Rabu, 07 Maret 2018

Response to Williamson on taxes

Steve Williamson has an interesting new post on corporate taxes and investment, in which he claims that taxing corporate profits has no effect on investment.


What happens if the corporate tax rate goes up permanently, with the tax rate constant forever...? This has no effect on investment or on the firm's hiring decisions in any period. That is, if VB is before tax profits, then (1-t)VB = V, so maximizing VB is the same as maximizing V, and the tax rate is irrelevant, not only for investment decisions, but for the firm's hiring decision. In the aggregate, there is no effect on labor demand, and therefore no effect on wages. 
Basically, investment is an intertemporal decision for the firm. But the corporate tax rate affects per-period after-tax profits in exactly the same way in every period, so there is no effect on the after tax rate of return on investment the firm is facing. Therefore, the firm won't invest more with a lower corporate tax rate ...
Steve concludes
But, the tax bill is not about investment. The primary effect is redistribution. In the short run, the tax bill makes the rich richer and the poor poorer...
You can see there is a problem. If Steve is right, then why not a 99.999% capital tax rate? Per Steve, it won't distort any decisions, neither investment nor hiring nor starting companies, it will give a revenue bonanza for the government and it will transfer income efficiently. Surely if 99.999% corporate taxes had no disincentive effects, governments would have noticed? Surely not every single Republican is, as Steve implicitly charges, either lying through his teeth or an economic ignoramus when they state the goal of the tax cut is to spur investment, and thereby productivity and wages?



The answer is in a previous post on the burden of taxation, and Greg Mankiw's algebra but at the cost of repeating let's isolate the central issue. (The previous posts were too long, for sure.)

If you want equations, go back to  Greg Mankiw's algebra. There you see a model in which corporate taxes do distort the intertemporal incentive to invest.

The key difference: In his simple model, Greg defines profits as sales - wages. Then if the firm pays $100 to invest today, makes $10 out of it tomorrow after paying wages, but faces a 50% tax rate, it gets a 5% rate of return, while without a corporate tax it gets a 10% rate of return.

Steve defines profits as sales - wages - costs of investment. He effectively assumes that all investment is tax deductible. Then indeed a constant tax rate does not distort the rate of return. The firm gets the tax deduction on the investment made today, and that compensates for the lost profits tomorrow.

This is then the same argument that was floating around last time, (see posts for links) that full expensing of investment alone should solve the intertemporal distortions, and then tax capital at any rate you like including 99.999%.

What's the problem with that? Well, if you apply it completely, there is nothing left to tax. If a debt-financed firm can deduct from its sales all wages, inputs, investments, and interest payments, there is nothing left to tax.

The tax code seems to think payments to shareholders are "profits" which can be taxed without distortion and interest payments are "costs" like the electric bill that must be deducted. But there is no  fundamental economic distinction between debt and equity as a marginal source of investment funds. Dividends (and capital gains) are the returns you must pay to attract equity investors, just as interest is the return you must pay to attract bond investors.

So how do you deduct investment and leave something left over to tax? It rests on two ideas. First, that the tax code can distinguish "real" investments like buying forklifts from "financial" investments like buying stocks and bonds, and only deduct the former.

Second, that there is some pure "profit," some pure "rent," some "unreproducible input" (i.e. something that did not come from a past unmeasured investment), something like the classic "unimproved land" that can be taxed, without distorting any decision.  It goes hand in hand with the  complaints of greater monopoly.

But I find it hard to find and name a concrete source of profits that, once named, does not distort the decision to undertake some useful activity to make those profits. Starting, organizing, and improving a business, figuring out the intangible organizational capital that makes it a successful competitor, creating a product and a brand name, are all crucial activities for which  no investment tax credit will successfully offset a large profits tax.  "Intangible capital" is about all most companies have these days.

Aside the investment distortion, I see an important political economy argument against corporate taxes. Corporations have a lot of money, and really good lawyers and lobbyists. The higher the corporate tax rate, the more they will run to Washington to demand special credits, exemptions, and deductions. Like expanded investment deductions. Already, the corporate tax was effectively about 20% rather than the statutory 35%. I can't see any defense other than a lower rate, and tax people rather than corporations.

Two  final points of clarification.

First, Steve positioned his post as a response to my buyback fallacy post

"Here's John Cochrane, writing about the 'buyback fallacy:' 
'Many commenters on the tax bill repeat the worry that companies will just use tax savings to pay dividends or buy back shares rather than make new investments.' 
But, John concludes: 
'Investment will increase if the marginal, after-tax, return to investment increase...'"
The second point, which we are discussing here, has absolutely nothing to do with the first point, the buyback fallacy. Whether corporate taxes do or do not distort investment decisions, buying back shares has nothing to do with it. The buyback fallacy remains a fallacy even if Steve is right and 99.99% corporate taxes have no effect on investment.

Second, he writes
this has no effect on investment or on the firm's hiring decisions in any period.
Noone, not even Congressional Republicans, claimed that lowering capital taxes increases the incentive to hire directly. The reason is clear from the above -- in everyone's model, wage payments are deductible, profits = (sales - wages - ....), wages go inside the parentheses. The argument has always been that lowering corporate profits taxes increases the incentive to invest, and moreover to start new firms or reorganize them, that this investment would raise productivity, and that would lead to higher wages.

Steve didn't say otherwise, but you might have gotten the impression.