The velocity of money is one of the most important economic concepts you can ever learn. It isn’t perfect, and it doesn’t fully capture vital influences on the way a nation’s money supply behaves as driven by behavioral economic considerations such as mass panic, fear, overoptimism, et cetra, but it does have very important implications for determining an appropriate taxation policy to generate the optimal amount of governmental revenue from the population. This is meant to be a very basic, simplified explanation so beginners can grasp the velocity of money, and how it interacts with the so-called Laffer Curve.
What Is the Velocity of Money?
Simply defined, the velocity of money is a measure of the economic activity of a nation. It looks at how many times a unit of currency ($1 in the case of the United States) flows through the economy and is used by the various members of a society.
All else equal, the faster money travels (the higher the velocity of money) and the more transactions in which it is used, the healthier the economy, the richer the citizens, and the more vibrant the financial system. The velocity of money tells you how efficient $1 of money supply is at creating economic activity.
How to Calculate the Velocity of Money
Without getting into the breakdown of the individual components, the bottom-line calculation for the velocity of money can be expressed as:
Vt = The Velocity of Money for All Transactions
nT = The Nominal Value of All Transactions
M = The Total Average Amount of Money in Circulation in the Economy
An Example of How to Calculate the Velocity of Money
Imagine that a farmer, a grocer, a doctor, and a scientist live in the world’s smallest country. Between all of them, they have $1,000 in money supply. Over the course of a month, the following transactions take place:
- The farmer sells $500 worth of food to the grocer.
- The grocer marks up the price and sells $700 worth of food, split among the doctor and scientist who are his two customers.
- The grocer falls and hurts his knee. He goes to the doctor and pays $200 to the physician.
- The scientist needs fertilizer for an experiment. He goes to the farmer and pays him $300.
- The physician is working on a liquid band-aid product with the scientist. He pays him $300.
The total value of the transactions in our time period is $2,000. We have $1,000 in money in our economy, so the velocity of money is 2.
Using the Velocity of Money to Determine Taxation Policy
In our discussion of the Laffer Curve, you learned that there comes a point at which raising tax rates results in lower tax revenues. This is mostly due to how confiscatory tax rates slow the velocity of money. If you are going to be taxed a very high rate for buying something, earning money, or partaking in an economic activity, you may decide that the payoff – the net amount you get to keep – isn’t worth the effort. Humans are in a constant fight against laziness. From an evolutionary perspective, this makes sense because it preserves metabolism, calories, and stores energy for periods of famine.
The idea behind lower tax rates resulting in richer governments is a simple one. By lowering some taxes (not all taxes have the same influence on the velocity of money, which we will discuss in a moment), people see less of a disincentive to do something – work, save, shop, build, or give. Every time they do one of these things, the government gets a bite at the apple.
Imagine we have two governments in two countries. The first is Greenville, the second is Bluetown. Both nations consist of a handful of citizens. We look at two factory owners, both of whom earn $100,000. We are going to use a simplified example, ignoring things like accelerated depreciation tax benefits, et cetera, because on a net basis, those really serve to lower the tax rate and would bolster the point, anyway.
- Greenville has low taxes. For every $100 you earn, the government takes $20. The factory owner sends $20,000 to the government. He uses $40,000 to support his family by purchasing food, clothing, shelter, and furniture. The remaining $40,000 gets reinvested in his factory so he can make more money in the future. He buys equipment, raw materials, and hires new employees.
- Bluetown has high taxes. For every $100 you earn, the government takes $75. The factory owner sends $75,000 to the government. He is left with $25,000 on which his family can live. He has no money to reinvest in his business and really feels no incentive to grow. Why work harder if the government is just going to take all of the fruit of his labors, anyway?
Greenville is going to have a much higher velocity of money. A citizen in Greenville gets to keep more of his money, which he can then save, invest, give away, or spend. Even if he is saving his money, that represents someone, somewhere spending more (e.g., if he buys municipal bonds, it may represent a local village building an elementary school). Very few people take money out of circulation by buying gold, silver, or burying wads of cash in coffee cans in their backyard. Thus, money moves faster; or, rather, the velocity of money is higher.
[mainbodyad]There is also a much more important consideration. Ultimately, standards of living are driven by individual men and women who create things that make life better – indoor plumbing, air conditioning, microwaves, wrist watches, automobiles, airplanes, light bulbs, perfume, mattresses, etc. If you are a self-motivated person, a Thomas Edison or a Steve Jobs, it isn’t hard to guess which country is going to appeal to you the most. Over several generations, if Greenville has a reasonably accommodating immigration policy, it is going to soak up a vast majority of the intellectual human capital of Bluetown. The technological difference between the two will widen into a chasm, and then the structural advantages will result in Greenville becoming a superpower.
Doubt it? Go back and look through the history of the United States during the Industrial Revolution and through World War II when it took its place at the head of military, scientific, financial, and political power. A substantial percentage of the people who created the ideas, products, services, and devices permitting this to happen were not born in the United States, but rather moved here attracted by the political and economic freedoms that were available to the common person.
If You Still Have Trouble Understanding the Velocity of Money …
If you still have trouble understanding the concept, think of it this way: Every time $1.00 moves in Greenville, the government gets 20¢ of it. Every time $1.00 moves in Bluetown, the government gets 75¢ of it. In basic, simplified terms, human nature being what it is, the lower taxes are, the higher the velocity of money tends to be.
Imagine both Greenville and Bluetown have a total average money supply of $10,000,000. In Greenville, the velocity of money is 10. In Bluetown, the velocity of money is 2. How much money will be collected by each government?
- Greenville = $10,000,000 money supply x 10 velocity of money = $100,000,000 GDP x 20% taxation rate = $20,000,000 government budget
- Bluetown = $10,000,000 money supply x 2 velocity of money = $20,000,000 GDP x 75% taxation rate = $5,000,000 government budget
Due to a higher velocity of money, Greenville is collecting 4x as much in tax receipts as Bluetown despite having a much lower tax rate. Greenville has much more money to give away to the poor through social programs, students through college programs, and spend on defense, through the military.
The Velocity of Money Argument Has Been Hijacked By the Radical Right in the United States
That simple economic truth is absolute beyond assault. Unfortunately, the way it has been implemented is downright criminal. A radical wing of the Republican Party has essentially re-written the basic mathematics dealing with the velocity of money and used it to argue that tax rates should only be cut for the rich, which will then “trickle down” to everyone else. That is not true. In fact, those who are ignorant of economics now see supply side taxation arguments as essentially synonymous with policies designed solely for the rich.
The truth is, when the velocity of money is high, and tax rates are low, everyone prospers. This explains, in part, one of the reasons the United States has now found itself in the ridiculous position of defining a family earning $45,000 per year as being below the poverty line when that very income puts the household in the top 1.72% of income globally.
It is not tax cuts per se that result in expanding government revenue. The name of the game is to increase the velocity of money. Tax cuts are merely a means, a mechanism, to achieve that end result.
[mainbodyad]Since 1950, the tax rates levied on the poor and middle class have skyrocketed in a lot of ways. Consider the payroll tax for a self-employed person. When Warren Buffett was in his 20’s, a self-employed person would have had to send $2 for every $100 he earned into the Federal government before paying a penny in income taxes, state taxes, property taxes, or sales taxes. Today, that same self-employed person would have to send $15.30 into the government before paying any of those other taxes; it comes right off the top. Any party that was actually interested in increasing the velocity of money would address the 700% increase the poor and middle class have seen on the very first tax burden they face. It is going to have a far more profound influence on the metric than shaving another few percentage points off the capital gains tax rate paid by the wealthiest Americans. Yet, the average American doesn’t have a lobby in Washington fighting for him or her.
Many of the Democrats are no better. Instead of lowering the tax burden on the poor and the middle class, their proposal is to simple raise the tax burden on everyone else to the same level! Ultimately, economic growth is the result of consumer demand. Thus, you want money in the hands of people who will spend it, in turn, increasing the velocity of money. Tax cuts that only benefit the rich, rather than the average school teacher going into Target to buy a box of cereal or a video game for her child, are a failure.
Raising Taxes Very Rarely Results In As Much Revenue As One Expects
The best way to increase governmental tax receipts is to increase the health of the underlying economy so the velocity of money is higher. Countries often find this out the hard way. In the United States, individual states find it out the hard way, as well. A few years ago, the Maryland legislature passed a special tax on millionaires. The government expected an additional $106 million in revenue. However, it didn’t account for human behavior. Roughly 1 out of every 3 millionaires left the state, and instead, tax receipts were $200 million less, resulting in a $306 million gap from expectations.
If you want to live in a rich civilization where the standard of living is expanding for the average person – which is the only metric that counts – you need as much human capital as you can attract. The human capital needs to feel valued, respected, and above all, believe that it is being treated fairly. Thus, all taxes are not equal. Wise tax policy is as much about emotional psychology as it is raw mathematical figures. In the end, you are dealing with people.
Raising tax rates to the point a negative feedback loop is established and the human capital feels abused is one of the surest ways to drive off the top contributors of ideas, products, and services. In the end, everyone ends up poorer.
My personal opinion? The perfect economic system is one that rewards entrepreneurs by making it easier to amass wealth, puts money in the hands of poor and middle class consumers who create demand-driven increases in the velocity of money, and, over time, raises the standard of living for even the least successful, not as the result of transfer payments, but as a by-product of opportunity for the workforce. The United States has veered too heavily in the direction of favoring one group of people over another from time to time, but by and large, we’ve gotten the equation right. Or, at least, gotten closer than most of the other nations on the planet, which explains our having 50% of the world’s wealth despite only being 5% of the global population.