January 09, 2006
Hazards of partial reading and partial equilibrium analysis
For some people, the answer to every problem is a tax cut
Jan. 9 (Bloomberg) -- With President George W. Bush's State of the Union address approaching, Washington wonks are stewing over the year's policy agenda. A look at the latest economic data suggests an obvious change that should have broad bipartisan appeal: a cut in the corporate tax.
The case for a reduction begins with jobs. Because the U.S. economy is growing nicely, almost everyone expected healthy job creation in December. But last week's jobs report showed an addition of just 108,000 jobs, about half the expected number.
He concludes thus:
So what explains the advantage gained from locating production overseas?
The most powerful factor appears to be taxes. The U.S. has the highest corporate tax rate among the world's most developed economies. With a combined federal and state tax rate of 39.3 percent, the U.S. taxes corporations at a rate that is 10 percentage points higher than the average of other nations in the Organization for Economic Cooperation and Development.
In a world of tight margins, a 10-percentage-point disadvantage is humongous. And the U.S. rate is well above that of countries such as Ireland, which has enjoyed an economic boom that coincided with a reduction in corporate taxes to 12.5 percent.
I have two observations. The first is that it would be useful to note what a recently released Congressional Budget Office report on the international comparison of corporate tax rates noted:
Although the United States' statutory corporate tax rates are among the highest of those in OECD countries, they are comparable with the statutory rates imposed by other members of the Group of Seven (G7)....
How effective marginal corporate tax rates in the United States compare with other countries' rates depends on the type of corporate investment being made and the way in which it is financed. Corporate investments are financed by either shareholders or lenders (which include corporate bondholders). Compared with the average effective marginal corporate tax rates for shareholder-financed investment in machinery among all other OECD countries, the United States' rate is slightly higher; compared with the average among other G7 countries, the United States' rate is about the same. Compared with the average rate for shareholder-financed investment in industrial structures among all other OECD countries, the United States' rate is significantly higher; however, the United States' rate is close to the average among other G7 countries. In contrast to rates for shareholder-financed investment, the United States' effective marginal corporate tax rate for lender-financed investment in machinery is low by comparison with the average for other OECD countries and for other G7 countries. From an international perspective, although the United States' effective marginal corporate rates for shareholder-financed investments are higher than the average, such rates for investments financed by a combination of shareholders and lenders may be lower than the average if a sufficient fraction of the marginal investment is financed by lenders.
My reading of the CBO report is that US effective corporate tax rates are not necessarily out of line with those in other OECD countries. (There is also a vigorous debate on this subject on at Angry Bear, where the CBO report was discussed earlier).
My second, and more important, point (here is where partial equilibrium comes into play) is that the analysis ignores completely the fiscal implications in the U.S. At a time where the medium and long term Federal budget deficit trajectory looks grim, private consumption is widely acknowledged to be too high, and the dollar's appreciation is placing additional stress on U.S. manufacturers, decreasing tax receipts, and further exacerbating the budget deficit, seems wrongheaded.
Now, in a Lafferite world, or a world where one believes the Bush Administration and the Congress would agree to cut spending in line with the decrease in tax receipts, perhaps this would make sense. I leave it to the readers to decide whether such worldviews, or the textbook view, is more in line with reality.
Posted by Menzie Chinn at January 9, 2006 11:20 AMdigg this | reddit
On utilitarian grounds, the additional tax bite in the US would obviously have to be larger than the additional cost involved in importing the goods or services now produced offshore, if the tax itself were the only, or even the main reason for offshoring the production in question. That seems unlikely, but as usual, though, when it comes time to talk cutting taxes on business, you don't really need a reason.
Posted by: M1EK at January 9, 2006 12:38 PM
Though I am not an econimist by any means, I read this analysis and would like your opinion. It shows the deficit trend line is very favorable toward balancing by 2008. The link is still active.
Posted by: Mike at January 9, 2006 01:27 PM
So well done - I had nothing to add except a link to this post over at Angrybear.
Posted by: pgl at January 9, 2006 01:57 PM
M1EK: I agree insofar as cost vs. benefit should be the guiding principle in determining whether to undertake a policy course or not.
Mike: On this point I'm with the Austrian artist Hundertwasser, who said that straight lines "are the devil's tools". Less colorfully put, we know that linear extrapolation has led to many subsequently embarrassing predictions -- remember "Japan as Number One"? Technically put, one could not reject the null hypothesis that Federal government receipts and government spending are both integrated processes (somewhat akin to a "random walk"). Hence, linear extrapolation is inappropriate.
That is not the sum content of my argument; I would say that as intelligent observers trained in any discipline, one shouldn't rely upon extrapolating trends. Rather, given that we have an idea of what determines both variables, we should use that information. On this count, I would say, look at the CBO's assessment of the long term fiscal outlook (using "current law"), and then add in or subtract figures in accord with your expectations of what restraint will be imposed on spending, or on taxes.
pgl: Thanks for the compliment, and the link.
Posted by: menzie chinn at January 9, 2006 02:30 PM
I would argue that if the corporate tax rate were zero, IBM would still offshore every job they could, steal evem more pensions and take away more healthcare.
Posted by: me at January 9, 2006 03:20 PM
It's been quite a few years since I've studied the issue (I used to be something of an expert on the subject) but once upon a time the U. S. was the only major industrialized nation that required depreciation of business purchases. That's a big deal for a number of reasons. Keeping track of such things adds overhead. But most importantly depreciation makes businesses less nimble and reduces the incentive to upgrade productive capacity through capital expenditure.
I guess my real point is that there's more to comparing tax systems in different countries than marginal tax rates or even effective tax rates. How you calculate income is important, too.
Posted by: Dave Schuler at January 9, 2006 03:41 PM
The real issue is the size of the U.S. government, NOT whether tax is too high, or budget deficit is too large. Is our government too big, just right, or too small? That's the real question. I think most people would agree that the size of our government is too big. What if the optimal size is 1/10 of what we have today? If that were true, then of course, the curret tax rate is too high. You should focus on the "cause", instead of analyzing the "effect".
Posted by: Anonymous at January 9, 2006 05:16 PM
Dave Shuler: Good points. The "effective" tax rates calculated by the CBO take into account the differences in how capital is "expensed" via depreciation allowances. However, you are right that it is difficult to capture the economically relevant measure of income, even after taking into account tax credits.
Anonymous: I don't know what empirical evidence you are relying upon in stating "I think most people would agree that the size of our government is too big." You may very well be right, although the only information I could find indicated that the difference of 45% too big vs. 42% too small is well within the margin of error of 3 percentage points, for 11/2003. See this article, near the bottom. (By the way, these estimates indicate that there is some time variation, so things may have changed especially given the rapid increase in nominal government spending over the past four years).
Posted by: menzie chinn at January 9, 2006 06:04 PM
"I think most people would agree that the size of our government is too big."
Well, most of the people who think that also don't think we should cut military spending. So let's look at the effect of cutting other spending.
Cutting Medicare, for example, aside from the devastating human effect of cutting health care for seniors, what do you think would be the economic effect? Local hospitals? Employment? Isn't health care the sector with most of the employment growth?
What about cutting retirement? Aside from the devastating human effect of cutting retirement for seniors, what would be the effect on the economy? Local grocery stores, etc...
What about cutting law enforcement? Infrastructure investment?
NO WONDER the wingnuts who always say we should cut the size of government never, ever will spell out WHAT they would cut!!!
Posted by: Dave Johnson at January 9, 2006 07:16 PM
The real question, from an accounting standpoint, is the impact of tax rates on individual business decisions.
It is all about cash flow, cash flow, cash flow.
Any action which a) increases an inflow or 2) decreases an outflow weighs on any decision model.
Cutting taxes is an obvious example of reducing an outflow, and is very relevant at the point of each individual decision.
Depreciation has an impact in that the expense reduces the tax liability and therefore reduces an outflow. Immediate expensing causes all of the impact to land in the first year, where the present value of the savings is higher.
Also, state corporate rates and methods vary all over the map, which is being touted as a competitive advantage by some states.
Economists tend to look at this in the aggregate, us beancounters tend to look at individual decisions and the impacts of tax rates on a single company.
No easy answers, but anything that sucks cash out of the company hurts investment to some degree.
Posted by: save_the_rustbelt at January 9, 2006 07:28 PM
Dave Johnson: I think what you're saying is that everybody is for less spending as long as the reduction in spending is on those things viewed as unimportant.
save the rustbelt: Of course, the relative impact of tax rate reductions versus tax credits differs. But different models have different orderings, for a given reduction in dollar tax liabilities. If firms do not face credit constraints, then a q-theoretic approach makes the most sense (see Summer's Inflation, Taxation, and Corporate Investment: A q-Theory Approach). If firms are credit constrained so that a financial accelerator effect exists, then what indeed matters is "cash flow, cash flow, cash flow".
I take your point that there is diversity in effective rates; I didn't mean to say there was one effective rate that applied to all types of firms. What I have cited is a mean rate. But even the CBO report, which focuses on cross-country comparisons, notes the wide diversity of effective rates.
Posted by: menzie chinn at January 9, 2006 08:56 PM
There are tax rates, effective tax rates, and actual global effective tax rates - the point is not the tax rate but capital's increased ability to socialize costs on a planetary scale.
What must be remembered is basic: each particular firm struggles to maximize its particular profit,,too many models ignore the evident.
Posted by: juan at January 10, 2006 12:08 AM
Other taxes that are less damaging than income taxes could be raised.
For example $5 per gallon on transportation fuels would bring in a trillion Dollars in receipts, allowing a cut in incomes taxes to zero.
Assuming that a phased in increase halves transportation fuel demand, based on European precedent, the tax would still bring in half a trillion Dollars and allow cutting individiual and coroporate income taxes by half (or it could be used to cut social security contributions etc...)
Posted by: Heiko Gerhauser at January 10, 2006 02:29 AM
Fed can tax fuel and the local and state can tax property. The fed would be taxing the use of resources on the most basic level and the state and local would generate revenue by increasing property values.
Of course, maybe property tax only would be better since we probably don't want the fed to encourage consumption of resources.
Posted by: aaron at January 10, 2006 06:26 AM
Socialized risks, privatized rewards.
Posted by: John at January 10, 2006 01:19 PM