Posted on 05/19/2003 5:46:37 PM PDT by Exton1
Velocity of money and why tax cuts work.
Velocity of money* is the movement of money from one person or entity to another. Money moves through a series of products and services, doing multiple jobs at once. Each dollar becomes more valuable, increasing the effective rate of return significantly. In effect, the movement of money is the same as having more money; hence the term “velocity of money multiplier effect.”
So if you count the number of hands a dollar goes through in one week, from you to the baker, from the baker to the gas station, to the baby sitter, and on and on, it could turn over as many 10 times or more. This would mean to the economy, that the one dollar you originally spent bought ten dollars worth of items or services. This turnover of the dollar is called the velocity multiplier. Since the dollar went through 10 different hands the multiplier would be 10.
However, if the money goes to the government in the form of a tax, or fee (basically the same thing), the multiplier number would drop to about 2 or 3. There are several reasons why this drop happens, one reason is that approximately one third of the dollars taken in by the government is wasted. Another reason is that the time needed to process your check and have it go through the government system takes the money out of circulation for a period of time. This lag time slows the number of times the dollar can turn over. Further, the government sometimes spends the money overseas, which takes it out of the US economy for an even longer period of time, dropping the turnover to 1 or 0.
Taxes act like a brake on a moving car; the higher the taxes, the slower the turnover, the less money traveling through the system. If the velocity of money multiplier is too high, the country experiences inflation, if it is too low a depression.
This multiplier effect is very important when trying to understand why the government takes in more money after reducing taxes, and less when it raises taxes. The reason being that with lower tax rates more money is circulating through the economy and more people have more money to pay taxes on. When taxes go higher, there is less money circulating, meaning fewer people have less money to pay taxes on.
Therefore lowering the tax rate would be a boost to a slow economy because it would give more people greater purchasing power.
For those wanting to do the math, the following is an example.
Let us assume that the government has a choice of taxing you at 60% or at 25%, which would bring it more money?
At a tax rate of 60% would bring the multiplier down from 10 to 4 (60% of 10 is 6, 10-6= 4). However the government also wastes about one-third of what it brings in, therefore reducing the multiplier even more, and lowering it to approximately 2, or that the dollar would only turnover twice. By using the same method the multiplier for a 25% tax, with one-third wastage, would bring the multiplier to approximately 6.7.
What this means is that at a 60% tax rate over a one-week period, two people would each pay $0.60 in taxes for every dollar they made for a total of $1.20 in taxes ($0.60 x 2 =$1.20). With a 25% tax 6.7 people would each pay $0.25 in taxes for every dollar they made, for a total of $1.68 in taxes ($0.25 x 6.7=$1.68). In addition the lower tax rate would leave almost seven people with $0.75 each in purchasing power as opposed to two people with $0.40 each in purchasing power.
*It is an indicator used in the Federal Reserve Board’s management of Monetary Policy, and is calculated on yearly turnover.
You also have to factor in the fact that as the money changes from your hands to the governments hands, you have received nothing of value in the exchange. Yes, yes. I know the money eventually gets spent on something tangible whether it be asphalt for a highway or a diamond necklace for a mistress, but that would be like going to a diner and ordering a sandwich but all you get is an empty plate and the owner of the diner takes the money you gave him and buys himself a pack of cigarettes. Yes, money changed hands and eventually something of value was received by somebody but somebody else got screwed out of something in the process.
Personally, I define waste as follows:
Type A Waste is spending public money on completely unnecessary things. A $500,000 study of the sex life on the yellow-bellied red-crested snail darter is an example of this.
Type B Waste is spending public money on things that are arguably necessary, but spending excessively high amounts of money relative to the amount of goods/services purchased. For example, suppose the Navy needs 50,000 new computers to support its business processes. An impartial cost analysis determines that the required performance level and life-cycle supportability can be achieved at a cost of $2,000 per computer, or a total cost of $100,000,000.
However, because Senator Larson E. Pettifogger's biggest campaign contributor and drinking buddy, Joe Schlocker, owns a computer business, and because the Senator is an effective log-roller, the Navy is told to skew the cost analysis in favor of the Schlocker Enterprises computer at $5,000 apiece, or $250,000,000, on pain of getting long-lead items for their next aircraft carrier deleted in the next House-Senate budget reconciliation conference--an aircraft carrier that all parties, interested and disinterested alike, agree is necessary for the Navy to perform its mission in support of American foreign policy and national strategy, and that delay in procuring that aircraft carrier is going to degrade the Navy's ability to perform its mission during the period it otherwise would be available.
This means, first, that the nation has paid $150,000,000 more than needed for a specific good.
Second, if the Navy resists this pressure, the Navy will pay a price--in being good stewards of the public's money, they will be less capable of performing their mission. However, Senator Pettifogger isn't the only Senator playing this game. If this happens often enough and long enough, the Navy will be virtuous in managing the public's money--and unable to perform its mission.
The key thing to understand is that government spending, for all of its massive AMOUNT, actually moves money quite slowly. It's not unheard of for federal contractors to go from six months to over two years without getting paid. (Incidentally, the odds of getting stiffed appear to increase with the basic constitutional legitimacy of the contract; Senator Pettifogger's pork barrel projects get paid for in a relatively timely fashion, while many defense contractors wait YEARS to see a check.) It's in the nature of the beast; any expenditure of public monies SHOULD be accompanied by due diligence to ensure that Uncle is not defrauded.
Anything that increases the total money spent by the government inevitably slows the velocity of that money.
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