Consumption vs. Investment: A Real Difference?

Here’s a topic that has bothered me ever since it has been introduced in macroeconomics—consumption and investment. See macro slides these things in there without really ever explaining them and then doing fancy math to bust your balls. So you think, “geez, this guy is smart, he must be right.”

A version of the argument usually goes like this. Consumption just spends money on things without concern for the future. Consumption is wasteful by nature. Investment on the other hand builds future wealth through innovation. Investment employs a lot of really smart people that invent the next great thing. And finally, this results in more future growth. Consumption today sacrifices growth tomorrow. Macroeconomists love this kind of talk because it gives them a job in policy making. “People will naturally be irrational and spend too much, therefore, we need to rationalize them and create more incentives to invest.” And these top-down government economists eat this shit up. (Not to mention Wall Street firms love these sentiments).

But I have to say I have never found much sense in defining consumption and investment differently. Let’s think about it from the micro view for a second. Consumption decisions are personal optimization decisions just as investment decisions are. The individual says, “well, hell, I want to enjoy my time on earth right now so I’m going to spend some of my income right now.”And there is no more important time than the present due to future uncertainty.

Then he also saves money. He saves money because he is making tradeoffs between the present and the future. He needs an investment portfolio than saves and grows value in order to protect against future uncertainty (fluctuation in income streams, fluctuations in costs). Basically, the individual has decided that his present profitable spending opportunities have diminished relative to profitable investment opportunities (which are future profitable spending opportunities). [Profitable used in the sense of utility]

Although, it’s not important why he spends or saves. The decision is based on a hypothetically infinite number of preference issues. The bottom line is some spend more than save, some save more than spend (corporations included). Those that have high levels of consumption can be thought of to have less profitable opportunities to invest. They prefer more present spending to future spending. The money doesn’t vanish but eventually finds its way to someone who has different opportunities and preferences. This person has a comparative advantage in investments over consumption. Therefore, the consumption and investing decisions on the individual level lead to an outcome once again where those with the greatest comparative advantage find the money to use it most productively.

And where is this digression leading? To capital gains taxes of course. To preface, I think that lower taxes are always better than higher taxes. But that being said I am also worried about tax distortions. Different levels of taxes for different things incentivize people to engage in behavior not solely based on personal choice metrics. The deciding factor of a consumption vs. investment decision could very plausibly be a tax difference. The result would have been different if tax levels were equal. The government has distorted choice.

It hurts me to ever propose a tax hike (on capital gains here specifically), so I’ll just argue for the other tax levels (without getting into the difference between income tax and other taxes) to be lowered to the capital gains rate 15%. Hah, in a perfect world, right?

This will be a common theme for me. Taxing reduces incentives to work in all the traditional ways. But differential levels also have distortionary effects. Future examples: health care, debt, and others.