A Market-Based Economy is a Pass-Through Economy

A Market-Based Economy is a Pass-Through Economy

Middle class economics and reversing the Citizens United ruling are both themes which promise to become major issues during the upcoming 2016 general election season. Here is an explanation for why these are important issues.

The economy is all about activity. We produce goods and services, and we buy goods and services. We invest, and we save. We hire workers, or we are the workers hired by others. We innovate, or we enjoy an increase in the standard of living because others have been innovators. As individuals, we participate in the economy in various ways.

You might not have thought about it in these terms, but in order to understand how the economy works, and why it doesn’t always work, you should be aware that the economy is a pass-through economy. Economic activities are all inter-related. In order to produce anything, you need to be motivated to do so. Your motivation comes from the expectations of profit. But you won’t get profit unless you have customers willing and able to buy what you produce. If your customers don’t have the means to pay for what you produce, then you have no reason to produce.
Labor markets, financial markets, foreign markets, and the government all play roles in this. Without going into detail on these various roles (because that would be going off-topic), my point is this:

Wealth and financial assets keep the economy growing, keep the economy producing, keep people employed, and increase the standard of living – but ONLY as long as wealth and financial assets continue to PASS THROUGH from one sector of the economy to another. When wealth and financial assets are taken out of the loop, they no longer benefit the economy. In order for wealth to benefit the economy, it has to keep circulating throughout the economy. That’s what makes it a pass-through economy.

None of this is a secret. It’s a design feature of a market-based economy. Have you heard of the “invisible hand” in economics? A pass-through economy is necessary for the invisible hand to work its magic. The government provides the infrastructure which is necessary for the economy to even exist. The government provides incentives, especially tax incentives, designed to promote economic activity. Businesses do not pay taxes based on the amount of total revenue. Instead, businesses are allowed to deduct all business expenses before taxes. This includes the amount paid for employee wages and benefits. Tax deductions provide an incentive for more money to continue to pass through the economy. Progressive income taxes on earnings net of business expenses decrease the cost of keeping wealth working through the economy RELATIVE TO the cost of taking wealth out of the economy. Capital gains receive favorable tax treatment.

Why does the government provide these incentives? Keep in mind that these are the fundamental ways in which the government “interferes” with the private sector in the economy. Incentives are designed to keep wealth passing through the economy. The health of the economy and the standard of living depend on it. If you make money, you can make even more money if you invest it back into the economy. There is actually no upper limit to how much you can make with these incentives; they allow individuals to get ahead through hard work and innovation, which provides an incentive for others to work hard and innovate. The good news for everybody is that all of this benefits the economy. There is nothing socialistic about any of this. The more money you put back into the economy, the more money you can make. The more money you make, the more you can put back into the economy. The better your investments perform, the more money you can make BECAUSE your investments are benefitting everybody in a pass-through economy.

Without the benefits of a pass-through economy, all arguments claiming that a market-based economy is superior to other economic systems fall apart.

That’s how it is supposed to work. That is the basis of a market-based economy. Economic activity occurs in the private sector. The government provides infrastructure. Wealth is rewarded with more wealth when it is being used to benefit the economy. It is in the national interest for the government to provide incentives to make this happen. Rewarding people for allowing their wealth to pass-through within the economy is essential to a market-based economy.

BUT IT DOESN’T ALWAYS WORK THAT WAY. Laws are being written in order to provide incentives for NOT letting wealth pass through within the economy. Wealth is being removed from the economy, and the culprits are being rewarded for doing so.

  1. Not all types of “investments” receiving preferential tax treatment are actually investments back into the economy
  2. Tax cuts for NOT investing actually INCREASE the cost of putting wealth to work in the economy RELATIVE TO the cost of taking wealth out of the economy
  3. Corporations are being rewarded with tax breaks for removing wealth from the country and from the domestic economy – and for taking jobs out of the country
  4. Labor laws are being weakened, decreasing the amount of money that flows through the working class and into the wider economy
  5. Wealth is being removed from the pass-through economy via corporate tax breaks handed out by all levels of government, instead of providing infrastructure improvements that are vital for the economy to operate smoothly
  6. Instead of using cash to invest in the pass-through economy, corporations are being rewarded for using that cash to finance political campaigns, for hiring lobbyists, and for a media campaign on their behalf – ALL FOR THE PURPOSE OF RECEIVING INCENTIVES TO REMOVE WEALTH FROM THE PASS-THROUGH ECONOMY

As a result of misguided policies…

  1. ALL wealth created through economic growth and productivity has been retained by the extreme upper class – this is not a theory or a political point of view; it has been an economic fact since the late 1970s
  2. Our infrastructure is crumbling
  3. The most vulnerable of us – the elderly, the young, the poor, and the sick – are being told that they will have to get by with less in order for corporations to receive more tax breaks
  4. The middle class is shrinking, fewer people are making a living wage, more people are making poverty wages, more people must rely on public assistance, and politicians are joining the media chorus in blaming the victims – “hey, the rich pay all the taxes and the poor are free-loading off of tax dollars from the rich, so let’s cut government spending on programs which benefit the poor, and instead let’s cut taxes for the rich who are paying all of the taxes” and “hey, those who complain about this are lazy people who are engaging in class warfare” – THEREBY ADVOCATING FOR MORE OF THE SAME TYPES OF POLICIES WHICH CREATED THE PROBLEM IN THE FIRST PLACE

Too many people don’t understand the relationships among incentives, policy, infrastructure, income, tax rates, and tax dollars. This is unfortunate, because it means that not only do people support policies which are against their own self-interest, they also support policies which undermine the entire economy. The political and media chorus only confirms their misconceptions.

Here is a reality based on mathematical truth: Top marginal corporate and individual income tax rates are extremely low by historical standards – much lower than the rates which were in effect when the middle class was growing and the United States reached economic superstar status – despite widespread political rhetoric about stifling tax rates on the rich. Once you grasp that fact, consider this mathematical fact: The amount of tax dollars paid is equal to the effective tax rate times the amount of taxable income. When effective tax rates become LESS progressive, which they have, and yet a larger percentage of tax dollars is being paid by those at the high-end of the income scale, it can only mean one thing: a larger share of the income has stayed at the top. High tax rates on those at the top didn’t cause this to happen, and lowering high-end tax rates won’t fix it. This problem was created because less wealth has been passing through the economy. It was created by policies which increase the incentive to take wealth out of the economy. Lowering corporate and high-end tax rates will provide more of an incentive to take wealth out of the economy. It will mean more of the same policies which created the problem.

Math, basic economic principles, rational thinking, and the historical record all point to this reality. Unfortunately, too many people ignore all of that in favor of political rhetoric that doesn’t agree with reality. This situation is not sustainable, but as long as so many people are falling for the rhetoric instead of the reality, it might have to get much worse before it gets better. The rhetoric is allowing the few to profit at the expense of the many until reality sets in.

A sustainable and smooth-running market-based economy requires rewards for allowing wealth to pass through the wide economy. Policies which hand out rewards for taking wealth out of the pass-through process can only undermine the economy. Either we wait until the situation gets so bad that it wakes people up to the reality, or we find a way to get more of them to see the reality today. A highly publicized general election campaign focused on middle class economics and reasons for reversing the Citizens United ruling is a small step towards educating the population to economic realities.


A version of this essay is included as a chapter in the book Common Misconceptions of Economic Policy by Jerry Wyant. You can purchase this book in paperback form from Amazon and other online book distributors. The list price is $12.99 (only $9.99 using discount code TA9GTK7E when ordering, depending on the distribution channel). Or if you prefer, you can download a digital version on your device (Kindle, Nook, etc.) for $4.99.

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Jerry Wyant