressive taxation, taxing high incomes at higher rates than low incomes. The other way it does it is by spending more on low-income households through such transfer programs as Medicare, unemployment insurance, veterans benefits, food stamps and family assistance.
For the aggregate effects, I will refer to the study by Thomas Piketty, Emmanuel Saez and Gabriel Zucman for the Washington Center for Equitable Growth. The researchers divided the U.S. population into three broad income groups, and then compared their shares of national income before and after taxes and transfers. Here’s what they found for 2014:
- Top tenth: 47.0% of income before taxes and transfers, 39.0% after
- Next two-fifths: 40.5% of income before taxes and transfers, 41.6% after
- Bottom half: 12.5% of income before taxes and transfers, 19.4% after
Overall, 8% of the national income was reallocated downward from the top tenth of the population, with 1% going to the next two-fifths and 7% going to the bottom half. That reallocation had a big impact on those who received it, boosting the average income of the lower half of the population by 54%. Since the top tenth already had so much, what they gave up only amounted to 17% of their income.
Redistribution from the haves to the have-nots tends to boost consumption and aggregate demand. Lower-income households have a higher propensity to consume; they consume most of any additional dollars they receive. “This arises because lower-income families find it harder to purchase enough goods and services to maintain basic survival given their income levels.” Wealthier families have a higher propensity to save. They “not only consume more in absolute terms, but also have more free income after they have purchased all the basic essentials.”