Taxes are taking half my income...

and half my brain cells too

I didn’t want to write this article.

But I realised something. Most people don’t understand economics. And I want them to. That’s why I write Fresh Economic Thinking.

One of the most potent ideas in economics is that money flows in closed loops within the economy. Sometimes we call this the circular flow model. Essentially, it means that the income I earn was paid by someone else, whose income was paid by someone else, and so on. Since all the someone elses are all part of the economy, money circulates around and around between people.

There is no start or finish line to payments in the macroeconomy.¹ It’s a system of passing money around and around and hopefully, in the process, the people who pay require that the people being paid to do useful and productive things.

Which brings me to the reason for this article. The below tweet.

This example makes absolutely no sense. It’s wrong. Conceptually. Economically. I hope Ms Smudge can get some sleep when she realises.

But such stories are popular. This viral image got multiple millions of approving interactions.

Given how wrong these statements are, it was puzzling that I couldn’t find anyone in the over 360 replies to the original Ms Smudge tweet who realised the error. Most replies agreed and doubled down.

Some replied by nit-picking about how much the fuel excise really is and what the tweeter’s tax rate really should be. But who cares about being precise when you are measuring something with no conceptual basis?

What’s worse is that the people who shared the post are the self-proclaimed “economically sensible” ones, and politically active. My goodness!

The error that no one can see

Have you spotted the error yet?

Once you have in mind that money flows from person to person in the economy, it should be more obvious.

If you count a person’s tax from one transaction when they are the seller, and another transaction when they are the buyer, you are double-counting the tax but not the payments.

If you did this for everyone, and added it all up, your number would be exactly twice as high as the total amount of tax raised.

Here is the Ms Smudge tweet visually.

The blue line and label represent the payment to Ms Smudge from her employer. In this case, Ms Smudge is the payee and the employer is the payer (or customer). The orange line and label represent the payment from Ms Smudge, who is now the payee, or customer, to the petrol station, who is now the payee.

Ms Smudge counts as their tax when they are a payee in the first transaction and then again when they are the payer in the second transaction.

But you can’t do both.

You can say “Out of the $100 I earned, I paid $32 tax”.

And you can say that “Out of the $68 earned by the petrol station, they paid $39.44 tax”.

But you can’t take credit for the fact that money circulates in the economy. Otherwise, what’s to stop you from taking credit for the tax when the petrol station pays their employee out of the payment you gave them?

Other people pay taxes too!

Notably, what is completely overlooked is that the original $100 payment buys $100 of labour plus $68 of petrol. How can $100 be used to buy $168 worth of things? Well, that’s what happens when you double-count.

How to turn a 10% value-added tax into 100%

I want to drive home the absurdity of the double-counting approach to taxation and arm you, dear reader, with more ammunition to call it out with when you see it.

Consider a simple case of two people who produce massage services in a simple economy with a 10% value-added tax. So a $100 payment for a 100-minute massage has $9 of tax leaving $91 to the masseur (for U.S. readers, it is worth knowing that prices in Australia are required to be quoted inclusive of value-added taxes).

This is represented in the Round 1 column in the below table, where the blue cell is the payer, Person A, and the yellow cell is the payee, Person B.

Now, consider that Person B, who gave a massage in Round 1 and got $91 after tax for it, decides they need a massage from Person A. For Round 2, they ask for a 91-minute massage at $91, and that payment has an $8 tax, so Person A gets $83 after tax for that service.

Then Person A wants another massage, but only has $83, so asks for an 83-minute massage from Person B in Round 3, which has an $8 tax, leaving Person B earning just $75 after tax.

After the money circulates three times, $25 of tax is paid out of that first $100. After it circulates nine times, $58 has gone to tax. If payments continue to be made in this way, the 10% tax will eventually eat up all of the original $100!

But this is not really the tax from only $100, is it?

It’s the tax from a $91 massage, plus an $83 massage, plus a $75 massage, and so on. The Cumulative output row of the table does the same adding up exercise, but not for taxes, but for the value of services produced in the economy.

When we divide the cumulative tax, by the cumulative value of services produced, we find that indeed, a 10% tax on value-added does tax only 10%—nothing more, nothing less.

What is missing from this simplified example, however, is taxes are also not one-way payments. They also circulate. So unlike this example, where each round the taxes are sucked away from the economy, shrinking it, taxes are in reality spent back into the economy.

When politics and economics mix

This wrong understanding of economics persists and is widely popular even amongst groups that profess to be economically literate and sensible.

Economics teaching can’t be blamed. It is one area where the textbooks and teaching are usually very good. There must be thousands of economics graduates who can set people straight so that memes and stories like this stop circulating.

The reason must be political— preferences for certain policies override logic, even for those who are well-trained in economics. Instead of discussing which types of public programs are effective and should be funded by taxes, it is easier to joke and mislead about how high taxes “really” are, all the while ignoring a huge conceptual error. Unfortunately, such situations are common, give economics a bad name, and are one reason I am compelled to write Fresh Economic Thinking.

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1. Money balances are of course created and destroyed within this system of payments via lending and repayment of debts. I’ve written previously about this.