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.
One technical comment.
There is no “average business,” therefore the “average corporate tax rate” is meaningless in business decision models.
I understand economists must average large pools of data, and rarely look at enterprise level data, but beware of drawing conclusions from “average” anything.
How does the capital intensiveness effect the tax rates, and charts. Our feel our economy has shifted toward businesses that are less capital intensive. Compare Apple, to say Caterpillar. Yet Apple reaps a lot of $$$$/profits off little investment. Could that explain the sort of secular downtrend since 1980 in the third chart?
Maybe I should have differentiated between labor intensive, versus capital intensive too. Hmmmm. I gues in my first post I am referring to R&D, plant investment, materials etc…
I think its a great idea to have corporations pay tax on their gaap income. Tax lawyers talk about this sometimes in the context of reconciling book and tax income, and they usually come up with lots of reasons why income for financial reporting purposes shouldn’t be used as income for tax reporting purposes. Maybe Linda Beale will get into the conversation and enlighten us. I am not convinced. In addition to reducing corporate ability to create loopholes (and thereby reducing the influence of corporate lobbyists in the congress) using gaap to report income for tax purposes means that the irs would be policing the financial statements used in the securities market. That has to improve compliance with securities laws. I also think that the tension beween the corporate desire to maximize reported income for financial reporting purposes but to minimize reported income for tax reporting purposes would result in inherently more honest books, especially if rates were significantly lowered to keep down the cost of honest accounting. And if somehow, every penny that came out of a corporation for the benefit of a person was attributed to that person and taxed as personal income at progressive rates, that would be a plus too. I would much rather tax the corporate lords of the universe than the corporations anyhow. Somehow, this is beginning to sound more and more like a progressive fantasy and less and less like a practical tax policy initiative…
I recently read a claim somewhere—I don’t remember where—that the German tax system uses gaap income, and that it hasn’t improved corporate tax compliance. Instead, German corporations report very low income for financial reporting purposes and somehow investors make the translation. However, I’d trade the economic growth. employment stability and product quality record of the German corporate sector for our corporation sector’s record any day.
“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.”
Yes, but. I suspect over time GAAP would change under pressure to reduce profits.
That said, I think it makes sense for businesses to be taxed according to GAAP profits. It eliminates the current incentive to push up GAAP profits for the street and push down IRS profits. It reduces double counting and aligns the firm’s incentives with the IRS’ incentives, though I suspect you’d have to do away with asterisks.
Actually, I would be in favor of completely eliminating the corporate tax if it was accompanied by eliminating the lower tax rate on capital gains and dividends. the real rational or justification for lower tax rates for capital gains and dividends is to compensate for the double taxation of business profits.
Moreover, I think the market would do a pretty good job of policing firms to make sure they did not try to hide earnings. If firms under-report earnings and hide the money it would negatively impact the stock and it shouldn’t take too long before some sharp investment banker recognized it and bought out the firm to get at the money. This would also generally cost the CEO their job.
If we taxed capital gains at the ordinary income tax rates I would allow people who sell small and/or private business to use some form of income averaging so they could spread the income out over several years.– three to ten, maybe. If a person were selling the business to retire they could recognize the income over several year in the future when their other sources of income probably would be lower and they might be in a lower marginal tax bracket.
First, never assume GAAP is coherent or immune to politics.
Second, IRS involvement would do little or nothing to improve GAAP reporting.
Could it work, certainly, and would make life easier for accountants. Problem is, Congress has often threatened to get involved in GAAP when the wrong oxes were gored, and this would accelerate the problem.
I am half on board. I was planning to spend some time looking at the effect of corp. taxes on growth. But I have a few reservations, regardless of the effect. It might provide justification for some posts.
The argument in favor of high corporate taxes is that they keep companies from accumulating money indefinitely. Money flows into limited liability collectives, but rarely flows out, except as executive bonuses. It’s not as if the owners of the corporation get to see a nickle of it. They are expected to take their profits by selling their interest at a profit. If corporate bonuses were more widespread throughout the corporation or corporations forced to pay dividends some money would seep back into the economy, but most bonus goes to rich people who simply roll it into another collective where it may as well never have been printed.
We might be able to eliminate corporate taxes by limiting corporate life spans. If a company had to be liquidated and the proceeds turned over to the owners every 10 or 20 years, we could afford to subsidize business collectives, but with an indefinite life span, they are pernicious to the health of the overall economy.
Money flows into limited liability collectives, but rarely flows out, except as executive bonuses.
You are crazy. Companies constantly have to reinvest into new products, plant and equipment, as product life cycles are becoming increasingly compressed. Not to mention they hiring a lot of people besides paying executives. Also, most companies pay dividends and buy back stock.
Your comment is bizarre and bears no resemblance to reality.
“would make life easier for accountants” – Hardly. Accountants work on a fee per hour basis. The more complicated, convoluted, and labor intensive, the more fees to accounting professionals. If you’re skeptical, you might look into the the increased audit requirements in response to Enron.
I’m not saying accountants don’t fulfill a crucial role. I only aim to point out that the accounting industry has major conflicts of interest, many of which are rarely discussed (probably because they are not required to disclose financal statements to the public).
” and that it hasn’t improved corporate tax compliance.”
Perhaps European and US compliance with their corporate tax laws would improve if they used the Chinese government’s approach to criminalization and sentencing for business infractions.
Our tax system is so convoluted. It is written by lobbyist. Highest statuary rates applys to small, “little people” businesses. People that are well connected, and/or hiring savvy tax firm can lower their effective tax rate, just look at GE, Microsoft, Google; George Soros, Warren Buffet…. They all paid the federal government a different tax rate.
The tax code, I hate to say this, needs to change to a flat taxation rate. Stop all deductions, no loopholes whatsoever. This will even out the field between small businesses and large businesses. This will nail both left and right side. The congress is just a show… The Democrates and the Republicans all have their own lobbyist “moneyed” from their prospective patrons.
I am all for progressive tax rate. But all this debate is so silly when the little guy always getting short end of the stick….
I am assuming you have adjusted for inflation in the “Taxes vs. Pre Tax Profits?”
minds think alike. I just told Mike Kimel that he has to look at the investment graph to write one of his posts on taxes and … (I might have written that *after* you posted this post but before I read it).
Also I like the idea that profits as declared to shareholders and income as taxed by the IRS should be the same number. I made that proposal in my very fourth blog post ever (on July 15 2002). It’s not the same as your proposal because it was just post ENRON