In Praise of a Corporate Tax Cut

Bloomberg View columnist Tyler Cowen, a professor of economics at George Mason University and Marginal Revolution blogger says "Republicans have science on their side when it comes to corporate tax reduction." Is Cowen right? If so why?

It is not often I agree with Cowen or academics in general. But sometimes they get it. Cowen is largely on target when he says Yes, a Corporate Tax Cut Would Increase Investment.

A common criticism of the current Republican tax plans is that they will not boost private investment. While I have major reservations about these plans as a whole, this particular objection is oversold.

The evidence on investment behavior is fairly clear. When companies have more “free cash” at hand, they tend to invest more, and this effect is distinct from any effect of the tax cut on expected rates of return. So, in other words, when critics call the corporate rate cut a “giveaway” to business, that is precisely the mechanism that tends to boost investment.

Furthermore, while these investment boosts are strongest for companies that are cash constrained, they also seem to occur for the companies that have a lot of cash on hand, as is often the case with today’s profitable corporations.

A related worry is that companies will take their cash windfalls and simply return them to investors in the form of dividends and cash buybacks. First, the evidence doesn’t support this fear.

More generally, sending money back to investors doesn’t have to mean no new investment. What if those investors take the money and put it in a venture capital fund or invest it in some other manner? The whole point of capital markets is to recycle resources into the most profitable new opportunities, and that may or may not involve the companies that initially earned those profits.

Many economic effects operate without all of the participants knowing exactly what is driving the final result. For instance, more cash in corporate coffers could induce managers to develop more good project ideas for the CEO. The CEO might feel he or she is responding to the higher quality of project ideas, rather than to the corporate rate cut per se.

More importantly, let’s take the extreme scenario where companies simply take all of the proceeds from the tax rate cut and put them in the bank, never increasing their own investments as a result. Well, the banks now have more funds to lend out, and so investment still is likely to go up, even if this happens somewhere far and wide from the original corporation earning the new profits.

Whoa! Stop Right There

Until that paragraph, Cowen was 100% spot on.

Where is Cowen wrong? The answer is banks do not lend from reserves or excess reserves.

Professor Steve Keen agrees.

BIS Study

The level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.

The main exogenous constraint on the expansion of credit is minimum capital requirements.

An expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. (emphasis by Mish).

Cowen Conclusion Back on Track

Just to be clear, I think the currently circulating versions of the tax plan are unwise. They increase the deficit too much, don’t have the right kind of distributional consequences to prove stable, and they might eliminate the Obamacare mandate without a planned stabilizing replacement. Those and other more technical reasons are enough to bring at least parts of these proposed laws back to the drawing board.

But when the critics allege that corporate tax rate cuts won’t boost investment, that’s going against basic economics.

Pertinent Tweet

Political Labeling

One of my readers was upset with me last week when I agreed with a bunch of EU academics regarding Catalonia. The reader's objection was that I agreed with a bunch of academics.

I asked the reader what that they said that he disagreed with. He could not come up with anything other than I was siding with academics.

I see the same thing all the time in politics. People are anti-Trump and will mock him just because he is Trump. The same thing happened with Obama.

It's important to put politics aside and look at what people say.

I did not think I would be agreeing with Cowen on much of anything. But here we are. Cowen nailed the essential idea even though he got a bit off base on one of the reasons why.

Mike "Mish" Shedlock

Comments
No. 1-6
SleemoG
SleemoG

Yes, much more an art than a science.

Stuki
Stuki

Economics never pretended to be a "science" in the empirical sense. Practiced properly, at the "macro", or "political economy" level, it's just deductive logic. Predicting the future based on observation of the past, which is what natural science is about, simply has no basis, when every single individual atom under study (in economics individual actors), are actively trying to game every other, based on all of the same information that led scientists to make their predictions in the first place.

SleemoG
SleemoG

"One of the reasons economics isn't a real science is that no one ever tests their hypotheses." Agreed Jon. Another reason is because it's impossible to perform controlled experiments. It;s also helpful to define terms -- if something isn't a "real" science, then it is not a science at all. We call those other things "religions" or "superstitions."

Stuki
Stuki

A more fundamental objection to what Cowen is preaching, is that at what is (one would at least hope) the peak of a pump-everything-as-high-as-it-goes asset bubble, more investment, directed by the same people who are already doing plenty of it, is exactly what is not indicated. All it leads to is even more malinvestment than what is already undertaken. AKA, even more chasing the same arbitrarily-classed-as-investment-hence-a-priori-presumed-to-be-good-by-the-drones pumping up of idle “asset prices” than we are already seeing. With the sole effect of driving up costs for, hence displacing, actual value adding projects, that could otherwise have been undertaken cost effectively.

The funds that will supposedly be spent on “investments,” won’t just pop out of nowhere. Instead, they will necessarily reduce the amount of spending someone else is able to undertake. If that someone else is just government waste (as in proposed corporate tax cuts or no tax cuts at all), no doubt any other potential use is a benefit. Up to, and by now probably, investing in military capabilities for ISIS and Kim.

But if the tax cuts are instead directed at people, who are currently not in a position to direct where as much spending goes as corporate decisionmakers are even absent tax cuts, we may just see some new projects undertaken that, lo and behold, may actually be useful. Even in not exactly low wage Silicon Valley, most innovation, and most cumulative value add, is without doubt undertaken by people making at most $250K/year. So just crank the standard deduction as close to that as possible, and you’ll increase the share of spending/investment (as if the two really differ…) directed by people who just may have something useful to contribute. Instead of just throwing ever greater discretion over total spending at a group whose spending is deep into diminishing returns already, and will hence just lead to even more destructive waste than what is already occurring.

gstegen
gstegen

Professor Cowen missed the point on the bases for corporate tax cuts. He says: “When companies have more “free cash” at hand, they tend to invest more, and this effect is distinct from any effect of the tax cut on expected rates of return…. a “giveaway” to business…is precisely the mechanism that tends to boost investment.” He admits an effect from expected [after tax] rates of return but suggests simply giving corporations more cash is the main effect. The expected risk adjusted after tax return on investment (ROI) may not be the only consideration in investment decisions but it is certainly the primary consideration for well-run companies and for investors considering investments. Relative ROI of alternatives also affects decisions on where the investment facilities will be physically located and deal structure. Investment options with attractive ROI will tend to get funded, either from available cash, by borrowing, or if need be by selling additional stock.
The corporate tax cut is expected to increase investment by increasing expected after tax return on investment. However, a primary objective is to influence both where the investment is located and where the corporate owners of investments are located (domiciled for corporate tax purposes). Specifically it is intended to increase the probability that new investments will be made within the US and to increase the probability that investments will be owned by US domiciled companies.