Supply side fairy tales

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.


30 Responses to “Supply side fairy tales”

  1. As acclaimed Princeton economist Paul Krugman wrote of Supply Side alchemy-economics:

    …not only is there no major department [university, not propaganda machine] that is supply side in orientation; there is no economist whom one might call a supply-sider at any major department.

    Supply Side “Economics” claims that with tax cuts people will work so much harder and take so much more risk, that economic growth will explode.

    But first, there is little link between tax rates and work hours over the long run as long as tax rates don’t hit extreme levels that we’re far from (also the Republican shredding of the safety net and opposition to universal health care makes it far more risky to start a business or innovate and greatly discourages it – See Yale Political Scientist Jacob Hacker’s outstanding book, “The Great Risk Shift).

    Look up the old and totally accepted income and substitution effects in any intermediate college microeconomics text. The gist is this if your wage per hour goes from $8/hour to $12, you might (in the short run) want to work 45 hours per week instead of 40, because you get an extra $4 for an hour’s work, but if your income went from $40/hour to $1 million per hour, you’d probably cut your hours to like 40 per year! That’s the income effect kicking in big time.

    Taxes generally don’t seriously affect work hours in the long run unless they hit a very high extreme that we’re far from. Cornell Economist Robert Frank has an excellent discussion of this in a book of his you would like, “Luxury Fever”. For something quicker, however, please read his New York Times Economic Scene article from April 12th, 2007, “In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up”. A quote:

    Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. In their familiar rhetorical flourish, they insist that a more progressive tax system would kill the geese that lay the golden eggs. On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.

    The surface plausibility of trickle-down theory owes much to the fact that it appears to follow from the time-honored belief that people respond to incentives. Because higher taxes on top earners reduce the reward for effort, it seems reasonable that they would induce people to work less, as trickle-down theorists claim. As every economics textbook makes clear, however, a decline in after-tax wages also exerts a second, opposing effect. By making people feel poorer, it provides them with an incentive to recoup their income loss by working harder than before. Economic theory says nothing about which of these offsetting effects may dominate.

    If economic theory is unkind to trickle-down proponents, the lessons of experience are downright brutal. If lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. According to trickle-down theory, then, the cumulative effect of the last century’s sharp rise in real wages should have been a significant increase in hours worked. In fact, however, the workweek is much shorter now than in 1900.

    Trickle-down theory also predicts shorter workweeks in countries with lower real after-tax pay rates. Yet here, too, the numbers tell a different story. For example, even though chief executives in Japan earn less than one-fifth what their American counterparts do and face substantially higher marginal tax rates, Japanese executives do not log shorter hours.

    Trickle-down theory also predicts a positive correlation between inequality and economic growth, the idea being that income disparities strengthen motivation to get ahead. Yet when researchers track the data within individual countries over time, they find a negative correlation. In the decades immediately after World War II, for example, income inequality was low by historical standards, yet growth rates in most industrial countries were extremely high. In contrast, growth rates have been only about half as large in the years since 1973, a period in which inequality has been steadily rising.

    The same pattern has been observed in cross-national data. For example, using data from the World Bank and the Organization for Economic Co-operation and Development for a sample of 65 industrial nations, the economists Alberto Alesina and Dani Rodrick found lower growth rates in countries where higher shares of national income went to the top 5 percent and the top 20 percent of earners. In contrast, larger shares for poor and middle-income groups were associated with higher growth rates. Again and again, the observed pattern is the opposite of the one predicted by trickle-down theory.

    The key to long run growth, as shown by a series of Nobel Prize winning, and likely to win, economists from Robert Solo to Paul Romer to Paul Krugman, is high saving and smart investing in human and physical capital and technological , medical, and scientific advance – not taking trillions which could have been spent on that and instead giving it to the super wealthy so it’s instead, over time, spent on giant homes, yachts, $20,000 watches, $500,000 Ferraris etc., which produce almost no growth in long run productivity.

    Supply-Side “Economists” will object that taxing and government spending on basic scientific and medical research, infrastructure, alternative energy, education and training, etc., would be wasteful. If it was so good the free market would do it better, but this is far from the truth and based on simple-minded slogan economics. These are the kinds of things that the free market will grossly underprovide and/or provide less efficiently due to very well proven and accepted in economics market problems like externalities, inability to patent, asymmetric information, giant economies of scale/monopoly power, and many more which you can find in any intermediate college economics text (usually micro).

    The key to long run growth is to greatly raise taxes and spend the money on high return investments. This would cause a great shift from consumption to investment and would make us much wealthier over the long run. Taxes should be raised on the wealthy and on negative externalities like carbon production, so that they give an incentive to act efficiently.

  2. Sorry, I’m rushing; the Krugman quote is from his book “Peddling Prosperity”, page 85.

  3. Patrick writes:

    Just a couple of notes:

    Tax burden may fall on workers, while tax relief may accrue to shareholders in the short-term (wage-stickiness says Dr. Coe ;). Higher returns to shareholders (assuming interest rates unchanged) should pique the interest of rational investors and bid up the price per share.

    Firms care about after-tax rates of return. After a tax break, opportunities that previously were marginally bad, now become marginally good and doable (assuming interest rates don’t increase).

    The crux appears to be the effect of a corporate tax break on interest rates, which seems to depend on marginal propensities to consume or invest….


  4. RueTheDay writes:

    If you really wanted to encourage equity financing over debt financing, you could take it a step further and make dividends deductible and at the same time make interest expense NOT deductible. Or even further, make dividends AND retained earnings deductible, but not interest expenses. That would, in essense, be a pure Pigouvian tax on debt.

  5. Patrick — The point about a short-term wage stickiness effect is clever, and well-taken. That could lead to a one-time windfall to investors, paradoxically proportional to the incidence of the tax on labor. Investors might spend part of that windfall in new investment (or they might consume it, or alter capital structure). Wages are thought stickier down than up, which might mitigate the effect. But it’s an excellent point.

    Still, at best, that uses a permanent change in the tax code to give a one time benefit to investors, which should translate quickly into a small zetz to stock prices. Whether it translates to new investment would depend on how investors divide the benefit between reinvestment, consumption, and capital structure changes (safety).

    We really have to be careful, though, about the simple claim that

    Firms care about after-tax rates of return. After a tax break, opportunities that previously were marginally bad, now become marginally good and doable (assuming interest rates don’t increase).

    If the tax is currently borne by labor, then at equilibrium, opportunities that were marginally bad look better because they are untaxed, but worse because labor costs have risen, and the result would be a total wash. One could get subtle, and argue that firms would substitute capital for labor, and thereby come out ahead. But then you’re really making an argument in favor of reduced taxes on labor, and eliminating the corporate income tax is a roundabout way to do that.

    If the tax is borne in large part by investors, then, as you say marginal projects would look better after-tax if required equity returns don’t rise. But it’s not only about interest rates. The cost of equity can be decomposed into an interest rate and a price of risk. One would expect, if capital is limited and competitively allocated (and if it is not, what use is encouraging investment?), investors to demand higher risk-adjusted returns following a subsidy to after-tax cash flows. How they achieve these is hard to predict. Suppose investors find the risk of leverage less attractive after the tax benefit of debt financing is reduced. Then even if the marginal propensity to invest is high, interest rates might fall (as firms shed debt) but firms’ overall cost of capital might rise (equity financing will still be more expensive) leading to a higher cost-of-capital for less leveraged firms. Both investors’ consumption preferences and their risk preferences have to be taken into account.

    It might be the case that eliminating the corporate income tax would make otherwise marginal capital projects worthwhile on an after-tax basis. But that’s not at all certain or obvious, however easily one can make it sound like it is.

  6. RTD — I certainly agree that those policies would be pretty effective at tilting cap structure away from debt. I’m not sure we need to go that far. I’m hopeful a so-called “level playing field” might be enough, and there are benefits to debt financing as well… We could just make dividend payments deductible, that’d be another way of leveling playing field that would arguably make markets “smarter”, as investors would be more called upon to actively reinvest rather than let firms retain on their behalf. Or we could make interest payments nondeductible, and the we wouldn’t have to worry about offseting lost tax revenue at all!

  7. I agree with RueTheDay that the tax favoritism for corporate debt and against dividends is inefficient. It causes firms to take on too much debt, and Wharton financial economist Jeremy Siegel makes a very strong case that the discouraging of dividends is a cause of inefficiency in corporations.

    The gist of one of Siegel’s main arguments is that managers can do lots of things to cook the books and mislead shareholders in the abscence of having to pay much or any dividends, but if they have to pay a large regular dividend then it’s much harder to mislead about how well the firm is doing, becasue if it really isn’t doing well, and/or is being mismanaged, it won’t be able to keep paying the high dividend.

    There are other benefits too to dividend payout. Siegel lays out the case nicely in his excellent books, “Stocks for the Long Run” and “The Future for Investors”.

    There are a lot of more efficient ways we could tax, especially by taxing negative externalities, and that includes a lot more than just pollution. Cornell Economist Robert Frank lays out a compelling case for taxing against the negative externalities for self destructive prestige arms races in his book “Luxury Fever” and many other books and articles, academic and popular. This is a very important issue.

    But although taxes can be more efficient, a huge key to growth still is increasing them and making far more high return investments in basic science, infrastructure, education, etc.

  8. Benign Brodwicz writes:

    Great post, Mr. Waldman. The profit share of income is near record high levels, as are income and wealth inequality. The labor share is near record low levels, effective unions are nonexistent, and millions are afraid of getting fired and losing their houses. Moreover, no one seems to find anything wrong with management using share price as a measure of their own performance and then availing the firm of oodles of debt to buy back its own shares (actual US outstanding equity has been shrinking for some time) to boost its price–and telling people it’s a measure of their management effectiveness! We live an an age of larcenous financial tricksters… as if debt creates value!

    Giving management more money (which is where the money would go) would only ensure that labor gets screwed further. I see this as more of the “fracturing America” syndrome that some seem to welcome… (see D. Orlov, Reinventing Collapse, comparing the social declines of USSR past and US present).

    Fairy tales indeed. What world do these guys live in?

    Ending deductible interest, one of the many monopolistic subsidies to the banking system, is a great idea. Even with a Ph.D. in economics it took me years to figure out that the standard deduction was eating up my tax shield.

  9. anon writes:

    A one-time windfall to investors is valuation based – it does nothing in terms of new funds available for real economic investment.

    The question for investment is whether, taking into account any effect on wages, the firm generates more after tax return on equity – not how the cost of capital or stock prices are affected.

  10. anon — while you were writing here, I was addressing your comment with a very long response over at Mark Thoma’s. I’ll reproduce that here too:

    S’pose so, the simple story. S’pose the tax the after-tax ROE of corporate projects instantaneously rises by ~50% (a complete elimination of the corp income tax, incidence was entirely to equityholders). Is there new investment? Maybe.

    Suppose that capital structure is constant, the supply of capital is fixed, and that investors preference is to consume all capital above present returns. Very unrealistic, but work with me. In this case, obviously, no new investment can occur. Stock prices won’t rise, even though economic returns do. Managers considering new capital investment would have to deliver returns consistent with existing projects, so projects that were marginal before the change are still marginal after the change. But the after tax ROE on these marginal projects is now 50% higher than it was before the change, and are still not worth funding! How would we describe this situation? We would say that economic returns have increased, but the required return for an investment project has increased commensurably, so nothing has changed in terms of capital investment.

    Now that’s an unrealistic extreme case. If the supply of equity capital is not fixed, but is instead modestly sensitive to returns, holding all else constant, there would be investment projects previously unfunded that the new capital would fund. To a firm manager, it would appear that after-tax cash flows from potential projects would have grown, and return requirements from equity markets would also have grown, somewhat less than after-tax ROE, so marginal projects that previously wouldn’t have been funded now are worth pursuing.

    We can posit any “elasticity” to the supply of new equity capital with respect to after-tax returns as we want. That’s something we don’t know. So, under all the assumptions above, we’d expect capital investment to increase anywhere from zero to a whole lot.

    But that’s not the only factor we unrealistically held constant. By eliminating the differential taxation of debt and equity, we have made deleveraging much more attractive. Ceteris paribus, that would absorb equity capital without corresponding new investment, and we have good way of predicting how much investors would choose to avoid capital structure risk when there is no financial incentive to take it on. So, we have one effect that would increase capital investment by an uncertain amount, and another that would decrease. Note that tautologically this, capital structure changes would also show up in return requirements for new projects under the reequilibriated capital structures. So, we’d have after tax ROE pushed up by the change, required returns for capital investment diminished by an increased supply in capital but increased by changes in capital structure.

    Now there’s a third factor we unrealistically held constant, reinvestment. If after-tax ROE increases by half, if part of the difference is reinvested, that would obviously increase capital investment relative to our unrealistic starting case. Suppose investors hold fixed the fraction of returns they wish to consume after the change. Then, one period after the tax change, capital investments that had not otherwise been undertaken would be. Again, tautologically, from the perspective of firm managers, firm cash flows are higher than they would have been, but return requirements must have increased somewhat less, for these to be positive NPV projects.

    Return requirements give us a nice shorthand for capturing all of these effect. If after-tax ROE does grow, then how much new capital investment is undertaken is a function of how little return requirements grow relative to the after tax cash flows. If return requirements grow very little, there’d be a lot of new investment. If they grow very much, there could be no new investment, or potentially less investment, if the deleveraging effect predominates.

    It’s tempting to believe that the first factor would be the most important, that higher after tax ROEs would draw new aggregate investment. But it’s not at all clear that the total supply of capital is particularly elastic to ROE. Even if there is a strong relationship between equity capital and ROE (not at all clear, when you look at how valuations jump around), much of the capital attracted might be capital diverted from fixed-income markets. In which case bond prices would fall interest rates would rise relative to ROE, increasing the deleveraging. Effectively, funds might well merely shift from bonds to stock without any new capital being made available for investment.

    If you look at this decade, the savings glut era, it’s plain that an important part of the aggregate growth in supply of capital was return insensitive, the decision to save was independent of return expectations. Now perhaps this period has been an anomaly, but it did happen. And generally, it’s not so implausible that changes in after tax ROE would have a much stronger effect on capital structure than aggregate supply. How much to save or to consume might be much less price sensitive than whether to invest in stocks or bonds.

    Eliminating the corporate income tax almost certainly would have some positive effect on after-tax ROE, though more modest than a 50% increase, since investors don’t bear the entire tax. But it also almost certainly would cause some increase in required returns to capital, blunting its capacity to promote new investment. At the margin, probably it would make some otherwise unattractive projects attractive, but the magnitude of the effect might be not be large at all, especially if you believe Mankiw on incidence.

    (All this leaves aside the question of whether our failure to fund projects currently deemed marginal is harmful to future productivity and growth…)

  11. Richard — “…a huge key to growth still is increasing them and making far more high return investments in basic science, infrastructure, education, etc.”

    Couldn’t agree more. But it’s the quality of our investments than the quantity that has been lacking.

    I’m also with you on dividends and discipline, but we’d have to fix the tax discrepancy between pure capital gains from retained earnings and dividend payments / reinvestment cycles, and make equity issuance by firms more continuous and convenient to move to a world where in aggregate investors control the distribution of past earnings, rather than managers who retain and can abuse.

    B9 — Please, call me Steve.

  12. Patrick writes:

    Thinking over your point about a firm’s Weighted Average Cost of Capital: if investors favored lower-debt firms, the firm’s WACC would shift towards the firm’s borrowing rate as cost of equity fell (market up, firm up less or even down implies beta falling implying Cost of Equity falling). This only holds when the Cost of Equity runs higher than Cost of Debt (typically true due to the additional risk), so in firms with Cost of Equity > Cost of Debt, the increasing delta between after-tax returns and WACC means the firm would be more profitable (using WACC), rewarding investors who weren’t debt-averse….

    More interestingly (maybe ;), is the loss aversion story? Before the tax break, a firm would have a $100M investment to make $20M / year. The potential after-tax loss would be $65M versus the yearly after-tax benefit of $13M. Post tax break, the loss would be $75M and benefit $15M. Loss aversion may cause firms to balk at the additional benefit…. Very slick! However, do firms exhibit loss aversion?


  13. anon writes:

    Thanks for your response – more than warranted by an overly sparse comment. I agree with your description of the potential effects in various permutations of ROE, cost of capital, capital structure, reinvestment, etc.

    I was picking up on what I thought was a reference to a “one-time” tax windfall. (I don’t see it now. I must have misread.) Holding all other things equal for a moment, lower corporate taxes would immediately show up in equity revaluations (e.g. using old parameters, before the market “reconsiders” a new required after-tax cost of capital among other things). This pure revaluation effect has no impact per se on funds immediately available for investment (although the future cash flows it is discounting would have an effect in the future). Following that, all your other considerations would then be in play over time, and just about anything goes in terms of the distribution effect over time.

    This reminded me more generally of Greenspan’s testimony to Congress, when he was talking about the wisdom of personal stock market accounts for Social Security. He made quite a point of saying that capital gains don’t fund investment. The audience was of course glassy eyed.

    But after all I don’t think this sort of point was your intention.

  14. I read Mankiw’s piece and thought it junk. However. I favor the tax deductibility of dividends and have for over 30 years. Being a CPA, I can say the difference in “interest” and “dividend” taxation creates a lot of IRS problems. What would reducing the corporate tax accomplish in my opinion? An immediate boost in stock prices by about 10-15%, that’s all. A few investment projects would be undertaken as the market’s cost of capital decreases. So? It ain’t gonna bring us into the land of Merle Haggard’s “rainbow stew”.

    Guess what? I favor the proposal. Why? I favor tax cuts. The thought that government can better “invest” money than the market is a fantasy of academic economists and politicans. Any economist who thinks so, should show us his “cojones” and manage a mutual fund. We’ll quickly see how smart he ain’t. Imagine, there are fools out there who are today’s “Atari Democrats”.

  15. Jesse writes:

    Tax ‘cuts’ without commensurate tax spending reductions are just tax liability transfers.

    I would like to think that the ‘supply side economics’ myth is in sufficient disrepute by now to forego further discussion.

    We will keep stressing the financial system until it breaks, and then there will be a wailing and gnashing of teeth.

  16. pl writes:

    If I understand, you argue that a reduction in taxes would result in poor use of additional funds released by a reduced tax perhaps because attractive but constructive uses would likely not be available. Am I to understand from this that the taxes themselves are put to constructive and attractive uses?

  17. surferdude writes:

    to level the playing field bewteen debt and equity simply only allow 50% of each payment to be tax deductible. the post 2001 tax code change to lower the tax rate for dividends for individuals was not a properly structured incentive to encourage firms to use equity over debt financing. this change largely benefited wealthly individuals and did not alter the behavior of corporations.

  18. Benign Brodwicz writes:

    Steve –

    Please call me Benign. I don’t us the number.

  19. Benign Brodwicz writes:

    One last comment.

    In search of… fiscal balance in a contractionary environment, tax cuts should only be used when directly aimed at replacing contracting AgD:

    [C]onsumer spending increases should be approximately zero for the next three years. Further exacerbating the problem is the personal saving rate which declined from 5.2% in the decade of the 1990s to average 1.3% in the last seven years, and now stands at 0.3%. Should declining wealth, rising unemployment and poor economic conditions cause consumers to begin to save and lift the rate back to the 1.3% average of the past seven years, real consumer spending would experience a multi-year contraction.

    Source: Van R. Hoisington and Lucy H. Hunt, “Quarterly Review and Outlook,” John Mauldin’s Outside the Box, April 21, 2008

    If any sector gets a tax cut, it’s the relatively broke bottom 50%-80% of the household income distribution. Transfers to maintain social stability, such as bailing out people dumb enough to be tricked into taking on mortgages they couldn’t afford, may also be used. For the brokers, investment bankers, or rating agencies to point a finger and say “personal responsibility” is not creditable, as so few of them kept any skin in the game. And I have a feeling that public works project are going to be coming back into style. Even so, standards of living need to decline, as most Americans have been living beyond their means.

    Yet revenues need to be raised…and people pay taxes. No one has mentioned increasing the capital gains tax rate to, say, 20%, to eliminate the obscenity of hedge fund managerial compensation being taxed at a lighter rate than earned income (commented upon by W. Buffet). This should be done.

    A suitable floor should be established for the estate tax, say $5m-$10m, and the estate tax should recommence at the old rates, around 50% as I recall.

    The payroll tax ceiling should be removed. Then it would a pure flat tax, right? What could be wrong with that, ye neocons?

    Any finally, top marginal tax rates on ordinary income need to go up, say, to 50% on very high incomes, say above $250K-$300K, pushing the top 1% level. Marginal tax rates were much higher in the 1960s when growth was stronger.

    Spending cuts? I have to think that we can spend smarter in our military budget, save some money and replace some consumption demand lost closer to home. Social Security benefits will be further reduced by revised inflation measures and eligible age increases. Thnk of what the $500+ billion spent in Iraq could have done at home.

    I realize this is impressionistic, but when you have Big Establishment Mouth-Pieces like Mankiw going off the deep end with aphasic Reagan imitations pandering to the monied classes, you have to wonder if the level of public discourse isn’t a bit too rarified. There are some very difficult distributional decisions that need to be made.

    I used to say when in academics that the biggest fairy tale was that incomes reflected marginal productivity.


  20. Patrick — I don’t totally follow your comment. I’m not sure how the market-required equity returns would shift relative to market-required debt returns after the change, as firms would issue more equity (raising return requirements by investors) but shed risk (lowering the cost of equity), while debt would look the same to investors, but there would be less of it for clienteles that require it, potentially lowering market returns. It’s too complicated for me to predict. It’s also not clear to me whether the overall WACC of firms would rise or fall, because that depends on the overall supply of capital, which might or might not be affected by the change.

    Loss-aversion and leverage are certainly relevant to firms, although one can give theoretical justifications of why they should not be. Firms do try to avoid “distress costs”, and consider financial leverage risky. I don’t quite grok the numbers in your story, but I think there would be two conflicting headwinds re scale of losses: deleveraging would reduce losses as a fraction of owner equity, but the absence of a tax means none of the losses get absorbed by the Federal gov’t, as a sizable fraction is now. (Thus firm “deferred tax assets” would go away.) Overall, I think risk would be reduced, as when firms get in really bad shape, deferred tax assets become useless, they are only realizable when they are not desperately needed.

    But I think I have managed to miss both of your points!

  21. pl — it’s really a measure of differential uses. to like eliminating the corp income tax, you have to believe that the good investors will do, both by potentially increasing aggregate investment and with the additional returns they in aggregate realize, outdoes the the harms to someone else who no longer has those funds available. “The government” is not ultimately the funder of the tax cut, taxpayers or USD asset holders are. You have to ask, among other questions, are the benefits of making extra funds to investors worth the harms to whomever wealth is being transferred from. I claimed that an overabundance of capital meant that the potential benefits to the proposal from an increased supply of capital might be less than boosters suppose, potentially even destructive of value. That’s not really enough to make the case, though (even in broad utilitarian terms, putting aside legitimacy and equity issues). I’d also have to say something about the alternative use. Implicitly I’m suggesting that consumption/investment decisions of the people from whom funds would be taken (relative to the current baseline) would be better than that of those to whom funds would be transferred, including any dynamic effects of the transfer on investment in the overall comparison. That might or might not be true, but the simpleminded case Mankiw makes that investment is surely better than how other taxpayers would use their money is just as suspect.

  22. surferdude — i think if you look into the effect of the dividend tax change, it’s primary effect had to do with agency issues, namely insiders used it as an excuse to take funds out of firms without appearing to show a lack of confidence. From the perspective of firm managers, the dividend tax change only reduced firm cost of capital if investors are actually very sensitive to tax change in setting asset prices. I think the evidence of this is pretty weak. That makes sense too, nontaxable institutions might often be the marginal investor. If asset prices relative to fixed opportunities don’t adjust, for managers making capital structure decisions, the tax change is probably largely a no-op. If dividend payments were made deductible at the firm level as IA suggests, that might have a more significant effect, though it’s hard to predict, since the benefit would be mitigated by dividend payout rations less than 1 (firms always pay interest, but only pay a portion of stockholders’ earnings as dividends). If as RTD suggested, both divs and retained earnings were deductible, that would certainly be a change, but there’d be accounting nightmares if as manipuable a number as earnings translated to an immediate cash-flow tax break.

  23. Benign — Sorry! (I’ll try not to confuse you with ma11ent!)

    Fundamentally, income distribution and growth is the big background question here. You’re clearly into more “progressive” taxation (me too). Mankiw doesn’t expressly make the case in the NYT (that’d go over well), but when I try to make sense of his proposals, I conclude that he believes that income equality is simply bad for growth, that poorer peoples’ marginal consumption is less valuable than the growth that could be achieved by redistributing the same wealth to richer people with a higher propensity to invest. That’s not a ridiculous position, however offensive it might be to those having their money redistributed. One can make an honest case that the growth achievable by upwards redistribution outweighs its harms, eventually even to the immediate-term losers. China might be cited as a case-in-point, as its currency policy caused to workers subsidize firms in the name of national growth in a project that arguably proved worthwhile to the poor subsidizers. If you really believed this to be the right approach for the United States, you might decide that the politics make doing the right thing impossible, so it’s best to argue for the “good” policies with more palatable justifications. Anyway, there is a serious controversy here. I’m not at all persuaded by the upward-distribution case, but I’d respect it a lot more if it were candidly made. You seem quite clearly to have taken a side, different from Mankiw’s, I think… “difficult distributional decisions” is code for pursuing policies directly opposite the view of prosperity embedded in Mankiw’s proposal.

  24. Benign Brodwicz writes:

    Steve –

    My preference for more progressive taxation and less distributional inequality than we have currently has economic support; see Richard Serlin’s excellent May 25 post in the central banking thread. There is evidence of better economic performance with an “optimal” degree of inequality that we have apparently exceeded. Nor does the past 28 years of US economic performance provide strong anecdotal evidence for stronger economic performance associated with sharply increasing inequality (nor does the 1920s).

    Ultimately, the basic issue is that societies fail to cohere beyond a certain level of inequality. Out of such conditions are revolutions born.

    I recommend Strauss &Howe’s The Fourth Turning for a historico-psycho-socio-economic perspective on all this. Most of their prophesies from over a decade ago have come true. We are entering their “crisis” generation.

  25. Benign Brodwicz writes:

    Richard B. Freeman, Alexander M. Gelber

    NBER Working Paper No. 12588

    Issued in October 2006

    NBER Program(s): LS POL

    —- Abstract —–

    This paper examines performance in a tournament setting with different levels of inequality in rewards and different provision of information about individual’s skill at the task prior to the tournament. We find that that total tournament output depends on inequality according to an inverse U shaped function: We reward subjects based on the number of mazes they can solve, and the number of solved mazes is lowest when payments are independent of the participants’ performance; rises to a maximum at a medium level of inequality; then falls at the highest level of inequality. These results are strongest when participants know the number of mazes they solved relative to others in a pre-tournament round and thus can judge their likely success in the tournament. Finally, we find that cheating/fudging on the experiment responds to the level of inequality and information about relative positions. Our results support a model of optimal allocation of prizes in tournaments that postulate convex cost of effort functions.

  26. Benign — I’m definitely with you and Richard on this one, very much actually. As you say, I think we’ve hit terrifying times, center not holding, things fall apart, as Yves Smith reminded a while back.

    But what’s frustrating is that the people who disagree with us have some fair points on their side, but they won’t make the argument. Instead, they get sneaky, doing what they think is right without being candid about why, dissembling in the name of prosperity. That’s bad on a lot of levels: it creates an environment of distrust and conspiracy theory, polarizes the argument (those of us who think inequality is a hazard must always be on guard for hidden foes), and ends up leading to different groups pushing hard in different directions without ever speaking to one another. But (not to be pseudohegelian or marxist), we actually need a serious synthesis of these views. As the abstract you’ve posted points out, there’s probably a U-shaped function here, degrees of inequality (supported inevitably by some form of upward transfer, even if that’s hidden in the wheels of “the market”) that ought to enjoy broad public support and degrees of inequality that are a problem. There’s also such thing as too much equality as well. Americans understand this, historically preferring fairly much inequality, believing that the system that creates it is good for everyone, and that everyone has a not-too-unfair shot at succeeding. But, Americans’ tolerance has led to complacency, so we’re tolerating inequality to degrees that are not beneficial overall and terribly unfairly distributed. As you suggest, I think there will be a reaction, and a bad one, if we don’t resolve this.

    It’d be nice if we could talk to the people on the other side, thoug, because we’ve got to figure out both sides of the U. Mankiw could have candidly stated that, by distributing funds from “spenders” to “savers”, as his regressively funded tax break would, that would probably increase the total supply of capital, and if you believe that capital is the limiting factor in growth and short-term consumption losses by “spenders” would be outweighed by future prosperity, that would be a worthwhile thing to do. But that would have meant admitting that his suggestion is driven by a desire to transfer wealth from poor to rich, because rich invest while poor consume, and he doesn’t have the guts to do that except obliquely and abstractly. He knows he’d be pilloried for stating that in the NYT. So, instead he advocates the policy, but attributes its affect to magical incentives, rather than the wealth redistribution that drives it. There’s no way to have a public conversation about the right balance between promoting equity and sensible regard for the value of resources (favors more equality) and the importance of capital formation to future prosperity (favors inequality if the “savers” invest well) if one side of the conversation is self-righteous (that’s me) and the other side is afraid to make the case but willing to be sneaky.

  27. Joe writes:

    Mankiw blog does not allow comments. We are not to respond to his pronouncements, merely accept and move on w/o question.

    Citing the AIE for matters involving taxing capital is the same as citing scientist paid by Exxon for views regarding global warming.

    Mankiw took a position in a administration that had fired one of his predecessors for making an incompetent budget projection because the projection was not incompetent enough. The same administration that said that the vast majority of their tax cuts go to the middle class.

    Brad Delongs blames the New York Times for publishing Mankiw, I blame his colleages at Harvard for giving him their imprimatur. I’m view it more as the death spiral of the Harvard Economics Department.

  28. Benign Brodwicz writes:

    Just to clarify–productivity as a function of inequality is an *inverted* U-shaped function.

    Investment is primarily a derived demand. A windfall to corporations will just go into management’s and investors’ pockets (sort of like the Reagan-era “protection of American auto workers” went into management’s pockets in Detriot–labor employment actually went down). This would be twisting the knife….

    Consumption at ~70% of GDP has been running well over historical norms. As I’ve said before, the crying need in a contractionary environment is to replace lost AgD dollar-for-dollar as much as possible to prevent multiplier effects. If the Government’s budget could be redirected somewhat more toward Investment through infrastructure projects (public works, whether outsourced or not), that would be one way to do it and help solve the household income problem (and maybe change attitudes toward Government).

    It is entertaining to watch the old guard twisting in their chains.

  29. Joe writes:

    Yes the increase in income realized by the 1% of the population that owes 40% of the wealth or the top 10% that own 70% can be invested in bets on whether companies will go bankrupt (CDS) or MBS’s or CDO’s or all the government securities that will be produced or securiterized credit card oblgations or payday loans or reverse mortgages.

    Wasn’t over investment the end result of the tech boom.

    The right allways makes the claim that the rich never pay taxes that they are allways passed on or gotten around…and this is the reason we shouldn’t even try to tax them?

    I don’t see how you could claim that on direct tax on equity is somehow paid by labor. I could see that a direct tax on equity could be considered an increase in cost and therefore decrease supply and then the consumers of products would pay more but I don’t see the chain of causation other then that. That relative detriment might be offset by a stronger dollar (cheaper oil) and maybe other things for instance veteran benefits or pell grants or reduction in local taxes or or or or.

    I think at the end of the day unless and until there is a non-progressive tax structure with earned and unearned income treated equally, the right is going to continue to make these silly and akward arguements.

    Why doesn’t Mankiw just come out for such a scheme. It would be more intellectually honest then say working for an administration that fired one of his predessessors for not being incompetent enough on a budget projection or that stated that the vast majority of their tax cuts go to the middle class. You think he would have had a clue given how that administration convince us to go to war. It was their budget lies in their original platform that gave Krugman a clue that maybe their case for war might be suspect but I quess Mankiw isn’t as perceptive or as able assimilate information and draw accurate conclusions as Krugman.

    And why dosen’t Mankiw allow comments on his blog? I am sure he has an ostensible reason but I wonder why he only wants to post but not engage in ongoing debate. If he did maybe we could ask him directly about all the nuances in his assertion that a cut in the corporate income tax would be advantageous to all Americans not just the ones that bribe the Republican Party and finance AEI.

    Here’s hopeing.

  30. Benign — I got you on the inverted U, that’s what I meant as well, tho putting degree of equality on the X axis and some totally subjective measure of aggregate welfare on the Y.

    Joe — Mankiw used to allow comments on his blog. Here’s his explanation of why he turned them off.