Accounting Numbers versus Economic Numbers

Posted by Jeff Carter
on March 30th, 2010

Americans are under a severe misconception. They don’t understand the difference between accounting numbers and economic numbers. This works its way through lots of financial decisions. In business, if you use accounting to guide your decision making, the odds are very good that you will make a bad choice. In government, accounting numbers force you into terrible policy decisions.

What is the difference? First of all, all accounting numbers you see are not real, they are simply humans making value judgements based on guidelines set up by accounting boards like the Financial Accounting Standards Board (FASB). Accountants make judgements all the time. They don’t use a cash accounting system like you do at home. Your Profit and Loss statement would look pretty simple. Salaries-household expenses-saving=net profit. In a business, they judge when to properly recognize that revenue, and how to properly match it to a variety of expenses. One accounting firm may make a different judgement than another firm given the same data!

In many real life business situations, businessman have made terrible decisions when they use accounting. They feel like they are being very pragmatic by relying on numbers, but the numbers that they are relying on force them down a dead end path. In the socialized pre Margaret Thatcher economy in England, British Steel Company(nationalized in 1967) spent millions on a new steel mill based on accounting projections. They never started the mill! It was cheaper to let it sit idle.

In government, the fight over the budget shows how elected representatives don’t understand the difference either. Fortunately, we have some hard and fast real world examples. If we look at the government revenues from capital gains, we can see how accounting numbers in the budget severely differ from what happens in practice. Based on budget projections in in 2002, government estimated how much it would rake in from a 20% Capital Gains tax. In 2003, they cut cap gains by 5% to 15%. Accountants would tell you revenue would drop by 5%. Instead, revenue from the tax doubled. Economic activity increased. This is a tangible difference between accounting and economic numbers.

The Laffer Curve illustrates this effect graphically. It shows that revenue can actually increase with a decrease in taxes. Keynesians hate the Laffer Curve. On a chalkboard, they can show you how it doesn’t work. On the street, the average worker shows you how incorrect they are. Obama’s large increase in capital gains rates, marginal rates, and penalties for success will cut government revenue by more than you think. As a matter of fact, in their budget, the Obama team estimates that government revenue will increase under his new tax plan. History shows this to be Alice in Wonderland budgeting. In coming years, we will have a huge hole in our budget, bigger than anything we have ever seen in the US.

Obama’s budget, and Obamacare all use accounting numbers. They ignore economics.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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