“Real” Growth vs. “False” Growth

Real economic growth is not something that can be manufactured by fiscal tyrants and well intentioned politicians.  It’s something that happens naturally.  When profitable businesses are free to invest their funds in capital goods, both the rate and size of production increase.  In a free market, increased production leads to lower prices, more jobs, and higher wages (in other words, a better standard of living for everyone).  However, when a portion of profits are confiscated by governments, it impedes the investment process, which in turn slows down economic growth.

Not all growth is created equal.  There are many times throughout history when government actions have stimulated growth in the economy.  The “housing-bubble” of 2008 is a perfect example of manufactured growth.  The government action in this case was the manipulation of interest rates.  We often think of interest rates as instruments used by the Federal Reserve to affect the economy, one way or another.  However, this notion is utterly false.  It is economic activity in the marketplace that actually sets the interest rates.  Therefore, when the “real” interest rate is distorted by government action, people end up making financial decisions based on false information, which leads to unexpected losses and malinvestment.  In other words, the bubble bursts.

Governments can also create false growth by injecting money into the economy.  Monetary stimuli, bailouts, and subsidies are all examples of the government taking action in order to create growth.  The problem with the injection policy is that governments must take the money from one place and put it in another.  Governments cannot create wealth, they can only confiscate it, borrow it, inflate it, or redistribute it.  Think of it this way:  what if instead of allowing your child to grow naturally, you redistribute the energy necessary for brain development into the rest of the body.  What you end up with is a 7-foot tall ten-year-old that is incapable of even the most basic mental functions.

There is another form of stimulus that governments often employ in their attempts to create growth; tax breaks.  Tax breaks are basically an indirect form of stimulus.  Instead of taking money from one sector of the economy and giving it to another, governments simply allow certain corporations to pay a lower tax rate than everyone else.  Sounds good, right?  Well, the problem with this strategy is that instead of the consumer deciding which companies are deserving of financial gain, it is government that decides who wins and who loses.  Tax breaks create an economy of haves and have nots.  Government puts certain businesses (usually those that are politically connected) at a distinct advantage over the competition, which ultimately hurts the consumer and the economy as a whole.  Tax breaks can create some real growth, but often times the growth happens in places where the capital investments end up being wasted.  The growth is created by the special interests of a few as opposed to the wants and needs of the masses.

Can government do anything to create growth?  If nothing is something, then government can definitely do something to spur economic growth; stay out of the way.  Inaction by the government is the only way to spur real economic growth.  Basically, individual States can positively affect the marketplace by reducing government interventions. Generally speaking, states with lower taxes on business, lower minimum wage requirements, and fewer regulations tend to have better economic growth.  Of course, statistics on economic growth can always be skewed one way or the other in a managed economy.  Whenever a governmental authority attempts to influence the economy, it always leads to some sort of distortion.  However, as a rule, less interference leads to more growth.

 

It’s All About The Capital

No, I’m not talking about Providence.  Economic experts, politicians, and talk-radio hosts have offered a multitude of ideas for how the smallest state can create the greatest growth.  For example, some people believe that the state should abolish the sales tax.  It’s an interesting idea, and it would likely boost consumer-driven economic activity.  That being said, sales taxes are added to the cost of goods and their elimination would not alter the profit a business makes on any given product.  While it is possible businesses could see more patronage overall, it is impossible to predict with any level of certainty.  People may decide to take their sales tax money and put it in a jar to help pay for an island vacation.  Maybe they will take it to Foxwoods.  Neither of those actions would help Rhode Island businesses.

The most important factor in the growth of any economy is capital.  Now, when some people hear the word “capital,” the first thing that comes to their mind is money.  Capital is not money.  Money is used to make capital investments and purchase capital goods.  For instance, if a shipping company has $40,000 in the bank, it doesn’t mean the company has $40,000 in capital.  The shipping company only has capital if it invests the $40,000 in new forklifts, trucks, automatic sorting devices, etc.  If companies cannot increase capital, they cannot grow.  It’s really that simple.  It is a common myth that the owners of successful companies would simply spend increased profits on higher compensation for themselves.  Owners that spend their money that way will never grow their business without the help of government subsidies, and in a free market, government subsidies don’t exist.

So what does capital do?  Why is it so important?  Certain capital investments, like a farmer replacing a broken combine, are essential for production to continue at its current levels.  However, to compete effectively in the marketplace, that same farmer must also invest in capital goods that boost production.  To use a different example, if a piano teacher who drives to her students’ houses for lessons decides to invest in a small studio, she can see more students each day in the extra time that isn’t being spent commuting from lesson to lesson.  With the extra money she makes from the increased number of lessons, she might be able to afford to hire a video production team to create an instructional video.  Now, the number of students she can teach is practically endless.  This is how capital grows a business.

Government makes it hard to accumulate capital by using taxes, fees, and regulations to take money from a business owner who might otherwise spend it on capital investments and uses it towards other ends instead.  Now, certainly, businesses must pay taxes in order to help maintain roads, pay for police and fire services, and fund schools that educate the next generation of prospective employees.  However, these services should not be based on business/corporate income, but on property.  Doing business should not be a taxable activity, mainly because the act of making economic transactions doesn’t cost the government anything.  That being said, operating a business does cost the government money to pay for the services previously mentioned, and the local property taxes that businesses pay should suffice.

 

So What Can Rhode Island Do?

If the State of Rhode Island wants to grow the economy, it needs to allow businesses to build capital.  The best way to accomplish this is to eliminate the business corporations tax.  Lowering it from 7% to 6% or even 4% will not be a game changer.  Eliminating the tax all together will not only allow companies in the state to accumulate the capital they need to grow, but it will attract businesses from other states as well.  The government doesn’t need to lure business to the state by offering special tax breaks; we’ve already discussed how that policy negatively affects the economy.  We not only need to attract big corporations to the state but we also need to allow small business (the backbone of any healthy economy) to thrive.  Eliminating the business corporations tax will allow ALL companies to accumulate capital and compete on a more level playing field.

Now, the first question often asked of me when I propose this idea is, “how is the state going to make up that revenue?!” Well, quite simply, the state isn’t and doesn’t need to “pay for” the tax cut by increasing revenue someplace else.  The state needs to cut the budget.  Upon hearing this, the next question most often asked of me is, “how can the state function after slashing the budget?  We can’t afford to cut important government programs.”  First of all, it’s hardly slashing the budget, and the good news is the state doesn’t need to eliminate one single government program in order to repeal the tax.

So how much does the budget need to be cut, and how can the state avoid shutting down programs?  According to the proposed 2017 budget, the business corporations tax is expected to generate roughly $163.6 million in an $8.9 billion budget.  The tax revenues amount to about 2% of the entire budget.  So, instead of picking and choosing which programs can stay and which programs can go, the state should simply cut every line-item in the budget by 2%.  Think about that for a minute.  We can become only the third state in the nation, along with South Dakota and Wyoming, that doesn’t tax business and corporate income, and all we need to do is cut two cents out of every dollar the state currently spends.  A government program budgeted for $100,000 will do just fine with $98,000.  Don’t you think?  Of course, there are some line-items in the budget that can’t simply be cut, like contractual obligations.  However, and for the sake of argument; even at a 3% cut government programs should still be able to function well.

The state of Rhode Island has an opportunity to change the game.  Unlike South Dakota and Wyoming, Rhode Island lies in between two of the largest economic centers in the nation (Boston and New York City), as well as markets like Hartford, Worcester, Stamford, and Springfield.  The proximity to the economic centers of the Northeast Corridor and the absence of taxes on corporate income will be a combination no company could ignore.  Also, unlike South Dakota and Wyoming, we have easy and immediate access to the ocean.  Our ports would be busier than ever.  Perhaps most importantly, small businesses will be able to invest in the kind of capital that can boost production.  As production increases, the standard of living increases, and Rhode Island could certainly use a standard of living increase.