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The Economy Hits Home:

What Makes the Economy Grow?


Everyone should want the economy to But this idea is fatally flawed. First, our
grow. A growing economy puts more economy isn’t like an apple pie sitting
money in families’ pocketbooks and on the counter getting cold. With the
charities’ budgets, the poor and unem- right conditions, we can create more
ployed have an easier time finding jobs, wealth: That is, we can make the pie
and families saving for retirement or grow. Some create more than others
their children’s education can see their and may end up with bigger slices;
nest eggs grow. but in the long run, everyone can end 1
up with a bigger slice than they had
So what makes the economy grow? before. That’s a win-win.
You don’t need a degree in economics The second problem with the apple pie
to answer this. Common sense can idea is this: Who’s doing the slicing?
help expose some popular but mistaken Usually that task is assigned to the
myths about the economy. federal government, but the govern-
ment didn’t bake the pie in the first
Many think of our economy as if it
place. American work and ingenuity
were a big apple pie with that flaky
did that. So when government tries to
criss-cross crust on top. You can slice
slice the pie into equal pieces, it’s sim-
the pie this way or that. You can cut ply spreading income around by taking
eight or 10 or 12 equal slices, or you from some and giving it to others. At
can cut some slices thinner than others. best, that’s win-lose. And by picking
If you cut one of the slices really thick, winners and losers, such a policy dis-
though, you’ll have to cut the other torts the incentives that lead those who
slices thinner. It’s a trade-off. So it produce more to do their best, which
seems unfair that some should have means they produce less, they earn less,
and the pie shrinks.
more than others. It seems fairer to
slice the pie into equal slices. Trying to spread income around by

Contributors: Leslie Carbone, author, Slaying Leviathan: The Moral Case for Tax Reform (Potomac,
June 2009). Jay Richards, author, Money, Greed, and God: Why Capitalism Is the Solution and Not
the Problem (HarperOne, May 2009).

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
redistributing what people have earned saves rather than spends some of the
through their own efforts actually hin- proceeds, he can invest the money and
ders the creation of new income. And create even more income in the future.
creating more income—growing the
This isn’t rocket science. It’s common
pie—is the only known way to increase
sense, and it’s been true for thousands
overall prosperity.
of years. But in Washington, unfor-
Fortunately, we know how to grow the tunately, it’s not very common. In an
economy—how to make the pie bigger: economic downturn, it becomes down-
by individuals working and trading right rare. Many lawmakers use tempo-
and creating freely, not by government rary downturns to increase their power
taxing away our income, restricting our permanently by taxing, spending, and
2 economic freedom, and spending our borrowing rather than supporting poli-
money supposedly on our behalf but cies to grow the economy.
really on its own priorities. (To see the
Of course, some of the federal govern-
link between economic freedom and
ment’s work—such as administering
prosperity, see the Heritage/Wall Street
the judicial system and maintaining
Journal Index of Economic Freedom.)
national security—is vital to society
Think of a dozen engineers at Apple and the economy. But income redistri-
Computer who invent an easier way bution and other forms of government
to find information on the Web, meddling often shrink the pie or keep
which Apple then includes on its new, it from growing. They take income
wildly popular iPhone. Thousands away from those who earned it and
of people buy and enjoy the new give it to those who didn’t. In the
iPhones, providing jobs for Apple process, they divert resources to less
employees and money for future productive uses and thus impede the
research at Apple. New income and creation of new opportunities that
wealth has been created. would otherwise benefit everyone in
the long run.
Similarly, when a farmer tends an apple
orchard and then sells the apples, he For instance, when the government
gets money to buy what he needs for imposes a tax and takes income from
his own use and to sustain his apple Apple Computer or the apple farmer
business, while customers get the and hands it over to somebody else,
apples, which they prefer to the money it is merely redistributing—not
they give the farmer. Income has creating—income. Total income has
been created by developing products not increased by one penny, and the
that consumers want. If the farmer government has discouraged both

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
Apple and the farmer from creating customers will be in the market and
more products of value to others. willing to pay an adequate price.
So what really does make the economy When these elements are in place,
grow? individuals invest in their own abilities
through education and training, and
The economy grows when individuals
so increase their value to the market.
and businesses recognize new markets
When these elements are in place,
and new opportunities and have suf-
businesses invest in new production
ficient confidence to accept the risks
facilities in the hope of expanding the
involved in pursuing these opportuni-
quantity or range of their products and
ties in the hope of earning income
to employ the latest technologies to
if they are successful. Each of these 3
reduce cost.
elements is important, like a recipe of
many ingredients. The absence of any Importantly, economic growth is
ingredient would diminish the taste not the consequence of government
of the dish. For example, the economy policies or of some master economic
grows when someone sees an oppor- plan. It results from millions of people
tunity to meet a need and can marshal individually seeking what is in their
the resources to meet that need. That own interests by providing what is
need may be to supply an existing good in the interests of others, and the
to a new market, or it may be to sup- collective consequence of their actions
ply something brand-new, like Apple is to increase the number of jobs in
Computer’s file-sharing program in the the economy, the wages earned by
example above. workers, and the income and wealth of
the nation.
For the supplier to meet the need,
however, there must be a marketplace But lawmakers rarely admit these
in which the supplier can meet poten- realities. The idea of transferring
tial buyers and where they can settle income from families and businesses to
on a price. The supplier knows there government gets repackaged in all sorts
will be risks involved, and so must have of creative but deceptive ways. We hear
some confidence about a whole range talk about stimulating the economy,
of issues to be willing to accept those creating jobs, putting people back to
risks. For example, he must be confi- work, bailing out allegedly critical
dent that his goods won’t be stolen by industries, and making the rich pay
someone else or confiscated in whole their “fair share.” Though these myths
or in part by the government, and he are all variations on the same theme,
must have some confidence that the let’s deal with them one at a time.

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
Growing the Economy:
Separating the Myths from the Facts

MYTH #1: Government spending grows with taxes or by borrowing, it is not


the economy by pumping new money creating new income; it is merely
into it. redistributing existing income.
FACT: Every dollar that government Because government must first take
“injects” into the economy must first or borrow money from people before
be taxed or borrowed from families, spending it, the claim that pumping
businesses, or other nations. new money into the economy will
4 grow the economy is ill-founded.
In tough economic times, lawmakers
often launch new spending programs
to rev up the economy by “injecting”
MYTH #2: Government spending makes
money into the economy. But this
people more productive.
approach does not increase produc-
tion or create new income; it only FACT: Government spending often
moves money around within the encourages behavior that has bad
economy. In other words, it does economic consequences.
not encourage growth in either the Some government spending can
overall economic pie or the family improve our productivity. In some
bank account. cases, for example, additional spending
Think of your family’s savings. If you on infrastructure can reduce transpor-
want to increase your investments in tation costs and increase productivity
a savings account without earning within the transportation sector,
more money or taking out a loan which then permeates much of the
that must be repaid, then you have to rest of the economy.
take that money from another part of Government spending on basic
your savings, such as your checking research can also increase incomes and
account. You haven’t increased your productivity in the long run. Basic
savings; you’ve just shifted existing research is often exceptionally high-
savings around. cost, is highly uncertain, and typically
The same logic applies to govern- generates returns many years after the
ment spending. Governments don’t initial investment (think of the space
create new income out of thin air. program, for example). These factors
When Congress funds spending discourage the private sector from

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
These cases are relatively few, however,
The Keynesian Myth and many government programs
fuel choices that actually make the
Using taxing and spending to economy worse. Welfare programs, for
manipulate the economy is frequently example, generally encourage recipients
called Keynesianism, after John to rely on government handouts rather
Maynard Keynes, the 20th century than to work. This is why welfare
economist. Keynes’s followers argued reform efforts that require recipients
that government should tax during to find work tend to succeed: They
times of prosperity and borrow and encourage choices that help both the
spend during economic downturns to individual and the community. Work
keep the economy growing at its ideal gives people dignity because it allows 5
pace. His theories influenced much them to become more self-sufficient
of 20th century big-spending policy, rather than depending on government
epitomized by Presidents Franklin assistance. And their work makes the
Roosevelt and Jimmy Carter. However, economy more productive.
Keynesian economics is fatally flawed.
In the same way, federal unemploy-
Behind the Keynesian myth is the ment insurance programs, which pro-
notion that the government has its vide income for individuals who have
own pot of money sitting around been laid off, create an incentive for
waiting to be spent—and the only individuals to remain unemployed so
question is how best to spend it (for that they can continue to receive insur-
example, through bail-outs, public ance payments. Federal flood insur­ance
works projects, or stimulus rebate programs encourage people to take
checks). The pot doesn’t exist. Every risks by building houses in flood plains.
dollar that government “injects” into How many people would actually build
the economy must first be taxed on a flood plain without insurance
from current citizens or borrowed and against floods? Some private insurers
repaid by current and future citizens. would accept such a risky venture, but
No new income is created. It’s merely only by charging a far higher premium
redistributed from one group of for the insurance.
people to another.
Besides encouraging bad choices,
government programs often discourage
investing adequately in basic research good economic choices. For example,
and provide a rationale for government individual saving provides the capital
spending in strategic research areas. for investment in new technologies and

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
new production facilities; but govern- once said, “If you want to encourage
ment programs to cover retirement something, reward it. If you want to
(like Social Security and Medicare), discourage it, punish it.” His words
housing (the low-income housing tax ring true 2,500 years later.
credit), and education expenses (Pell Bailouts for private companies usually
grants) discourage saving. Why set mean that failing companies receive
aside funds for big-ticket expenses taxpayer money, while their more
that gov­ernment says it will pay for? successful competitors do not. Does
Other government pro­grams—such as that make any sense? In the real world,
Medicaid, which funds health care for investors seek to put their money
the poor—have eligibility rules that where it is most valuable; that is, in
6 encourage individuals to keep their companies that succeed, not those that
incomes lower in order to qualify. fail. In the alternate world of govern-
Does this mean that society and ment bailouts in which lawmakers
individual citizens should do nothing spend taxpayer money rather than
to help the poor and unemployed? Of their own, failure is rewarded and suc-
course not. But we have to weigh the cess is punished.
real economic costs of government- With the frenzy of bailouts for private
controlled programs, especially income- companies, states have tried to hop
transfer schemes, against their real aboard the federal bailout gravy train to
as opposed to promised or imagined close budget gaps that result from their
benefits. If lawmakers actually did this, own overspending. After spending
few of these programs would exist beyond their means, they then argue
in their current forms, since most do that it would be in the best interests of
more harm than good. their taxpaying citizens to get a bailout
from the federal government.
A federal bailout of the states, however,
MYTH #3: The federal government
should bail out faltering industries and would transfer money from families
states to revive the economy. in states that have resisted extravagant
spending programs to other states
FACT: Bailouts harm the economy that have spent more recklessly. This
because they reward reckless pri- makes no sense. Imagine you have two
vate and state spending, leaving it sons, Peter and Paul, and you give each
unchecked and effectively encouraging
a weekly allowance. Paul spends his
more of the same in the future.
whole allowance on the first day; Peter
The Greek philosopher Aristotle budgets so that he’ll have spending

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
money throughout the week. Would general-fund budgets. Collectively,
you take money from Peter, who saved, they increased spending by 6.2 percent
to pay Paul, who spent? Of course annually. All booms eventually end,
not. That would not only be unjust; however, and these free-spending
it would teach both boys that careless states were unprepared for the
spending will be rewarded. 2002–2003 economic slowdown. Yet
instead of paring back their bloated
In the same way, it’s wrong to force
budgets, they demanded and received
families who have elected responsible
a $30 billion bailout from Washington
stewards in their states to pay for the
in 2003. Guess what happened? After
folly of those in other states who have
the 2003 bailout, states went right
elected irresponsible spenders.
back to spending—with states’ annual 7
Moreover, such schemes encourage budget hikes averaging 7.2 percent
responsible states to be less responsible over the next four years. Encouraging
next time: They figure that if they have such behavior is not only foolish; it is
the choice, it’s better to get a bailout also wrong.
than to pay for it. When states can
simply withdraw whatever money they Congress should resist such bailouts and
want from the federal ATM—money instead leave state governments to set
that has been earned by families in priorities, make trade-offs, and reduce
all 50 states—why bother budgeting unnecessary spending. And states that
responsibly? Their attitude becomes insist on deficit spending should not
one of spend now, bailout later. demand that Washington plunder
responsible states on their behalf.
Recent history bears this out. Because
most states depend on income tax rev-
enues—which vary a lot from year to MYTH #4: Public works projects stimu-
year—common sense tells us that they late the economy by creating new jobs.
should save during booms to cushion
Fact: In the short run, public works
the inevitable recessions. Instead, many projects have no real effect on overall
states keep responding to temporary unemployment. They simply displace
revenue surges with new permanent resources that could be used to
spending programs. create jobs in the private sector and
move those resources to the govern-
Between 1994 and 2001, for instance,
ment payroll.
most states were flush with new
revenues. But instead of building up Nowhere is the myth of public works
rainy-day funds, many expanded their spending more widespread than in

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
highway spending. As we saw in our MYTH #5: Tax cuts simply pad the
previous examples, before the govern- pockets of the rich without helping a
ment can spend money hiring road weak economy.
builders and purchasing asphalt, it FACT: Smart tax cuts encourage work,
must first tax or borrow that money savings, and investment to help stimu-
from other sectors of the economy. late economic growth that benefits
Deprived of that money, other sectors people across the board.
must contract, leading to a loss of jobs.
Some argue that cutting taxes,
Again, this should be common sense. particularly tax rates, doesn’t help a
Suppose a family is saving money to weak economy and might even make
build a swimming pool. This would, of it worse by increasing deficits. This
8
course, provide work for the contrac- ignores the way in which people at all
tors and workers who would build income levels benefit when the overall
the pool. Now suppose the family economy grows. It also misses what
learns that they are expecting a new creates growth in the first place. As we
baby. They decide that a swimming have seen, government spending does
pool would be too dangerous with a not increase income; it merely diverts
little one around, and what they really income from some people to others.
need is an addition to their house. The United States has what is called
So, instead of hiring people to build a progressive income tax. This means
the pool, they hire people to build the that, as a family’s income rises, so does
addition. This provides work for labor- the rate at which their income is taxed.
ers on the addition, but it is instead of, The last dollar earned is taxed more
not in addition to, the work that would heavily than the first dollar. There
have been done by the pool builders. is nothing fairer about a progres-
Public works schemes are like this, sive tax system when compared to a
except that they often do more harm proportional tax in which taxes would
than good. That’s because, like state increase proportionally with incomes,
bailouts, public works projects tend and a progressive system does far more
to direct resources to less productive, damage to incentives that generate
inefficient projects like “bridges to economic growth such as working, sav-
ing, and investing.
nowhere” (a boondoggle recently
proposed by Congress). This hinders For example, suppose a parent pays
economic growth, which ultimately is a child an hourly wage for help-
about increasing productivity. ing around the house, but the wage

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
decreases after each hour. The child’s create new ones. This in turn requires
motivation will wither along with his consistently higher investment in new
hourly wages. production facilities and technologies
The same problem exists in the adult and a motivated, productive workforce,
world. For the economy to grow, busi- and investment requires that businesses
nesses must either produce increasing and individuals have financial resources
amounts of goods and services or to invest.

New deal or raw deal? 9


History has a lesson for those who want to pump up government spending to
“stimulate” the economy and create jobs: During the Great Depression,
President Franklin D. Roosevelt’s New Deal programs never drove unemploy-
ment lower than 20 percent. The jobless rate actually climbed during the
second phase. The onset of World War II, not government spending, prompted
America’s economic recovery.
Unemployment Rate for Non-Farm Workers, 1926-1947
FDR’s first Supreme Court declares much
New Deal of New Deal unconstitutional
40%
New Deal, Part 2, begins
35%
World War II begins
30%
U.S. creates “war economy”
25% U.S. enters WWII

20% 5.5% — Normal


Stock unemployment
15% market rate, 1970–2008
crash
WWII
10% ends
5%

0
’26 ’27 ’28 ’29 ’30 ’31 ’32 ’33 ’34 ’35 ’36 ’37 ’38 ’39 ’40 ’41 ’42 ’43 ’44 ’45 ’46 ’47
Sources: Department of Commerce, Census Bureau, Global Insight heritage.org

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
Yet imposing higher tax rates on the the more you earn, the more of your
last dollars earned shrinks the amount additional income you can save and
of money a worker keeps as he creates invest—but also the more tax you pay.
more value. These taxes discourage That’s why lower tax rates on those
all of the wealth-creating activities dollars encourage working and saving,
mentioned above, since the last dol- which, in turn, grow the economy.
lars earned are the ones most likely
History confirms common sense. High
to be saved and invested rather than
tax rates were reduced during the
consumed.
1920s, 1960s, and 1980s. In all three
Think of it this way: You spend your decades, lower tax rates contributed to
10 first dollars on necessities like food increased investment, and robust eco-
and rent, which everyone needs; but nomic growth followed: The economy

Lower Taxes Result in More Jobs


The 2003 tax cuts sparked a growing economy that created more than 9
million jobs — more than 2 million jobs per year for four-and-a-half years.
Number of U.S. jobs, in millions
150
Jan. 2000 – May 2003: May 2003 – Nov. 2007:
985,000 new jobs 9.1 million new jobs
(+0.72%) (+6.63%)

145

Recent
economic
downturn
Tax cuts
signed into law
140 May 28, 2003

135
2000 2001 2002 2003 2004 2005 2006 2007 2008
Sources: U.S. Bureau of Labor Statistics / Haver Analytics heritage.org

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
grew by 59 percent from 1921 to 1929, over fake stimulus schemes that only
42 percent from 1961 to 1968, and 34 put money in consumers’ pockets for
percent from 1982 to 1989. the short run.
But lawmakers often reject tax cuts Reporters and lawmakers should ask
and spending restraint that foster which policies will best encourage the
long-term economic growth. Instead work, savings, and investment needed
they propose stimulus gimmicks to to expand the economy’s capacity for
“put money in people’s pockets” and growth. Such growth benefits not just
“get people to spend money.” They are the rich, but also those who are looking
counting on taxpayers to notice the for jobs, those who are saving for their
check in the mail while markets ignore kids’ educations, or those who are sim-
the borrowing that financed the check. ply hoping to increase their earnings 11
from hard work.
Take past tax “rebates” as an example.
Washington borrowed billions from
investors and then mailed that money
to families. In 2001, typical families
received $600; in 2008, it was $1,200.
This simple transfer of borrowed Proportional Taxation vs.
money had a predictable effect: The Progressive Taxation
consumer spending rate went up, while
investment spending went down. No It seems fair that those who earn
new income was created because the more should pay more in tax. The way
so-called rebates did not increase pro- to achieve that is with a proportional
ductive behavior: No one had to work, tax. For example, say someone
save, or invest more in order to receive earning $40,000 pays $4,000 in tax.
a rebate. Does anyone really believe Someone earning $80,000 would
that we can improve our economy by then pay $8,000 in tax, so each
borrowing and consuming more and is facing a 10 percent tax rate. In
saving and investing less? contrast, under a progressive tax, the
In contrast, the 2003 tax cuts reduced individual earning $80,000 might
unemployment and helped grow the pay $16,000 in tax—a 20 percent tax
economy since they encouraged long- rate. The United States tax system is
term productive behavior. But this suc- based on progressive taxation rather
cess was not well reported. By contrast, than proportional taxation.
there has been much more commotion

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
Conclusion
“As they say on my own Cape Cod,” effect on the U.S. economy—and on
President John F. Kennedy was fond of the family bank account. Policies that
noting, “a rising tide lifts all the boats.” try to transfer income from one group
President Kennedy meant that overall to another are based on myths, not
economic growth benefits everyone. reality. They do far more harm than
That’s why one of his major acts as good. In contrast, if public officials will
President was to slash the top income pay attention to the lessons of history
and common sense, avoid short-term
tax rate from 91 percent to 70 percent,
“stimulus” gimmicks, and instead enact
12 helping to trigger the increased pros-
reality-based economic reforms, they
perity of the 1960s.
can put the country back on the road
Government policies can have a huge to sustained prosperity.

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
To read more on these topics, see:
• Brian M. Riedl, “Ten Myths About the Bush Tax Cuts,” Heritage
Foundation Backgrounder No. 2001, at heritage.org/Research/Taxes/
bg2001.cfm.

• Bill Beach, Rea Hederman, and Tim Kane, “The 2003 Tax Cuts
and the Economy: A One-Year Assessment,” Heritage Foundation
WebMemo No. 543, at heritage.org/Research/Taxes/wm543.cfm.

• Daniel J. Mitchell, “The Impact of Government Spending on


13
Economic Growth,” Heritage Foundation Backgrounder No. 1831, at
heritage.org/Research/Budget/bg1831.cfm.

• Heritage Foundation/Wall Street Journal 2009 Index of Economic


Freedom, at heritage.org/Index/Default.aspx.

The Heritage Foundation The Economy Hits Home: What Makes the Economy Grow?
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solutions are consistent with those “The Economy Hits Home” series is a
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