In 1936, John Maynard Keynes aptly dismissed the macroeconomic orthodoxy of the day that supply creates its own demand – a theory known as Say’s Law. Keynes’ reasoning was simple: without growing wages, employment, or productivity, consumers physically cannot demand more goods, irrespective of the quantity supplied, due to their personal financial constraints. It therefore appears nonsensical that 80 years on the U.S. Congress is attempting to force through a tax reform bill that flies flagrantly in the face of economic literacy by assuming that vast tax breaks to large corporations will serve to kickstart growth and productive investment – without a corresponding boost to variables such as wages or productivity.
The theory behind slashing corporation tax is that higher profit margins will allow firms to invest more in their business which will in turn improve the quality of physical capital and drive up wages as well. Some would even go as far as to argue that this additional economic activity could provide sufficient tax revenue to cover the losses from the lower rate. However, contrary to Mr Trump’s personal philosophy, the empirical data must be considered before conducting such dramatic reforms. Analysis conducted by the Peterson Institute for International Economics found that cuts to corporation tax since the 1960s, when the rate was at 50%, have had no effect on gross business investment as a percentage of GDP – which has consistently been at around 10%. However, corporate tax revenues as a percentage of corporate profits has decreased markedly – from around 40% to 20%.
The glaring issue raised by this data is around where the money is actually going. The repatriation tax cuts initiated by Bush in 2004 had no tangible impact on growth as the vast amount of additional profit was spent on stock buybacks, and it is extremely likely that this would continue to be the case if the Republican plan passes through Congress. Corporate profits as a % of GDP in the US are approaching an all-time high, but despite this investment is still low. This suggests that companies are not reluctant to invest through lack of available cash – but rather that they conclude that there is not sufficient demand for additional production, due to slowly rising wages and productivity. As such, increased investment is seen as potentially uneconomical for firms.
This point is clearly illustrated through the Bloomberg analysis of the finances of the tech giants in the U.S., which found that through the first 9 months of 2017, $55bn was spent on productive investment, compared to $190bn being kept in cash, dividends, and stock buybacks. It seems clear from this that it is not a lack of cash that is hindering investment. It follows that it is therefore extremely unlikely that an additional handout will serve any productive purpose at all, and the net impact on growth will be minimal. Kent Smetters, a former economic advisor to the White House who now oversees the Penn Wharton Budget Model, does not expect the legislation to produce any more than a 0.1% increase in annual growth rates over the next 10 years. The one area of the U.S. economy that is likely to see growth is the stock exchange – as increased demand through buybacks will continue to fuel asset price bubbles and exacerbate economic inequality.
The Republicans have attempted to brand this plan as relief for the American middle class. While there are headline clauses that hint this is not truly an equitable tax reform programme, such as tax relief for owners of private jets, more subtle analysis paints an even more insidious picture. One very tangible effect will be the $1.5tn black hole in public finances caused by loss of tax revenue over the next 10 years. This will necessitate future budget cuts if Congress is to adhere to its self-imposed fiscal targets. This means $136bn of cuts in federal spending in 2018 alone, which is likely to come through changes to health insurance and child benefits. Furthermore, the Tax Policy Centre estimated that by the time individual tax cuts have expired in 2027, more than 60% of the benefits would accrue to the wealthiest 1% of Americans. This damning statistic surely reveals the reality of the tax plan: its benefits will predominantly be felt by those whose wealth resides in stocks, who are certainly not the ‘hard working middle class’ that the Republicans claim to be championing.
The desire for genuine, reasoned tax reform transcends party lines, and this plan has elements which are certainly laudable. Under the current system interest on debt is treated as a business expense (as opposed to a return on capital) and is therefore a tax-deductible expense of the borrower. This provides a tax incentive to fund activity through debt rather than equity, which exacerbates the precarious levels of corporate debt in America. The plan passed through the Senate proposed capping the amount of tax-deductible interest at 30% of a company’s taxable earnings, although this is unlikely to affect many companies. This tentative step in the right direction demonstrates the potential for progressive reform, although it does not go far enough.
While there is a case for cutting corporation tax to kickstart investment in certain circumstances, the economic climate of astonishing corporate profits combined with stagnant wages indicates that the current plan will do little to generate the promised growth. This will merely serve to line the pockets of U.S. corporations ultimately at the expense of the Federal budget and worse, the American people.