One last time on who benefits from corporate tax cuts
Larry Summers
I recently asserted that Kevin Hassett deserved a failing grade for his "analysis" projecting that the Trump administration proposal to reduce the corporate tax rate from 35 to 20 percent would raise the wages of an average American family between $4,000 to $9,000. I chose harsh language because Hassett had, for what seemed like political reasons, impugned the integrity of people like Len Burman and Gene Steuerle who have devoted their lives to honest rigorous evaluation of tax measures by calling their work "scientifically indefensible" and "fiction." Since there have been a variety of comments on the economics of corporate tax reduction, some further discussion seems warranted.
The analysis from Hassett, chief of the White House Council of Economic Advisers (CEA), relies heavily on correlations between corporate tax rates and wages in other countries to argue that a cut in the corporate tax rate would boost returns to labor very substantially. Perhaps unintentionally, the CEA ignores our own historical experience in their analysis. As Frank Lysy noted, the corporate tax cuts of the late 1980s did not result in increased real wages. Actually, real wages fell. The same is true in the United Kingdom, as highlighted by Kimberly Clausing and Edward Kleinbard. These examples feel far more relevant to the corporate tax issue analysis than comparisons to small economies and tax havens like Ireland and Switzerland upon which the CEA relies.
There has been a lot of back and forth, but notably no one has defended the $4,000 claim as a "very conservatively estimated lower bound," let alone endorsed the plausibility of the $9,000 claim. In fact, the Wall Street Journal op-ed page published two very optimistic versions of what the wage increase could be, which were below CEA's lower bound.
Casey Mulligan and Greg Mankiw also do not defend CEA's numbers, but do make use of simple academic abstract models that do not capture the complexities of a policy situation to argue that wage increases could be larger than the tax cut. The inadequacy of their analyses illustrate why well-resourced, team-based institutions with a strong culture of attention to detail like the Congressional Budget Office, the GAO, the Joint Tax Committee Staff or the Tax Policy Center are so important.
Mankiw's blog is a fine bit of economic pedagogy. It asks students to gauge the impact of a corporate rate reduction on wages in a so called "Ramsey" model or equivalently in a small fully open economy, with perfect capital mobility. Even with these assumptions, he does not get answers in the range of the CEA's estimates.
As a device for motivating students to learn how to manipulate oversimplified academic models, Mankiw's blog is terrific as one would expect from an outstanding economist and one of the leading textbook authors of his generation. As a guide to the effects of the Trump administration's tax cut, I do not think it is very helpful for three important reasons.
First, a cut in the corporate tax rate from 35 to 20 percent in the presence of expensing of substantial or total investment has very little impact on the incentive to invest. Imagine the case of full expensing. If a company is permitted to deduct all of its investment costs and then is taxed on all of its investment profits, the tax rate has no impact at all on the investment incentive. If investments are financed in part with deductible interest, as would be true even under the Trump plan (where expensing would be total), a reduction in the corporate tax rate could easily reduce the incentive to invest. Mankiw assumes implicitly that capital lasts forever and companies take no depreciation and engage in no debt finance. This is not the world we live in.
Second, neither the Ramsey model nor the small open economy model is a reasonable approximation for the world we live in. In the Ramsey model, savings are infinitely elastic, so the real interest rate always returns to some fixed level. In fact, real interest rates vary vastly through space and time, and generations of economic research show that the savings rate rather than being infinitely sensitive to the interest rate is almost entirely insensitive to the interest rate.
The United States is not a small open economy. If it were, the effect of an effective investment incentive would be a major increase in the trade deficit as capital inflows forced an excess of imports over exports. I imagine that President Trump at least feels that a greatly augmented trade deficit is not good for American workers.
Third, a big cut in the corporate rate does not happen in isolation as a break for new investment. Mankiw's model does not recognize the possibility of monopoly profits or returns to intellectual capital or other ways in which a corporate tax cut benefits shareholders without encouraging investment. It means either increases in other taxes or enlarged deficits, both of which have adverse effects on households. It also means that capital moves out of the non-corporate sector into the corporate sector, tending to hurt workers in the non-corporate sector.
Mulligan accuses me of rejecting the results of my 1981 paper on Q Theory which he claims to like and teach. I'm flattered that he appreciates my paper, but am fairly confident he draws the wrong conclusions from it.
One central aspect of this paper was the recognition that the corporate tax rate is, contrary to Mulligan and Mankiw's assumption, not a sufficient statistic for assessing the impact of the corporate tax system. As I explained above, the paper emphasizes that to examine the impact of a corporate tax change, it is necessary to build in assumptions about depreciation allowances, debt finance and so forth, even if these are being held constant. If Mulligan did this, he would get a very different answer.
The main point of my paper, which Mulligan entirely ignores, was that because of slow adjustment costs, the impact of tax changes was felt primarily on asset prices for a long time. This meant that as my paper showed, the primary impact of a corporate tax cut would be to raise after-tax profits and the stock market. This in turn, as I noted, primarily benefits wealthy individuals. Note that because a corporate rate cut benefits investments already made, this conclusion does not depend on assumptions about depreciation allowances and the like which are important for new investment.
Mulligan also fails to recognize that a corporate rate cut benefits capital and hurts labor outside the corporate sector because it draws capital out of the noncorporate sector, raising its marginal productivity and reducing that of labor. It is true that if the corporate sector is small, this effect is small in terms of return, but by assumption it is large in total because it applies to a large quantity of capital and labor.
It is worth noting that Larry Kotlikoff and Jack Mintz's response to criticisms of the Trump tax plan suffers from the same deficiencies as Mulligan's. The authors include no corporate tax detail, no recognition of the impact of the tax proposal on asset prices, and no treatment of the budget consequences of tax cuts.
The newest boldest bit of claim inflation regarding the tax bill comes from the Business Roundtable: "a competitive 20 percent corporate tax rate could increase wages sufficient to support two million new jobs." This would, coupled with job growth projected even in the absence of a corporate rate cut, take the unemployment rate well below 3 percent! I would be very interested to see the underlying analysis. I would be surprised if it is convincing.
By far the highest quality assessment of corporate tax issues has been provided by Jane Gravelle, writing under the auspices of the Congressional Research Service. It looks at all the literature. It recognizes that the issues are complex and cannot be captured by a single model or regression equation. It does not start with a point of view. Unfortunately it provides little support for claims that corporate rate cuts will raise revenue, help the middle class or spur rapid wage growth.
During my years in government, I served with 7 CEA chairs — Martin Feldstein, Laura Tyson, Joe Stiglitz, Janet L. Yellen, Martin Baily, Christy Romer and Austan Goolsbee. I observed all of them fighting with political figures in their Administrations as they insisted that CEA analysis had to be of a kind that would be respected and validated by outside economists. They refused to cheerlead for Administration policies at the expense of their professional credibility. I cannot imagine any of them releasing an estimate as far from the professional mainstream as $4000 to $9000 wage increase from a corporate rate cut claim. Chairman Hassett should for the sake of his own credibility, that of the Administration he serves and the institution he leads, back off.
Harpers Ferry, WV
