Greg Mankiw offers a strong endorsement of a proposal to cut the corporate income tax from 35 to 25 percent, claiming "It is perhaps the best simple recipe for promoting long-run growth in American living standards." (Hat tip Mark Thoma.) A good case can be made for cutting or even eliminating the corporate income tax. But Mankiw's argument does not cohere.

Let's start positive. Mankiw is right to point out that the "incidence" of the corporate income tax might not in fact be as progressive as its proponents would wish. He quotes studies suggesting that workers end up paying 70% to 92% of the taxes in the form of lower wages. I'm skeptical of those numbers, but it is surely true that some fraction, perhaps even a large fraction, of the corporate tax burden falls on workers and customers rather than presumptively wealthier investors. Mankiw does us all a service by reminding us of this.

Then he tells us a fairy tale:

A cut in the corporate tax... would initially give a boost to after-tax profits and stock prices, but the results would not end there. A stronger stock market would lead to more capital investment. More investment would lead to greater productivity. Greater productivity would lead to higher wages for workers and lower prices for customers.

First, if as Mankiw has argued, the lion's share of tax burden falls on workers, the "boost to after-tax profits and stock prices" would have to be correspondingly small. You can't have it both ways — either investors pay the tax, and stocks would be more valuable without them, or workers pay the tax, and stockholders are mostly indifferent. Perhaps Mankiw doesn't think that workers pay the tax after all.

Suppose there would be a surge in profits and stock prices, either because the corporate tax does burden stockholders, or out of irrational exuberance by cigar-smoking plutocrats. What then? Would "a stronger stock market... lead to more capital investment"? The tax change can't affect the economic opportunities available to firms. It can only affect investment decisions by reducing firms' cost of capital. As long as firms are correctly valued, the cost of equity depends on investor expectations going forward, not the level of the stock market today. Counterintuitively, if investors expect high future stock returns, that implies an increase in the cost of equity, and less corporate investment as existing opportunities face a higher "hurdle rate". Steepening return expectations only lead to more capital investment if they reflect an improvement in the opportunities available to firms. That is beyond the power of a tax cut.

Unreasonably high stock prices can, of course, encourage capital investment, as managers try to exchange overpriced paper for valuable projects, but the quality of investments under those circumstances is questionable at best. Surely, Mankiw does not think we should jolt stock markets into a bubble, because then firms will invest willy-nilly to preserve value before investors come to their senses?

A more charitable interpretation would be that Mankiw meant that investors' required return for stock investments wouldn't increase as much as the after-tax value of investment opportunities would, effectively reducing the equity cost of existing opportunities. But if the after-tax opportunity values would improve (they wouldn't, if workers bore the tax), there's no reason to think investor return requirements wouldn't increase as well. Just as it's hard to say who a tax will ultimately fall on, it's hard to know a priori how the proceeds of an investment tax break will be split between reinvestment, consumption, and safety. Some of the tax windfall would (thank goodness!) go towards delevering to reduce risk, and some would be withdrawn and spent by investors. How much actually goes to new capital investment would depend upon investor preferences, credit markets (which set the cost of safety), and the quality of potential new projects.

In theory, when firms do not have productivity-enhancing new projects at the ready, they return funds to investors. But, in the aftermath of first the dot-com bubble, and then a massive credit & housing bubble, it's worth asking what actually happens when the economy experiences positive shocks to the supply of capital. Perhaps, in a world where agents are informationally limited and distinct from the owners of capital they deploy, it is not always optimal to increase the rate at which capital is made available to firms and investment professionals, when the same wealth might otherwise be consumed or held for future use. We might illustrate this to supply-siders as a "Laffer Curve", with an optimal cost of capital above which productivity-enhancing investments are foregone, but below which wealth-destroying projects are funded. I think we've been on the wrong side of that curve for much of the past decade, so before I get excited about policies that purport to deliver growth by increasing incentives to save and invest, I'd like to see evidence that if we had more capital at hand, we'd use it well rather than employing well-paid intermediaries to destroy stuff in crazy schemes.

Supply side economics is a nice story, a hopeful story. It offers a clean, plausible policy framework: encourage investment, always and everywhere, and prosperity is sure to follow. But this decade has been about a pure a test of that idea as we could hope for. Capital in the United States was incredibly cheap, and what did we do? We destroyed a lot of wealth. We don't need more capital (although we might soon, if our foreign backers get skittish). We need more discriminating capital. In the meantime, the only thing I'm sure "works" about the supply side story is that it shifts the tax burden from richer to poorer. I'd rather that stop working so well.

Postscript: It is always deflating to see good ideas supported by poor arguments. I'd enthusiastically support eliminating the corporate income tax entirely, if the change were paid for by new taxes at least as progressive as the corporate income tax was intended to be. But my reasons are different from Mankiw's. Currently, the portion of corporate earnings payable to shareholders is taxed as corporate income, while the portion of earnings payable to debt holders is not taxed at all at the corporate level. (The accountants don't call the latter earnings at all, but that is semantics.) This differential tax treatment effectively pays firms to borrow funds rather than raise new equity when they need cash, which is bad public policy. Corporate leverage has social costs, "negative externalities", in terms of financial stability. To the degree government interferes in the capital structure decision at all (and I'm not arguing that it should), policy should favor equity financing since equity-funded firms are better able to internalize the costs of their misfortunes than are highly leveraged firms. So, three cheers for a progressively funded abolishment of the corporate income tax!

Alas, Mankiw proposes increasing gasoline taxes to replace the lost revenue. While there is much to be said for a higher gas tax, it fails the progressivity test. (Poorer people spend a much larger share of their income on fuel than do the affluent. Surely a Pigouvian would delight in redistributing the proceeds of a carbon tax as a flat transfer back to citizens to offset that unfair burden. A rebated carbon tax could be wildly popular, and help save the planet too.)

If, instead, we funded the change by increasing the highest marginal tax rate, or better yet, by creating a new top tax bracket, eliminating the corporate income tax would be a grand idea.

Steve Randy Waldman — Monday June 2, 2008 at 2:09pm [ 30 comments | 0 Trackbacks ] permalink