Reports suggest that the US Congress is making progress toward tax reform. The House of Representatives is still slated to vote on its version tomorrow. It appears likely to pass. The Senate version will be marked up in committee this week. The latest revisions include repealing the individual insurance mandate and ending the middle class and small business tax break after 10 years to reduce the long-term costs while keeping the corporate tax cut permanent.
Many proponents of the proposals make it seem that a corporate tax cut is a panacea for all that ails the US. It will boost investment, which in turn will boost productivity. It will boost wages, which in turn will boost aggregate demand and inflation.
Why would anyone in their right mind object? The simple answer is history. In the recent history of tax changes, there is not much evidence that a corporate tax cut boosts investment or wages. The “trickle down” economics, which the Chair of the National Economic Council, specifically called the current proposals, used to be an epithet. It was a note of derision, and yet in a surreal and Orwellian way, it was used to defend justify it.
Reports suggest at yesterday’s WSJ CEO Council, Cohn, the Chairman of the National Economic Council was surprised that not more corporates planned on increasing investment if the tax reforms were implemented. There is a good reason not to be surprised. First, corporations have reported record profits. The lack of investment is not due to the lack of funds.
Second, businesses have been saying to whoever will listen that it does not plan to invest a windfall from lower taxes. A large US bank surveyed its300 +corporate clients over the summer and found the that paying down debt was going to be their chief use of funds freed up by lower taxes. After paying down debt, share buybacks and acquisitions were most frequently cited. New investment and R&D was toward the bottom of the priorities. This is consistent with what businesses actually did after 2004 Homeland Investment Act, which dramatically cut taxes on repatriated earnings.
Surely, allowing companies to write off the cost of new investment in plant and equipment for the next five years will boost investment. Not really. It assumes that there is some pent-up need that is not being met. Tomorrow, the US reports capacity utilization figures. In September, US factories were using a little more than 3/4 of their capacity. It has averaged 76.2% this year and 75.7% last year, and that is with growth the Fed says is somewhat above trend. The peak since the 2009 trough was in 2014 a little above 79%. Past cyclical peaks were above 80%.
The reason that business investment is low and wage pressures are modest is not because businesses lack funds. The reason is that business doesn’t have to increase such expenditures. To the extent, some businesses are experiencing a that a shortage of some skilled and unskilled workers (as seen in the Beige Book) wages have in fact edged higher.
Some proponents of the corporate tax cut argue that the fewer businesses are paying to the Internal Revenue Service, the more money is available for wages. The assertion that a corporate tax cut to 20% will boost typical household income by $3-$7k has been refuted by many economists, but it also does not pass the smell test. An online poll conducted for the NY Times found 78% of the respondents did not expect that they would receive a raise if their employer got a tax cut.
To be sure, this is not a partisan claim. The survey found 70% of self-identified Republicans and 65% who said they strongly approve President Trump’s performance recognized that corporate tax cuts are unlikely to trickle down to higher wages.
There may be other reasons that some may support the corporate tax cuts, but spurring investment and wage growth are not compelling or convincing arguments. The kind of investment that may be more necessary, and can boost wages and productivity is public investment, but the tax reform proposals will leave little room for an infrastructure initiative.
Although the equity market advance appears to be largely explained by rising earnings, some expectation for tax cuts may have also lent support. During period of Fed tightening, it is not unusual for the yield curve to flatten. Tax reform could help counter the flattening, but with around $11 trillion of negative yielding debt (in Europe and Asia), and the US the only major center that the supply of new bonds will outstrip the demand from the central bank, the demand for the long-end of the curve may not slacken much, while the short-end is anchored by Fed expectations.