CORPORATE TAXES AND INVESTMENT

Yesterday in the New York Times Greg Mankiw — a professor of economics at Harvard, an advisor to the governor of Massachusetts, in the campaign for the Republican presidential nomination and a former Chairman of the Council of Economic Advisers under president Bush — had a column in which he argued that a cut in the corporate tax rate would induce greater investment. This is a key premise of Republican campaigns that has driven Republican policy since the early 1980s. The article is here.

We should look at the record and see how well such cuts to corporate taxes actually has worked.

First, average corporate profits versus tax business pays. Contrary to the statutory rate of 39% widely quoted, the effective rate corporations actually pay is now about 22%. That is down from about 50% in 1950 and a local peak of some 44% in the early 1980s. The right likes to compare the statutory rate to other advanced countries statutory rate and claim that the US has about the highest corporate tax among advanced countries. But according to a recent study by the US Treasury the US effective rate is in about the middle of the pack of effective rates for advanced countries.

Second, let’s look at after tax profits as a percent of GDP. Despite cyclical swing there has been a strong secular trend since 1950. From 1950 to the early 1980s taxes as a percent of GDP declined from about 10% of GDP to under 4%. Since 1980 it has rebounded from under 4% back to about 10% of GDP and this measure appears to be on the verge of breaking out to a new record high.

Next look at business investment as a share of GDP . Again, despite cyclical swings there appears to be a secular trend. From 1950 to 1981 it rose and reached an all time peak of 14% in the early 1980s. Since 1980 it has been trending down from 14% and is now back to about the 10% level it was at in 1950.

…and compare it to taxes as a percent of GDP. Note the secular swing in investment is the exact opposite of the secular trend in profits. From 1950 to 1980 profits fell and investment rose. Since 1980 profits rose and investment fell. This is the exact opposite of Mankiw’s theory that cutting corporate taxes will lead to higher investments.

Mankiw writes a column for the NY Times every few weeks. Maybe in his next column he can explain why we should ignore this evidence that directly contradicts his theory.

His theory appears to be like the supply side theory that if we cut personal taxes on savings that people will save more. Since 1980 we have created IRA and other instruments that allow consumers to save on a tax free basis and increase their returns. So what happened to the personal savings rate over this period, it fell from 14% to almost 0%. This has to be about the greatest failure of an economic theory since communism. Remember, Milton Friedman said the most important test of a theory is how its forecasts work. Using Friedman’s basis the supply side theory about personal savings was a abject failure.

Now, I’m going to surprise you by saying that I completely agree with Mankiw that corporate profits taxes should be cut. But of course there is a catch.

What I want corporations to pay taxes on is their profits as defined by the Generally Accepted Accounting Procedures (GAAP) rather than profits as defined by the IRS. Congress does not establish GAAP so this change would massively cut the ability of Congress to create loopholes or special cases in the tax code. As a consequence incentives for firms to buy-off politicians would be massively reduced. If you are a corporate CEO would rather use the money you now have to spend on Washington lobbyist and expensive tax lawyers to actually expand your business. My primary objective is to reduce the power of corporate money in politics and if Mankiw is right that it increases investment all the better.

Almost to a man Republican and business leaders strongly agree that the US should not have industrial planning. Politicians should not be in the business of picking winner and losers. But the US has a major industrial planning system, it is just that we call it the federal tax code. And generally the critics are right, Washington does a poor job of picking winners and losers.

According to the GAO the industries with the highest effective tax rates like information technology are frequently the fastest growing industries. Moreover the slowest growing industries, like oil, have the lowest effective tax rate. The GAO estimate that the oil industries’ effective tax rate is about 11%, or about half the overall corporate tax rate.

Apparently oil executives learned decades ago that the get a much higher return on their capital if they use it to buy political favors rather that actually drilling for more oil. Surprisingly, domestic oil production actually rose in 2009 and 2010. This is the first consecutive annual increase in domestic oil production since Carter was president and oil faced price controls and windfall profits taxes. Maybe the oil executives realized they could not buy-off Obama and decided that to grow profits they had to do something really radical, like increasing domestic oil production.

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