Downward Redistribution Doesn't Boost the Economy

Background

In a discussion on universal basic income, it was postulated by one member of the group that by moving money from the rich to the poor the economy would be stimulated for growth. The notion was that rich people tend to save their money, but if transferred to poorer people it would more likely be spent on consumption, i.e. economic activity.

This was said by a professor of philosophy at the local university who, while clearly not an economist, is someone who can be categorized as educated and intelligent. It seems that the fundamentals of macroeconomics should be common knowledge, at least amongst people of that intellectual tier. If you have a grasp of macroeconomic fundamentals and understand the professor's mistake then there is no need to read any further. However if redistributing wealth downward sounds like a good way to boost the economy then this article is for you. Please note that I'm not claiming there are no good arguments to be made for downward re-distribution, just that overall economic growth is not one of them.

There seems to be a misperception of the very wealthy as Scrooge McDuck types who keep an enormous vault of money used for the purpose of recreational swimming. While clearly many rich people are guilty of overconsumption, that is not where the bulk of their money goes. Look at the example of Warren Buffet, who is the normal go-to example of how billionaires don't pay their fair share. Famously he pays a lower tax rate than his personal secretary. But he is also a model billionaire, who has stayed in Omaha rather than heading for a trendy city and still lives in the relatively modest home he's been in for decades. Almost the entirety of the man's wealth is not "saved" in the overstuffed mattress sense, but is invested in businesses. It is capital.

Perhaps to those who naturally recoil to the word capitalism then Buffet's capital investments are a waste and should be re-allocated to the poor who will spend it, as money is meant to be spent. And in fact, after I responded to the professor, another in the group (it's worth noting most of the discussion group are Trump-hating liberals) stated that capital investments do not contribute to economic growth. If that doesn't strike you as ridiculous it will in a moment.

Before we get into the economics part, there are a few ways to question their statements logically without even getting into economic theory.

• If moving money from to capital investment to consumption boosts the economy, then why don't we move all of the money? Why aren't capital investments heavily taxed?
• If capital investments don't lead to economic growth, then why do so many businesses spend their money on it?
• If consumption is the primary driver of economic growth, why would we ever limit it? Sales taxes should be immediately abolished, and savings discouraged. The Fed would have every incentive to keep the inflation rates high.

Macroeconomic Growth Theory

If we include human capital and technology into the category of capital investment, then it is not only a way to drive economic growth, it is the only way to drive economic growth. The size of the economy is measured in GDP. The formula for GDP is:

GDP = consumption + investment + government spending + trade balance

What happens to GDP in the short term if we move money from investment to consumption? Nothing! What happens to GDP in the long term if we move money out of investments? It decreases. The only way it might make sense for increasing consumption at the expense of capital would be if there was excess production capital not being utilized. It would be an unusual circumstance, caused perhaps by a massive economic contraction. So universal basic income might make sense in case of zombie apocalypse.

Example: Sticks & Scones

Let's consider a very simple economy to see what effects capital investments can make.

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In Simpletonia there are two towns: Woodville and Cornucopia. Woodville is deep in the forest and their sole natural resource is wood. Cornucopia lies on the plains and their only resource is grain. The two towns are connected by a road of very poor quality. Grain is used to make scones, the only food in Simpletonia. A citizen needs at least a batch of scones a year to survive, two to be comfortable, and 3 or more for luxurious consumption. Wood is the only source of energy, used for heating and cooking. It takes one bundle of wood to cook a bushel of grain into a batch of scones. A citizen requires a minimum of two bundles of wood to survive the winter, four to be comfortable, and six for luxury comfort.

Citizens of Woodville work as either lumberjacks or bakers. There are three classes of residents in Woodville.

• Five are low-class. They consume a minimum of resources: one batch of scones and two bundles of wood.
• Four are middle-class. They consume two batches of scones and four bundles of wood.
• One is an upper class baron. He consumes three batches of scones, six bundles of wood for heating, and extra bundles to expand his palatial home.

The total food consumption is 16 batches of scones per year. The four middle-class Simpletons work as bakers; each converting 4 bushels of grain to scones, and using 16 units of wood in the process. Grain is acquired from Cornucopia. They are always happy to trade a bushel of grain for a bundle of wood. However the trip is treacherous, so the traders require payment of two bundles of wood for the voyage.

The baron owns all the land. He hires the lumberjacks to cut wood, and pays them enough for minimal subsistence. Any excess wood he uses for his own luxury.

The five lower-class citizens works as lumberjacks. They can each cut 20 bundles of wood per year. Wood consumption is as follows:

• 32 for consumption
• 16 for cooking
• 48 traded for grain
• 4 per year used by the baron to improve his mansion

Let's look at some different scenarios and how they might impact the Woodville economy.

Redistribution

Some Simpletons suggest that the economy could be improved by redistributing wealth downwards. A tax is levied. All the baron's extra wood is given to the poor, and his own consumption is lowered to 5. All the lower-class wood consumption is thus raised to 3, somewhat above subsistence but not quite to the middle-class level. Nothing fundamental has changed in the economy; consumption has just been shifted.

Expand labor

The baron realizes he can get more production out of the lumberjacks by making them work more hours. They lumberjacks now each cut 24 bundles per year, for 120 total per year. The baron hoardes all the extra lumber.

Infrastructure investment

Seeing how well Woodville is doing, the King of Simpletonia conscripts one of the lumberjacks as a road worker. Wood production falls to 96. However the road is improved so much that the traders now only demand one bundle of wood. The wood distribution is modified.

• 32 traded
• 32 consumed
• 16 for cooking
• 16 extra

Capital investment

The baron decides to invest his extra wood and uses it to build a bakery. The bakery is much more efficient, doubling the production of each baker. The baron hires 3 of the bakers, who make 24 batches of scones per year. This raises the food consumption of nearly everyone. All lumberjacks now get 2 scones per year, and the three hired bakers get 3. Only the 4th baker, now unemployed, does not see his standard of living rise. The wood usage looks like this.

• 48 traded
• 32 consumed
• 16 for cooking

Human capital / education

The unemployed baker heads to Simpleton University and is trained as a master in lumberjack management. After graduation he returns to Woodville and is hired by the baron. He improves lumberjack efficiency 100%. After cutting back their hours, the baron is able to let one go and still produces 120 bundles of wood per year.

Analysis

The process for growing the economy is consistent. Production improvements free up labor that can be used to drive even more improvements in efficiency, yielding even more production improvements, and so on. Investments in capital, labor, and technology are the only practical way to grow the economy. Then notion that transferring money downwards because the rich are hoarding it all is a myth: the money they aren't spending is being used for capital investments.

The Real Reason for Redistribution

In our example the workers were always able to make an appropriate transition. For instance the lumberjack was able to transition to road worker, since they're both low-skilled labor. The baker, being already somewhat skilled, was able to retrain into industrial management. Typically technology will tend to eliminate low-skill jobs and open up high-skilled jobs. This is one reason for our obsession for education. But what happens to the people who can't be trained up? Certainly we shouldn't expect the 80 IQ laborer to ever be qualified for intellectual pursuits. It's quite possible these people will be left behind. And as AI advances, the displaced will be of increasingly higher IQs until, at the technological singularity, all humans are replaced from the economy. So there are very real arguments for a redistribution of wealth, but economic growth is not one of them.