Friday , March 29 2024
Home / The Angry Bear / Cutting Taxes on Profits and Reality

Cutting Taxes on Profits and Reality

Summary:
The post below is silly. It is based on bending over backwards to take silly arguments for the GOP tax plan seriously. This older post is the one with some relevance to the real world. The silly argument is that lower taxes on profits imply a lower cost of capital for firms. Investors will demand the same return net of taxes and so demand less from firms if the IRS takes less. The story continues that this lower cost of investing will cause firms to invest more which causes higher labor productivity and wages. This argument makes no sense for the following reasons 1) If you want to change investment, change the tax treatment of investment not something else. The gain (if any) from the GOP proposal should be entirely due to expensing investment.

Topics:
Robert Waldmann considers the following as important: , , ,

This could be interesting, too:

Joel Eissenberg writes You can’t fool Mother Nature

Bill Haskell writes NBC fires Ronna McDaniel, former RNC chair.

NewDealdemocrat writes A detailed look at manufacturing, and an update on freight

Angry Bear writes Alternate Ports for Shipments

The post below is silly. It is based on bending over backwards to take silly arguments for the GOP tax plan seriously. This older post is the one with some relevance to the real world.

The silly argument is that lower taxes on profits imply a lower cost of capital for firms. Investors will demand the same return net of taxes and so demand less from firms if the IRS takes less. The story continues that this lower cost of investing will cause firms to invest more which causes higher labor productivity and wages. This argument makes no sense for the following reasons

1) If you want to change investment, change the tax treatment of investment not something else. The gain (if any) from the GOP proposal should be entirely due to expensing investment. Reinvested profits will not be taxed. This should encourage higher investment in physical capital compared to paying dividends, buying back shares, or accumulating financial assets. I think it is good policy (and have thought so for 37 years at least). But once you have expensed investment, the tax on profits doesn’t affect the cost to the firm of investing. So long as it is constant it shouldn’t affect investment at all. Cutting the rate is a pure gift to owners.

2) Business investment doesn’t seem to be much affected by the cost of capital. This appears in aggregate data. The cost changes a lot with monetary policy as the interest rate changes. These changes have huge effects on aggregate demand, because they have huge effects on investment, in houses. The investment which depends on the interest rate is residential investment. Bigger houses don’t cause higher productivity and wages. For some mysterious reason the housing bubble’s expansion and bursting hasn’t convinced most economists to pay any attention to housing. Krugman says it’s been forgotten since the days of the dinosaurs

Back in the old days, when dinosaurs roamed the earth and students still learned Keynesian economics, we used to hear a lot about the monetary “transmission mechanism” — how the Fed actually got traction on the real economy. Both the phrase and the subject have gone out of fashion — but it’s still an important issue, and arguably now more than ever.

Now, what you learned back then was that the transmission mechanism worked largely through housing.

3) Been there done that. W Bush claimed he was going to cause high investment and wages by changing corporate taxation. In particular, the second Bush tax cut changed the taxation of dividends. Previously they had been taxed twice first as corporate income then as personal income of the shareholder. This, it was promised, would reduce the cost of capital for joint stock corporations (C corporations in IRS talk) and cause them to invest more. Importantly, it would have no effect on pass through firms whose profits are just taxed as personal income of their owners (some of these are called S corporations by the IRS). This means it was an experiment. According to W, if you look at a bunch of otherwise similar firms some of which are C corporations and some of which are S corporations, then following the tax reform investment by the C-corporations should increase compared to investment by the S-corporations.

Danny Yagan at Berkeley notes that it didn’t. Also there was not a statistically signficant difference in the growth of employee compensation.
American Economic Review 2015, 105(12): 3531–3563

I find analysis of the results of this experiment to be very convincing.

4) Capital is like clay, soft when you work it, then rigid once it is fired. In models it is easy to substitute capital for labor causing higher labor productivity. But in the real world, firms mostly invest to increase capacity. The substitution of capital for labor is slow. It has a lot to do with new establishments (new factories say) but not so much with refitting old ones. It is limited by technology. This means that investment has a lot to do with lack of spare capacity and not so much to do with the cost of capital. This story fits the aggregate data on non residential investment.

5) Just ask CEOs. Matt Yglesias reports

An awkward — but extremely telling — moment arose yesterday at a Wall Street Journal “CEO Council” event that featured the Trump administration’s top economic policy hand, Gary Cohn, as a key speaker.

John Bussey, an associate editor with the Journal, asks the CEOs in the room, “If the tax reform bill goes through, do you plan to increase investment — your companies’ investment — capital investment,” and requests a show of hands. Only a few hands go up, leaving Cohn to ask sheepishly, “Why aren’t the other hands up?”

And there is video

I got this from Natalie Andrews
I almost feel sorry for Cohn (OK I don’t but almost).

update: Matt Yglesias has another live one — a CEO saying the GOP argument is bogwash

Also Paul Krugman is still a dinosaur.

Robert Waldmann
Robert J. Waldmann is a Professor of Economics at Univeristy of Rome “Tor Vergata” and received his PhD in Economics from Harvard University. Robert runs his personal blog and is an active contributor to Angrybear.

Leave a Reply

Your email address will not be published. Required fields are marked *