The Progressive Income Tax

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How Markets Foil Collectivist Schemes


 by James Kroeger




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The Economics profession has largely failed society up to this point because it has failed to expose the utter folly of Collectivist Schemes promoted by politicians that are ultimately based on a logical error known as the FALLACY OF COMPOSITION.  The schemes are very popular, politically, because they foolishly promise to reward 'everybody', even though it is virtually guaranteed that they will end up rewarding nobody.  What is the Fallacy of Composition?  It is an error in logic that observers make whenever they mistakenly assume that all the members of a group will benefit from a certain behavior if a single individual clearly appears to benefit from that behavior.  In economics, there are many times when this assumption is simply false:

  • During a recession, it is prudent for an individual---who doesn't know if she will have her job four months from now---to postpone purchases of durable goods, avoid taking on new debt, pay off old debt, and save for new purchases.  But unfortunately, if everyone were to do that, the recession would quickly become much, much worse.

  • An individual firm, in an effort to expand market share at the expense of its competitors, might be inspired to cut prices.  But what happens if all of them do the same thing?

  • Saving money is always a good thing, right?  But what if everyone started saving for all of their purchases and no one ever again borrowed?  One of the celebrated benefits of saving money---earning interest income---would disappear.  It turns out that savers need borrowers if they want to benefit optimally from saving money.

Far more often than most people realize, it is exceptional behavior that is rewarded by the economy.

Let's consider one more hypothetical example:

When individual lottery winners collect their millions, they enjoy a dramatic increase in their purchasing power.  Suddenly, they are able to make a claim on the scarcest goods & services that the economy makes available. But what if our politicians in Washington were to decide one day to simply hand out a million dollars to every household in America?  We’d all be able to share the same great experience of luxury living then, wouldn't we?

Economists know that such a plan would simply cause an explosive round of inflation.  Over a fairly short period of time, the price of everything would skyrocket dramatically.  After the hyperinflation had finally run its course, there would still be the same number of rich and poor and middle class citizens in the country as there were before the million-dollar gift was distributed.  Why?  Because the amount of goods & services that would be available in the country the day after the million dollar giveaway would be essentially the same as the amount that had been available the day before.  Giving people more money would not make the scarcest goods & services multiply magically.  The end result?  The same quantity of good & services would be consumed as before, just purchased at dramatically higher prices.  Because some goods & services are absolutely limited in their availability, there would still be the same number of rich people as before.

What is the Market mechanism that guarantees that collectivist schemes like this will fail?  In a market economy, suppliers can always be counted on to charge the highest prices that their markets will bear.  That is to say, they will charge as high a price as they can, so long as they are able to sell everything they have.  If a shortage develops in some market, sellers will raise their prices because they know that some people will be willing to pay a higher price for what little there is.  Buyers will pay the higher prices because (1) they have the money to do so, and (2) they don't want to do without.  Sellers also raise their prices if they notice that an increase in disposable incomes has occurred.  They want to get as much money as their customers are willing to pay, period.  The only way they can find out what the optimal price might be is by raising the price until they are no longer able to sell what they have.

That's how The Market works.  Because there are not enough scarce 'experience opportunities' available for everyone to know them, the marketplace 'auctions them off' to the highest 'bidders.'  It's a different sort of auction from those that most people are familiar with, but it is still an auction.  Sellers try to guess what the highest successful 'bids' will be and set a 'price' for the goods they are selling.  Those who cannot afford to pay a seller's asking price will 'submit their own bids' only if the official selling price is lowered to a level that they can afford.  In other words, in this kind of auction, the only bids that are offered are those that are certain to be accepted by the auctioneer.


If a supplier/auctioneer sets her prices higher than she should, she won't be able to sell all of her product.  She will then have to lower her prices to a level that more consumers find affordable.  If, on the other hand, she doesn't charge the highest price she can get from the market, she'll find that she has too many customers clamoring for the limited amount of things she has to sell.  She will then want to raise her prices until she finds out which higher price imaginable is still low enough for her to sell all of her product.

Due to the limitations imposed on us by Nature, our economy is not able to produce enough of the "best quality" goods & services so that everyone can experience them.  In a market economy, if you want to be one of those who gets to experience the rarest of economic privileges, you must obtain a level of disposable income/wealth that is high enough for you to outbid other potential consumers for them.  This is essentially why it is the distribution of income/wealth that ultimately determines who gets to experience them and who doesn't.

What is important is not the dollar wealth you are able to accumulate; it's the dollar wealth you are able to accumulate compared to everyone else.  The purchasing power of your income is determined solely by its relative position amongst all accumulations of disposable income/wealth.  Because we have a market economy, an individual can improve her claim on the scarcest goods & services only if she can improve her comparative bidding position within the hierarchy of national money wealth distribution.

Whenever an individual household is able to increase its disposable income, its purchasing power will either increase, decrease, or not change at all depending on what has happened to the disposable incomes of all other households.  If your disposable income remains the same next year but everyone else's income declines you will actually see the purchasing power of your stagnant income increase.  Suppliers would be forced to drop their prices and you would discover that you have acquired a bidding advantage over others.  Even if your income were to drop next year, you would still be better off if everyone else's income dropped even more.

Perhaps now it is easier to see the folly of Collectivist Schemes.  What kind of schemes are we talking about?  Well, there's the "everybody needs a tax cut" ploy.  What happens if all taxpayers receive an income tax cut [in a way that preserves all taxpayers' rankings within the hierarchy of disposable income distribution]?  Answer: none of them experiences any real gain in purchasing power.  We can be certain that prices will rise in the marketplace until all of the extra 'purchasing power' is nullified (because sellers can always be counted on to charge whatever prices the markets will bear).

Likewise, it is also true that increasing the income tax obligations of all citizens in a way that preserves each taxpayer's ranking within the hierarchy of disposable income distribution ensures that none of them experiences any real loss in purchasing power.  Prices will drop until all citizens can afford what they would have been able to afford if they had not had to pay more in taxes.  The Progressive Income Tax is widely misunderstood today because people do not realize that it collects money from taxpayers in a way that ensures that each is spared the decline in purchasing power she would otherwise have experienced if only she had paid the tax.

Another example of collectivist folly is the legislation passed by Congress that seeks to help all businesses by reducing their costs.  If all firms benefit from the same kind of government-sponsored cost reduction (like a tax cut), then none of them ultimately benefits.  A firm can increase its market share only by obtaining more disposable cash than its competitors.  If all firms experience the same gain in profits, then prices in asset/resource markets will simply be bid up until the "gain" that every firm received is wiped out.  In business, the only way it is really possible to get ahead in a competitive environment is by cutting your costs more than your competitors.

Likewise, when government edicts force an increase in costs on all firms, they are all spared the hurt that each of them would have experienced if only they had been forced to absorb the cost.  For example, we know that if/when an individual firm gives all of its employees an extra week of paid vacation, its costs increase in a way that could put it at a competitive disadvantage.  But if all firms are forced to give all of their employees an extra week of paid vacation, then none of them is actually hurt by the requirement.  Either (1) they will all be able to pass on the extra cost to their customers or (2) they will all have to accept lower profits.  In the latter case none of them would lose out because all would be experiencing the same drop in net profits, which means price levels in resource markets would drop to levels they could afford.

Business owners in a market economy need to focus on two things if they want to optimize their "Real Wealth enjoyment": (1) They must optimize society's overall productive output generally, while (2) seeking also to minimize their own costs (maximize their own disposable incomes) vis-à-vis their rich peers/competitors.  If they seek instead to increase the disposable incomes of all rich people in a way that does not directly help to eliminate unemployment, then they reveal themselves to be deluded fools who end up victimizing themselves as well as others through their ineptitude.

It certainly is not difficult to think of more examples of these kinds of collectivist political attempts by various groups to obtain 'easy enrichment' for themselves (their group).  It's not just that they are foolish ideas; they cause a lot of unnecessary suffering to occur.  If, for example, the nation is suffering from unemployment, we can eliminate the problem painlessly by increasing the income tax rates of rich people and then using the money to finance government improvements of the infrastructure.  But that solution can never be exploited if most rich people mistakenly believe that a higher tax bill would actually deprive them of some purchasing power (it would not).  If we can all become aware of the true folly of Collectivist Schemes, we will be able to focus our attention on policy initiatives that can bring about real improvements in our collective welfare.


Edited, December, 2005





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