Posted by: Dirk | March 27, 2015

Old economic thinking in the UK

There is a rift in the economics profession, and here is a very good example why. Economics textbook author Alain Anderton writes in The Guardian:

The first concept an A-level student may well learn is the principle of opportunity cost. If you buy a car, you lose the benefits of what you could otherwise have bought with that money. If the government cuts taxes, what are the benefits that are going to be lost as a result of that decision, benefits like higher government spending or a lower national debt? However, to some extent we get the politicians we deserve. Too many people seem to think that there are simple answers to complex problems; we don’t want to pay for the choices we make. For example, we want high-quality public services but we don’t want to pay for them in taxes.

Our grasp of economics would be more mature if the acceptance of costs and benefits that are being acknowledged in classrooms were also being acknowledged at our dinner tables, in our local council chambers and in parliament.

The funny thing is that Anderton is ignorant of the idea that the principle of opportunity cost holds only in microeconomics (the example with the car), but not in macroeconomics (the example with the taxes). How is that?

A household – or a member of a household – indeed loses the benefits of what she could otherwise have bought with that money. This is simple microeconomics, where we look at (single) households and firms. They face a hard budget constraint and a given supply of goods, at least from the perspective of the household.

With taxes, this is a different thing. Anderton writes: “If the government cuts taxes, what are the benefits that are going to be lost as a result of that decision, benefits like higher government spending or a lower national debt?” This is a macroeconomic question, which means we should think in terms of a system and not in terms of one (or more) individuals. So, if the government cuts taxes, this will not leave incomes (and GDP) at the old level. Economists of all stripes – including those of Reagan and Bush, or Thatcher and Cameron – agree that tax cuts leave the private sector with more deposits and, if cuts are across the board, this will lead to more spending, more output, more economic growth.

So, Anderton’s textbook must be an outlier, since most textbooks on economics clearly state that expansionary policies, like increasing government spending or cutting taxes, are expansionary. Thus, tax cuts lead to higher incomes, which lead to higher tax income. Opportunity costs hence do not work on the aggregate level. And I thought economists have known this back since the 1930s, not only because of this gentleman.


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