I think especially now, this time in American history it’s essential for everyone to understand the mechanics behind growing an economy as large as the United States has become, and the ramifications [or effect] both good and bad public policy has had on our annual growth rates. For this exercise I chose to dust off a Gross Domestic Product (GDP), “Expenditures Approach” model. It’s really a simple linear equation. This model is probably the most popular way to calculate annual GDP growth [or declines in growth which we happen to be experiencing at this writing]. I want to point out that those of you who were challenged by a course known as “Macro Economics” at the Master’s level in college back in the day will be all too familiar with this material and its derivations. You probably lost more than a night’s sleep over it! A somewhat straightforward-looking linear equation like this can get quite complex once it is broken down into its component parts then rearranged [by some professor] and subjected to sensitivity analysis. The way each component can affect the ultimate outcome for the U.S. economy can sometimes be [surprising]? We will cover a couple of these topics here today.

The GDP “Expenditure” approach is best represented by the [original] linear equation below:
GDP = C + I + G + NX, where
C = personal consumption of all goods and services, represents around 70% of all U.S. economic activity.
I = investment in capital goods, physical plant and equipment. This number is very volatile/cyclical but is typically between 15-18% of GDP, we’ll use 15% here.
G = government spending [of all kinds], including even the salaries of those employed by the federal government, takes up about 20% of our annual GDP output.
NX = the symbol for net exports, in other words American imports minus exports. Please note that the U.S. has run trade deficits for many years now [see my previous posts regarding the harmful effects of offshoring American manufacturing for the past three decades!], so this net exports number has been a drag on GDP ever since, reducing U.S. GDP by at least 3% per year and we’ll use a value of -.05 to represent this component.
t = personal income and corporate taxes. I’m using an overall tax rate of 20% for this example.

Delving right in, in order to isolate and point something out I’ll rewrite the formula [later] to it’s root form using a superscript ^g to represent the pre-tax or gross amounts for Consumption and Investment. I just want to pause here [first] for emphasis on an important concept. Government spending can only exist because of tax revenue right? So, if we eliminated tax revenue and government spending altogether here’s what the model could look like:
GDP – G_t⁰ = [[(C + I)/(1-t)] + NX.
What you’re looking at here is the same model in the absence of any taxes and government spending when in reality we all know that after-tax dollars are the only moneys that create any consumption and investment in this country. We also realize that the government has to be funded and that funding must come from these individual and corporate taxpayers. So let’s rewrite the function to look something like this below where we refund the federal government with revenue from taxation:
GDP – G_t = [(C^g + I^g) * (1 – t)] + NX, where C^g + I^g are reduced by taxation from (1 – t).
Note that expenditures involved in personal and business consumption were previously taxed otherwise these amounts could have been much larger right? Then we now show that t, (for taxes), is potentially additive to Government revenues and spending going forward, hence the symbol G_t.

To see what effects, if any, the value of t has on C and I, I’m going to multiply 1/GDP to both sides of the equation, and return to using the standard notation from the original model:
GDP/GDP – G_t/GDP = [C + I + NX]/GDP
Thus , 1 – G_t/GDP = [C + I + NX]/GDP
Given this, it’s time to insert percentage weightings for each component of annual U.S. GDP growth [or decline]. I set the value of GDP itself @ a maximum weighting of 1.0, representing 100% of total output just for example purposes here. Now solving the equation for parity, as again we already know from the original model that GDP minus Government Spending has to equal Consumption plus Investment plus Net Exports, therefore –
1 – (.20/1.0) = (.70 +.15 – .05)/1.0
.80 = (.85 – .05)/1.0
.80 = .80
Okay, all good but we’re still not done yet, now we want to increase the tax rate, t, from 20 to 30% just to see what [if any] a higher tax rate will have on total U.S. output, or GDP [in the form of Consumption, Investment and Net Exports].
So now we have, 1 – (.30/1.0) = (C + I – NX)/1.0
.70 = (C + I – NX)/1.0
Here we see that values for Consumption and Income and Net Exports must decline or compress in order to achieve parity to accommodate the higher tax burden of 30%, which results in reducing values of C + I especially in order to equal only .70 from the above example. The take away from this exercise is to understand that government spending, along with increased tax burdens, can eventually crowd out personal consumption and investment, and result in a substantial negative for future GDP growth.

Is government spending all bad? Absolutely not! In a true capitalist society a delicate balance exists between government spending and personal and business consumption, a balance that must be maintained in order to protect the future of the Republic. I shake my head at these people that call for no government spending at all, that’s not the answer, because it turns out that the U.S. government is one big customer, and an important component of U.S. GDP. So we do need government spending, but only when it’s responsible is it ever a healthy add to our GDP growth. However, personal and business spending [along with maintaining low tax rates] remain THE MOST IMPORTANT ingredients to sustaining healthy annual GDP growth, always. Conversely, under Socialism the “investment” component, C, in this model would not even exist; it disappears because in this case a Socialist government takes over that effort. Once again, government spending can crowd out “Investment” and harm personal consumption should it get too large. Instead, increasing incentives to run private business enterprises are vital for the preservation of a capitalist society, whereas taxing authorities are the bottom feeders of any society. You read that correctly, the federal government is a “bottom-feeder” in a truly capitalist society. That’s easy to see as we have so many incompetents these days in key policy positions in Washington, D.C. and it’s agencies. This fact is beyond scary to say the least, and I worry daily over the abundance of ignorance that is displayed. Government spending as a percentage of U.S. GDP should never become the dominant factor [ever], lest we lose our Constitutional Republic.

Raising tax rates and/or finding new ways to tax society is never the answer in building and maintaining a strong economy. All that does is discourage what drives innovation and growth, the personal and business consumption of goods and services, and job creation. One thing that would greatly reduce the amount of government spending is to stop the constant financial supporting of foreign countries. No matter if they hate us or not, we are not responsible for the world, just our own borders. To me if our federal government has even $1 available to give away to another country then [in my mind] this means that our government has over-taxed society-at-large. 😉

Addendum: Last but not least I want to point out something interesting regarding the use of this simple linear equation for U.S. GDP. A Polish economist by the name of Michal Kalecki earned a PhD, in fact it may have been his doctoral dissertation paper [on the subject] that earned him worldwide recognition. He researched and demonstrated [mathematically, using this same model] that “deficit” spending is actually essential to U.S. GDP growth; whereas when the American government was ever on a “diet” and balanced our federal budget, our economy always suffered, falling into recession each time. The fact of the matter is that the U.S. government has only operated under a balanced budget seven times in its history and each time it did precede a recession. The last one to achieve a balanced budget in Washington was President Bill Clinton in his final year in office, the year was 2000. Do you remember the recession that began in earnest in the year 2000? I’ll never forget that bear market in stocks as it lasted 2-1/2 years. 😉

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