A frequent source of public policy confusion is the
issue of whether corporate tax cuts/tax cuts for the rich (the two are similar but not quite the same) help or harm the economy. The issue is also of increased
relevance at present given Trump’s pledge to significantly cut US corporate tax
rates.
The typical argument from conservative republicans and neo-classical economists in favour of tax cuts for the wealthy is that they boost the economy by providing
increased resources to finance investment. Higher investment, in turn, helps
the economy and creates jobs. A virtuous circle is kicked off, with the lower
economic tiers of society benefitting via the so called ‘trickle down’ effect.
On the other side of the spectrum, you have something akin
to the argument expressed by Nick Hanauer in the link below – that rich people don’t create
jobs, only customers. So who is right?
The answer - as is usually the case with complex issues of
policy and economics - is that it depends. Nuance is important here, and unfortunately such nuance is too seldom found in the debate. In some cases
tax cuts for corporates and the wealthy will help the economy, but in other
cases they will harm the economy. And at the present time, the latter is more
likely true than the former.
There was an excellent book written some years by Eliyago M. Goldratt called The Goal, that introduced the ‘theory of constraints’. The argument expressed
in the book is that to improve the efficiency of any manufacturing product
line, the best approach is to figure out where the largest bottleneck or
constraint to faster or more cost effective production is, and then focus resources on addressing that issue. A framework somewhat akin to that is useful when considering how to redress economic woes – what is the main constraint holding back the economy at
present?
There are two basic sub-optimal economic environments that
can prevail – one of supply-side constraints, and one of demand-side
constraints. In the former environment,
there is plenty of demand, but there is not enough investment or supply-side
capacity to meet that demand. This is usually an inflationary environment with
high interest rates, reflecting a scarcity of both goods & services and capital. The latter environment
is one where you already have more than enough supply-side capacity to meet existing
demand, but a lack of demand is holding back growth. Corporates will not invest and hire people, after all, if capacity utilization is already low - why should they? This is usually an
environment of low inflation/deflation and low interest rates. In an ideal
world, both demand and supply would be in balance and growing nicely along side one another – a ‘goldilocks
economy’ – but in the real world, things are seldom in perfect balance.
In a supply-constrained economy, tax cuts will indeed boost
the economy and job growth. In such an environment, the cost of borrowing is high and corporates do not
have enough capital to finance the investments they would like to undertake. Relieving this constraint by increasing resources for investment is the right
policy prescription, and tax cuts for corporates/the rich, who tend to save a high proportion of their income, will certainly help in that regard. Investment will rise; inflation will come down as capacity constraints ease; and job
growth will be robust. Furthermore, a larger tax base as the economy grows will offset lower percentage tax rates for government income, in typical 'Laffer curve' fashion. Everyone wins.
A supply-constrained economy is the environment that existed in the late 1970s. Inflation was high; interest rates were in the double digits; tax rates were extremely high - often above 50% at higher brackets; and labour markets were highly inflexible and excessively unionised. Dissatisfaction with the stagflationary status quo resulted in right wing conservative
governments being elected – think Reagan and Thatcher – who proceeded to implement supply-side reforms via deregulation and tax cuts. The economy subsequently did well and
inflation fell. This experience reinforced the ‘republican consensus’ that
supply side reform is always good and needed.
The problem is that that policy prescription only makes
sense in a supply-constrained environment, and there is an alternative economic
ill that can prevail – one of inadequate demand. And if supply-side policies are pursued to address demand-side problems, such policies will not only fail to solve the problem, but will likely actually actively worsen the situation. Republicans
and other conservative economists do not seem to understand this, and it is dangerous.
A demand-deficient environment is one that is usually caused by Keynes’ famous ‘paradox of thrift’. For any one individual, saving is a good
and prudent thing. But in the aggregate, excessive system savings are destabilising and can be a total disaster. When someone saves instead of spends, they withdraw demand from the
system and deprive somebody else of income. Increased savings is not a problem if there is a ready need to borrow and invest those saved funds – system demand is sustained – but if
such a need is lacking, left unchecked, excessive savings can trigger a downward spiral into a deflationary
depression. This is pretty much the dynamic that led to the Great Depression, as fiscal support - the only thing that can act as a 'circuit breaker' - was not forthcoming until FDR's 1933's New Deal. The same process was also set in motion after the 'Great Recession' in 2008, but fortunately Western governments ramped up fiscal deficits swiftly, moderating the pain (except in Southern Europe where mandatory EU fiscal deficit caps forced these countries into depression).
Inequality of wealth and income is a large potential cause of excessive savings. Wealthy people tend to only spend a small percentage of their income - i.e. they 'save too much' - whereas low to middle income earners tend to spend most of their income and 'save too little'. Rising inequality is therefore associated with rising excesses of system savings which, if left unchecked, will eventually crash the system.
Traditional economists do not understand this because
traditional economics is based on the fundamental principal of perpetual scarcity. The choke
point in economic growth is always assumed to be a lack of supply, not a lack of demand, and that presumed perpetual scarcity extends to the availability of capital. However, in the real world, it is entirely
possible for the supply of capital to exceed the demand for its use even with
interest rates at zero. We have seen that situation in Japan for coming up to
three decades now, for instance. Traditional economists are still scratching their heads at negative interest rates, as their (deeply flawed) models deem that situation impossible.
The short term solution to demand side ills is higher
fiscal deficits, but the longer term and more sustainable solution is a redistribution
of income (negative interest rates also contribute to the solution by effectively taxing excessive savings). As noted, low to middle income earners have a relatively high propensity to
spend, so in a demand-addled economy, a reduction in income inequality will raise aggregate spending (demand) and
lower aggregate system savings, and help restore the system's balance. Higher spending will then allow ‘customers to create jobs’ a la Nick Hanauer. By
contrast, pursing a policy of tax cuts for the rich in a demand-deficient environment would exacerbate the
existing savings imbalance, reduce system spending, and likely
trigger a recession.
What situation is the developed world in at the moment - a supply-constrained one, or a demand-constrained one? In my opinion, it is demonstrably clear that since the global financial crisis, the developed world (excluding Australia,
NZ, and Canada, whose great recessions still lie ahead) has been in a demand-deficient environment, not a supply-deficient environment. Wealth
and income inequality has continued to increase (and hence savings); interest rates have fallen to
close to zero (and negative in some cases), and inflation has been all but
non-existent. Consequently, what is needed are demand-side policies to improve
wealth and income distribution, not tax
cuts for the rich. At the present time, Hanauer is right.
LT3000
