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The Leprechaun Long Run

The more people think about the Republican proposal to cut corporate taxes the worse it looks. Most people dismiss the argument that the benefits will trickle down to workers. Supporters’ argument is that reduced taxes on profits will cause increased investment which causes higher production and wages. There are strong arguments that the tax cut won’t cause firms to invest more. But aside from that, increased investment wouln’t cause (all) of the promised increase in wages. In this post, I will, for the sake of argument, make many assumptions favorable to advocates of the tax cut.

As often, I am following Paul Krugman and thinking of tax incidence in an open economy. Among others including Jared Bernstein, he argues that advocates of the tax cut have neglected their assumption that the increased investment will require foreign funds & that foreigners don’t invest in the US as a charity and expect to be repaid. This means that, in the short run, advocates argue that foreigners will buy US assets (the US will have a capital account surplus) which means that the US will have an even larger current account deficit. The plan is to cause high trade deficits in the short run.

Krugman has a post on the dynamics of convergence which he correctly notes is insanely wonkish. I will write only about the long run — the new steady state. So the math will be relatively simple. But mostly he writes comprehensible about Leprechaun economics, which is what he names it, because the number one example of trying to grow by cutting corporate taxes is Ireland. The basic point is embarrassingly simple, since foreigners require a return on their investment, attracting it does not cause national income to increase as much as gross national product. With foreign direct investment, more would be produced in the US but a lot of the revenue would belong to the foreigners. He has written four posts on the topic (the first four hits in this search)

Another interest of his the Gravelle Geardown which discusses how Jennifer Gravelle explains why the effect of a corporate tax cut on wages would be lower than some have argued. The point of this post (if any) is that the two issues are linked — the effect on wages is reduced by the fact that the country which attracts foreign investment will have to pay foreigners returns on that investment in the new steady state. I tried to begin to argue this here (reading I see I didn’t get very far).

Some assumptions
1a) The economy is not in a liquidity trap so unemployment (and spare capacity) are at the levels targetting by the Federal Reserve Board. In practice this is like assuming that there is full employment. This means that additional investment has to crowd out something: consumption, government consumption and investment, or net exports.

1b) Consumption is not measurably affected by interest rates. This corresponds to the evidence. This is the reason supply siders have had to appeal to the open economy and foreign investment.

1c) we are talking about tax cuts without government spending cuts.

This implies that the increased investment corresponds to reduced net exports — to a larger trade deficit.

2a) firms invest until the marginal product of capital is equal to the return demanded by investors, so that return is critically important (in the real world interest rates have small effects on investment by firms & mainly affect residential investment).

2b) the production function is smooth and allows substitution of capital and labor. In fact I assume a Cobb-Douglas production function. This means that the concept of “spare capacity” doesn’t apply to the model (and vice versa the model doesn’t apply to the real world).

These are key (implausible) assumptions made by advocates for the tax cut.

3a) Capital and labor are paid their marginal products. This means that the wage measured as a quantity of domestically produced goods depends on the capital labor ratio.

3a) foreigners demand a fixed after tax real return on their investments r* which is not affected by the policy. This is the assumption that the US economy is small. Again a concession for the sake of argument to tax cut advocates.

4) for both US consumption and US investment domestically produced and imported goods are not perfect substitutes. Instead they appear in a utility function (for consumption) or what is called an aggregator for investment. I did algebra (which I won’t inflict on anyone) assuming both have the form (foreign goods)^beta(domestic goods)^(1-beta). I assumed this so the share of spending on foreign goods is fixed. This means that the ratio of quantities demanded is the inverse of the ratio of relative prices. This is, honestly, just a convenient assumption which simplifies algebra. It means that there is a valid price index — utility is the same if dollar spent divided by the price index is fixed, capital is the same if dollar investment divided by the price index is the same and production is the same if capital and labor are the same. The price index is (price of foreign goods)^beta(price of domestic goods)^(1-beta) [oh how convenient]

5) someting similar is happening outside the USA (over here) so the share of foreign spending on US exports is constant. Also, the US is small, so total foreign spending is constant. This means that the value (in terms of foreign goods) of US exports is fixed.

OK that’s about it. I might use some horrible notation. I will use e to refer to the real exchange rate, the price in US goods of a unit of foreign made goods. This means that an increase in e is a real depreciation of the dollar. I will set current e to 1, so e will always refer to the depreciation casused by the policy. I will also set the price of US made goods to 1. This means that the price index is e^beta.

OK the story.
As the economy converges to the new steady stat, the US will run trade deficits summing to the increase in US located capital due to the tax cut. This means that the US will have to run a trade surplus to pay the returns on to the foreigners. This means that, in the long run, the policy will cause a real depreciation of the dollar. e (real exchange rate) will rise.

This has two important effects. First workers are less well off for a given capital labor ratio. The capitol labor ratio determines the wage measured as an amount of domestic goods. The price index relevant for workers as consumers is e^beta times the price of domestic goods. The real depreciation makes workers poorer.

Second the product of capital is also an amount of domestically produced goods. But the cost of a unit of capital is also e^beta>1. This means that, for a given capital labor ratio, the rate of return is lower. So this means that the real depreciation implies a lower capital labor ratio is required to pay the foreigners their required rate of return.

Given the assumption of the same shares beta and 1-beta is spent on domestic and foreign goods both for consumption and investmnet, the two effects have the same magnitude for small changes in K. Both hurt US workers.

To solve for the depreciation required to finance the returns on the additional capital, I have to make some assumption about exports. I think assumption 5) makes sense. It implies that the share of foreign spending on US goods is constant, so the amount of goods exported is proportional to e (I almost wrote exports measured in units of domestically produced goods, but hey the exports *are* domestically produced goods).

This makes the closed form solution pretty simple (although not simple enough to type in plain ascii). Indeed the effect on wages of a cut in the tax on profits is reduced.

This Gravelle gear ratio is a bigger deal if a large share of spending is on imported goods (high beta) and if the share of capital is large. I’m pretty sure the closed form solution and those two statement depend a lot on Cobb-Douglas assumptions made for convnenience.

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Cutting Taxes on Profits and Reality

The post below is silly. It is based on bending over backwards to take silly arguments for the GOP tax plan seriously. This older post is the one with some relevance to the real world.

The silly argument is that lower taxes on profits imply a lower cost of capital for firms. Investors will demand the same return net of taxes and so demand less from firms if the IRS takes less. The story continues that this lower cost of investing will cause firms to invest more which causes higher labor productivity and wages. This argument makes no sense for the following reasons

1) If you want to change investment, change the tax treatment of investment not something else. The gain (if any) from the GOP proposal should be entirely due to expensing investment. Reinvested profits will not be taxed. This should encourage higher investment in physical capital compared to paying dividends, buying back shares, or accumulating financial assets. I think it is good policy (and have thought so for 37 years at least). But once you have expensed investment, the tax on profits doesn’t affect the cost to the firm of investing. So long as it is constant it shouldn’t affect investment at all. Cutting the rate is a pure gift to owners.

2) Business investment doesn’t seem to be much affected by the cost of capital. This appears in aggregate data. The cost changes a lot with monetary policy as the interest rate changes. These changes have huge effects on aggregate demand, because they have huge effects on investment, in houses. The investment which depends on the interest rate is residential investment. Bigger houses don’t cause higher productivity and wages. For some mysterious reason the housing bubble’s expansion and bursting hasn’t convinced most economists to pay any attention to housing. Krugman says it’s been forgotten since the days of the dinosaurs

Back in the old days, when dinosaurs roamed the earth and students still learned Keynesian economics, we used to hear a lot about the monetary “transmission mechanism” — how the Fed actually got traction on the real economy. Both the phrase and the subject have gone out of fashion — but it’s still an important issue, and arguably now more than ever.

Now, what you learned back then was that the transmission mechanism worked largely through housing.

3) Been there done that. W Bush claimed he was going to cause high investment and wages by changing corporate taxation. In particular, the second Bush tax cut changed the taxation of dividends. Previously they had been taxed twice first as corporate income then as personal income of the shareholder. This, it was promised, would reduce the cost of capital for joint stock corporations (C corporations in IRS talk) and cause them to invest more. Importantly, it would have no effect on pass through firms whose profits are just taxed as personal income of their owners (some of these are called S corporations by the IRS). This means it was an experiment. According to W, if you look at a bunch of otherwise similar firms some of which are C corporations and some of which are S corporations, then following the tax reform investment by the C-corporations should increase compared to investment by the S-corporations.

Danny Yagan at Berkeley notes that it didn’t. Also there was not a statistically signficant difference in the growth of employee compensation.
American Economic Review 2015, 105(12): 3531–3563

I find analysis of the results of this experiment to be very convincing.

4) Capital is like clay, soft when you work it, then rigid once it is fired. In models it is easy to substitute capital for labor causing higher labor productivity. But in the real world, firms mostly invest to increase capacity. The substitution of capital for labor is slow. It has a lot to do with new establishments (new factories say) but not so much with refitting old ones. It is limited by technology. This means that investment has a lot to do with lack of spare capacity and not so much to do with the cost of capital. This story fits the aggregate data on non residential investment.

5) Just ask CEOs. Matt Yglesias reports

An awkward — but extremely telling — moment arose yesterday at a Wall Street Journal “CEO Council” event that featured the Trump administration’s top economic policy hand, Gary Cohn, as a key speaker.

John Bussey, an associate editor with the Journal, asks the CEOs in the room, “If the tax reform bill goes through, do you plan to increase investment — your companies’ investment — capital investment,” and requests a show of hands. Only a few hands go up, leaving Cohn to ask sheepishly, “Why aren’t the other hands up?”

And there is video

I got this from Natalie Andrews
I almost feel sorry for Cohn (OK I don’t but almost).

update: Matt Yglesias has another live one — a CEO saying the GOP argument is bogwash

Also Paul Krugman is still a dinosaur.

update: I forgot the BOA/Merrill Lynch Survey of CEOs

A Bank of America-Merrill Lynch survey this summer asked over 300 executives at major U.S. corporations what they would do after a “tax holiday” that would allow them to bring back money held overseas at a low tax rate. The No. 1 response? Pay down debt. The second most popular response was stock buybacks, where companies purchase some of their own shares to drive up the price. The third was mergers. Actual investments in new factories and more research were low on the list of plans for how to spend extra money.

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Cutting the tax on corporate profits would probably reduce US national income

Paul Krugman has been explaining (very slowly and clearly) that if the US attracts foreign investment by cutting taxes on profits, then it will have to pay the foreign investors. The Tax Foundation appears not to have noticed that loans are not gifts.

First he quoted Stephen Rosenthal’s observation that the direct effect of cutting taxes on corporate profits is to give roughly 700 billion over 10 years to foreigners who own shares of US corporations.

This is the ultra-static effect of the cut in which its effects on behavior aren’t considered. Krugman went on to note that if there is a huge inflow of foreign cash (as promised by supporters of the bill) then there will be a huge increase in US payments to the foreigners. He calls this Leprechaun economics, because it is a very important reason that Irish GDP is much greater than their gross national income. He wrote

GDP is actually the wrong measure. If you’re going to be pulling in foreign capital, you’re going to be paying more investment income to foreigners; so gross national income – income accruing to domestic residents – is going to go up by less. And surely that’s the measure we care about.


There are really two bottom lines here. One is that the true growth impacts of Cut Cut Cut would be even more pathetic than the numbers you’ve been hearing. The other is that if you’re going to make international capital flows central to your arguments, you really need to think about the implications for future investment income.

Krugman raises a question

In fact, when you bear in mind the reduced taxes collected on foreign investors who are already here, GNI could actually go down, not up.

It is interesting. I think that somewhere he explains that the answer depends on another debated issue — the true incidence of taxes on profits. Enthusiasts for the tax cuts assert that, in the long run, all of the benefits will go to workers. People who look at data, estimate that about one quarter of the benefits of a reduction of taxes on profits go to workers

(before going on, there are no free lunches — the benefits are at the expense of the Treasury so other taxes will have to be raised or programs will be cut.)

This matters for the discussion of Gross National Income vs GDP, because roughly 35% of shares of US firms are owned by foreigners. So if the money goes to investors, 35% goes to foreigners. This is true both of the old foreign investment in the USA and the new investment attracted by the low taxes. After the jump I will try a lot of horrible pain ascii formulas attampting to answer Krugman’s question of whether a profits tax cut causes higher or lower domestic gross national income. The key parameters are the current tax rate, the incidence on workers, and the share of capital.

Doing the algebra, I conclude that unless more than half of the incidence of profits tax falls on labor, cutting the rate of taxes on profits below 35% reduces gross national income.

“Half” is embarrassingly close to a whole number, but it is what came out of the horrible algebra. Also 35% is coincidentally the current statutory rate. I regret the fact that messy calculations gave such a suspiciously simple result. I don’t totally trust my algebra and don’t think my effort added much to Krugman’s. The point is that, for plausible parameters, cutting the tax on capital income reduces US gross national income.

thanks for comments. I didn’t explain the model well. I add a bit of explanation here. First it is assumed that tax reform doesn’t affect employment. In fact, it is standard to assume full employment in these models. This isn’t horribly silly at the moment. This means that total employment is equal to labor supply and can’t be changed by firms (who can compete with each other for the scarce workers).
However, increased capital does affect labor income by causing higher wages. The story is that it causes a higher marginal product of labor and higher labor demand for any given real wage. So there would be more demand for labor and the same supply, and so the price of labor (the real wage) would go up. This actually isn’t totally crazy. Real wages did go up in the late 90s and have otherwise stagnated since 1973.

end update:

Warning horrible horrible algebra after the jump

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Why are Republicans About to cut $25 Billion from Medicare ?

The PayGo law forbids bills which increase the national debt. Unless it is repealed or waived, the Republican tax cuts would cause automatic sequestration of, among other funds $ 25 billion from Medicare.

This is an excellent as usual Vox Explainer by Tara Golshan

It all comes down to the “pay-as-you-go,” or PAYGO, rule — a 2010 law that says all passed legislation cannot collectively increase the estimated national debt. In other words, if Republicans want to pass a tax cut, they have to pay for it with mandatory spending cuts — or, inversely, if Congress boosts funding for entitlement programs, it has to increase taxes.

If Congress violates this law, the Office of Management and Budget, which keeps the deficit scorecard, “would be required to issue a sequestration order within 15 days of the end of the session of Congress to reduce spending in fiscal year 2018 by the resultant total of $136 billion,” the CBO said in a letter to Minority Whip Rep. Steny Hoyer (D-MD).

Democrats can filibuster a bill which waives PayGo. But can they block a bill which defends Medicare ? If they do, will they be blamed for the sequestration ? Back to Golshan

“for Democrats, the pressure of impending Medicare and federal program cuts would likely be enough to get them on board — even though it is a budgetary gimmick to make up for a Republican tax bill they don’t want passed.”

I have a proposed strategy. Democrats demand that the bill waive PayGo and also restricts the budget resolution/reconciliation process with a claus saying budget resolutions and reconciliation bills may not be used to change Medicare. Basically, Republicans (especially Paul Ryan) have pretty much said they will try to reform (that is cut) Medicare and Social Security to close the huge deficits created by their tax cuts. Democrats can demand that they be given a veto on such reform (by requiring any such bills to be filibusterable). I think this is a line they can hold. It may be key to blocking the tax cut/ destroy the ACA bill.

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Matrix or 1984 ?

We have virtually reached the singularity when virtual reality supplants reality.

A photo tweeted by the Russian Ministry of Defense Tuesday as “irrefutable” proof that the United States has allied with the Islamic State in Iraq and Syria turned out to be from a video game.

Do android phones dream of electoral sheeple ?
What is reality and is there an app for that ?

Russian Ministry of Defence: “irrefutable evidence that there is no struggle against terrorism as the whole global community believes. The US are actually covering the ISIS combat units to recover their combat capabilities”
Nerd: Twitter users quickly noticed one of the images used as evidence came from another source — a YouTube video of gameplay from the mobile phone video game “AC-130 Gunship Simulator.”

Nerds Rule !

Nerd in basement to nerd’s mom: I’m not geeking out with a video game. I am researching potential Russian propaganda so I can join the glorious twitter struggle for truth justice and ethics in gamer journalism.

If this weirdness drives me nuts, will I notice the difference ?

The tweet has been sent down the memory hole. Of course the ironies are
1) Orwell imagined 1984 without computers
2) computers are not only useulf tools to monitor and control the masses but also the internet with true freedom of the press (with word-press) and revolutionary facebook groups overthrowing Mubarak and all that.
3) hard disks can be wiped but the memory hole now leads to the google cache
4) no I am not a ‘bot. I am a real live human being.

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The Right Way To Reform Corporate Taxes

This post is largely a comment on a New York Times editorial “The Right Way To Cut Corporate Taxes”. I disagree with the Times’s editorial board. Key parts of the editorial are

“If Republicans worked with Democrats, they could reach a compromise to lower the top corporate tax rate to between 25 percent and 28 percent, eliminated loopholes and reduced the incentive businesses have to take on debt, rather than to use equity to expand.”

Grammar Nazi notes that the compound sentence is not correct. To use an infinitive then continued with a past participle is made an error.


“would do even worse. The proposals would close some loopholes but create new ones, like allowing the immediate expensing of new equipment. ”

The logic of the argument is that it is more efficient to have a broad base and low tax rates. It is asserted (or rather implicitly assumed) that taxes impose dead weight losses which are convex in tax rates. This reasoning is not accompanied by any sort of economic analysis or theory (the editorial board made me praise economic theory and I will never forgive them).

In standard theory expensing investment and increasing the rate to keep revenue the same makes perfect sense. It is narrowing the base and raising the rate. By standard pundit assumptions this reduces efficiency. The assumption makes no sense.

Consider a corporation deciding whether to invest. A problem with taxing profits at rate say tau is that it discourages investment as the firm gets only (1-tau) times the pre-tax return. If it is allowed to deduct investment before paying taxes it pays (1-tau) times the cost of the investment. The tax does not distort the decision at all if investment is expensed. Tau can be 99 %m it doesn’t matter.

The Center for Equitable Growth noted that this is a standard argument and conclusion

It is well understood that the effective marginal tax rate on new investment can differ substantially from the statutory tax rate on business income. For example, in the case of a business tax system that allows full expensing—a policy under which businesses may deduct the full cost of any investment in the year the expense is incurred—the business-level effective marginal tax rate is zero, regardless of the statutory rate.

Also cutting the tax rate reduces taxes on the product of old capital. That has no effect on investment decisions which have already been made. It is a windfall for shareholders. There is no reason to give them that money — no corresponding gain in efficiency — no effect on the past. Also cutting the tax rate reduces taxes on markups due to market power (monopoly rents)- This encourages efforts to reduce compentition which the Antitrust division of the Justice Department has only some ability to fight (even assuming Trump and his political appointees don’t interfere as they surely will).

I think a large part of the appeal (aside from pundit group think) is the love of bipartisanship the “If Republicans worked with Democrats”. The problem is that the Republican proposal is almost entirely aweful (except for the one good bit which I defend from the editorial board’s criticism). The Republicans are determined to go the wrong way, Democrats would achieve a better policy outcome by voting no and trying to convince 3 Republican senators than by compromising. Compromise is not good in and of itself and nothing useful can be achieved by trying to work with Republicans.

The mantra of broaden the base and reduce the rates is a declaration of faith. It has no empirical support. It doesn’t even have any theoretical justification. The argument has no merits whatsoever.

On the other hand, I generally agree with the editorial and this op-ed is excellent.

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Ricardian Equivalence

This is going to be a very long post with independent chapters (I won’t impose by making a series of posts)

I. What is “Ricardian Equivalence”

The basic idea is that the timing of taxes has no effect on anything, and especially not on consumption/saving choices, because rational economic agents know that the state has a budget constraint which is binding and anticipate their share of paying for the national debt.

This idea is clearly crazy. Even Ricardo (who generally lived in a world of theory detached from reality) wrote that it clearly had nothing to do with reality. Sadly, modern macroeconomists are more detached from reality even than Ricardo, and it is a standard feature of standard models.

Another way of putting it is that domestic government bonds owned by domestic agents are not part of national wealth — they are money we owe each other not an true asset like physical capital. Now it is clearly true that government bonds are not net wealth. The idea that they don’t influence consumption as net wealth does is clearly crazy. There is no evidence in US data for Ricardian equivalence. The most basic implication is that, if one looks at consumption as a function of disposable personal income (personal income net of taxes) then one should be surprised that it is so low when budget deficits are high. The equivalence claim is that the variable should be disposable income minus the deficit that is personal income minus government spending. But at the very least, deficits should crowd out some private consumption. There is no evidence of any such effect in US data (long pdf warning)

I shoud just quote Paul Krugman who writes better than I do

Ricardian equivalence says that what determines consumption is the lifetime present value of after-tax income, and hence that, say, a temporary tax cut won’t stimulate spending, because people will figure that whatever they gain now will be offset by higher taxes later. It is a dubious doctrine even done right; many people are liquidity constrained, and very few people have the knowledge or inclination to estimate the impact of current government budgets on their lifetime tax liability.

II Future tax increases will and won’t follow temporary tax cuts.

The point of this post (if any) is that advocates of tax cuts switch Ricardo on and off when he is or is not convenient.

I am going to assume no Keynesian stimulus effects. It is as if I assumed that there is no unemployment or spare capacity so GDP is determined by labor supply and technology. What I actually assume is that the Fed will set interest rates to make unemployment equal to their guess of the natural rate of unemployment. This means that vulgar Keynesianism (TM) is an error. As always I cite Krugman (who is right about vulgar Keynesians even if he regrets one word in “Greenspan … is not quite God”). I am also going to assume a closed economy. This is really silly, but it’s what I am going to do. The sensible reader is invited to stop reading.

Consider a proposal to stimulate investment by cutting the tax on profits.

An argument against cutting the tax on profits is that the lead to deficits and the national debt creates the illusion of wealth (as people act as if government bonds are net wealth). This causes higher than sensible consumption and forces the monetary authority to set high interest rates to prevent over heating and inflation and in the end this crowds out investment. The counterargument is that people know that taxes will be increased in the future (and not just back to the old level but higher in order to pay interest on the debt) so there won’t be distortion of consumption savings decisions. On the other hand, the good incentive effect of lower tax rates, which cause higher investment, aren’t affected because higher taxes in the future cause no bad incentive effects because taxes are terrible now but won’t matter then.

This makes no sense at all. Future tax increases are assumed when one discusses consumption, but the incentive effects of future taxes are ignored when discussing the desired level of investment for a given interest rate. I think there is no way to make a coherent argument. The actual belief of advocates of cutting taxes on profits is that taxes and government spending should be cut. But they don’t propose that, because government spending is popular. They then argue that, even without spending cuts, taxes should be cut. This makes no sense. Sometimes they argue that debt is good because it will force lower government spending & not tax increases. There is no support for this view — the evidence such as it is, is that when Congress discovered that they USA could run huge deficits, they increased spending. People claim to dislike deficits, but they really dislike taxes. To starve the beast, one would have to insist on a balanced budget (which is also advocated by the same Republicans who are eagerly adding what they claim will only be $1.5 Trillion to the national debt).

[rant bumped down after the jump]

III Ricardo Vs Laffer

The more extreme advocates of tax cuts argue that they will pay for themselves; That the effect on growth and tax receipts is large enough that no future spending cuts or tax increases will be needed to pay for increased debt. This claim, made by Arthur Laffer when he drew a graph on a napkin for Jack Kemp, isn’t taken seriously by any wonks. It is always made using another equivocation. Supply siders argue that tax cuts will be followed by growth which will cause increased revenues. This is obviously true, so will tax increases, the economy tends to grow. The trick is to equivocate post hoc and propter hoc — between after the tax cut, GDP will grow so revenues will be higher years after the tax cut than they were immediately after the tax cut and because of the tax cut GDP will grow more than it would have without the tax cut so revenues will be higher than they would have been. This ultra clumsy rhetorical trick seems to have worked for decades, but also seems not to be working anymore.

My point (if any) is that you can’t have both Laffer voodoo and Ricardian equivalence. If the tax cut now doesn’t imply any tax increases or spending cuts in the future, it will cause higher consumption. Laffer’s claim is that tax cuts will make us much richer. Those who claim to believe in Ricardian equivalence must argue that this will cause us to consume more (other things equal). It doesn’t really matter if the effect on consumption is due to bonds mistaken for net wealth or for authentic wealth. This means that Laffer must admit that growth enhancing tax cuts will cause consumption to increase if other things are equal. Laffer may have made even more extreme claims, but supply siders now argue that the benefits of their tax cuts aren’t a jump in GDP but a higher growth rate. This means that higher consumption implies lower national saving.

Demand will equal supply (recall I assumed above that it is fixed in the short run) because interest rates will increase causing lower investment. Any increase in investment could only occur if higher interest cause lower consumption. There is absolutely no evidence that they do (and even the simplest theory doesn’t unambiguously imply that they should — in elementary models higher interest rates could cause eithe higher or lower consumption depending on paramters with parameters fitting the data definitely implying that high intereste rates cause high consumption).

To avoid predicting increased consumption (which would crowd out investment in a closed economy) advocates of tax cuts have to argue both that they will and won’t make us richer.

OK so before posting, I have to note that advocates of tax cuts have basically conceded most of what I argue here. They, and in particular the Tax Foundation, now argue that cutting the tax on profits will make us richer by attracting foreign capital. They don’t seem to have considered the fact that the foreigners will collect interest on money they send to the USA. Nor that foreigners already own shares of US firms and so will get some of the direct automatic benefits of the tax cuts.

As usual, Krugman has explained this. Click here, here and here.

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A Bit More on Inflation Expectations

I honestly surfed here just to see if anyone was still interested in inflation expectations now that The Fed has shifted from extraordinary efforts to stimulate to normal efforts to take away the punch bowl before workers get uppity.

I was pleased to find the post by Bonddad immediately below

However, I don’t agree entirely with Hale Stewart and agree less with Stephan Poloz.

The first point is that expected US inflation has been very stable and very close to the 2% target (also when the target was informal). This is shown by TIPS spreads (as noted by Bonddad) and also in survey’s of people considered expert (say the Livingston survey).

But I think that this doesn’t mean that expectations are anchored. 3.5 years ago I wrote (PDF warning) “in practice “anchored” seems often to be used as a synonym for “low,” but it should be a statement about the relationship between expected inflation and variables which influence expected inflation – an anchor keeps a boat from moving when it is pushed – not all boats which are moving slowly are anchored.” I think a null hypothesis which can be tested against the alternative that expected inflation is now anchored and didn’t used to be is that expected inflation is a constant plus a constant times lagged inflation (this is called the “static expectations hypothesis” but I don’t know in what way it is static).

In fact The median Livingston Survey CPI inflation forecast is very well fit using only one observation of lagged PCE core inflation with an R-squared over 85%. It seems hard for the sometimes anchored sometimes not alternative to outperform the static expectations null.

There is no sign that inflation expectations were more anchored after June 1989 than before. The coefficient on the product of lagged PCE inflation and an indicator that the realization of inflation occurred June 1990 or later is statistically insignificantly different from zero and actually positive.

This simple pattern in a well known data set makes the fact that inflation expectations were regularly described as “anchored” a bit puzzling. I think that the expectations augmented Phillips curve was so firmly accepted that economists used “anchored expectations” to imply that unit labor costs were not growing rapidly or perhaps that actual inflation was not accelerating. In the language of contemporary macroeconomics the word “expectations” may refer to what should be expected given the ex post observed behavior of time series, or to what expectations must have been for a standard model to fit the data, but in any case not to any forecast made by an actual human being.

Also when a central banker says expectations are important, he almost automatically asserts that his credibility is important. The argument is that firm resolute determination to fight inflation is unambiguously good as it makes it possible to reduce inflation without persistently high unemployment. The argument is that it is best to firmly grasp the nettle as, for example, Paul Volcker grabbed it. The problem is that there is no hint at all in the Livingston data set that Volcker had unusually high anti-inflation credibility. In fact, the survey data suggests that he was below average in this.

The notoriously weak inflation fighter Fed chairs were Arthur Burns and G William Miller who allowed double digit inflation. Volcker is alleged to have tamed the inflation expectations beast after replacing Miller. There is much less than no evidence for this in the Livingston data

After controlling for lagged annual CPI inflation, expected annual CPI inflation was over 2.7 % higher when Volcker was chairman than when Burns or Miller were. This evidence that Volcker had lower inflation fighting credibility is strongly statistically significant.

Finally, the argument that anchored expectations elimininate the relationship beteen monetary policy and real outcomes is based on the assumption that Lucas was right and the only unexpected shifts in monetary policy affect output. The hypothesis was that, once economic agents understood the policy rule, the changes in interest rates, monetary aggregates and inflation rates caused by the the policy would be uncorrelated with real variables. Somehow this changed from a hypothesis to a revealed truth. The simple fact that inflation and unemployment are still correlated even now that inflation is stable and can be predicted (which doesn’t mean that real world non rational agents predict it well) is not allowed to touch the faith that this must not be true. It is argued that the apparent phillips curve has vanished even though data just like those plotted by Phillips show a curve.

Here is the average wage inflation over the 15 countries which were in the European Union in 1997 compared to the average unemployment rate. I’d say the Phillips curve still exists now and here (I am in Rome).

In sum, I think the confidence that inflation expectations matter *and* can be managed by firm resolute monetary authorities is a sign of blind faith and refusal to look at the evidence.

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The Phillips Curve is Alive and Well and Living in Europe

What happened to the European Phillips Curve ?
Recently many have argued that the Phillips curve has become the Phillips horizontal line. I am old enough to remember when the hot new idea in macroeconomics was that the long run Phillips curve is vertical so inflation varies but unemployment stays near the natural rate and average unemployment over medium long periods is constant. Oddly, this view is still the basis of policymaking including notably the European Central Bank’s single mandate to seek price stability and let unemployment handle itself. It also means that the standard ad hoc empirical Phillips curve shows the acceleration of inflation as a function of unemployment.

But now, the problem with the Phillips curve is supposed to be that it is flat. I know of quite a lot of work with US data which supports this view. A good place to start is with Olivier pdf warning Blanchard

The Economist has a blog post on the issue. They look at average core inflation and an estimate of average cyclical unemployment over advanced countries. They find that the slope of the curve has declined and was almost exactly zero from 1995 through 2013.

I decided to look at the 15 Countries which were in the European Union in 1997 (because I have data from DG EcFin). I prefer to look at wage inflation first (that’s what Phillips did & it most nearly makes sense). I took the simple average across the 15 countries (so Luxembourg counts as much as Germany) to see if the curve has become horizontal

mdw is wage inflation averaged over the 15 countries. mur is the average unemployment rate. That sure looks downward sloping to me. So how can it be that the Phillips curve has been declared dead ?

After the jump, I try to answer that question. I also posted an 8 page pdf here.

Briefly, I think the answer is that the very clear relationship, which is the same as the one noted by Phillips in 1958, has been obscured because of two choices made to respond to theoretical critiques of the orginally observed fact (and the choice to make facts bow to theory). First decades ago it was assumed that any relationship should be between unemployment and the acceleration of inflation not the level of inflation. Second, the high persistence of unemployment was assumed to be due to structural problems, so the natural rate of unemployment was assumed to vary and the acceleration of wage inflation depended on raw unemployment minus this variable natural rate. The estimates of the natural rate don’t make sense, and subtracting one of those silly series obscures the simple pattern in the raw data.

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A Comment on Krugman on Gravelle

Paul Krugman finds intuition for the calculations of Jennifer Gravelle difficult. Now even more than usually, you really have to click this link to know what I am typing about.

My comment.

yes that intuition is difficult. I have an attempt. So 1% of GDP is tradable. Also consumption and total production fixed. Mars cuts tax from t to 0. So to invest more Mars runs a current account deficit — all cyberservice provided by earlhlings & martian cyberworkers go build capital. Note all the extra capital belongs to earthlings (I assumed martian savings are fixed).

In the long run, there will be current account balance. This means Mars will have a trade surplus required to pay the return on earthling owned capital on Mars. They owe us delta(k)r per year. They can run a trade surplus of only 1% of GDP so delta(k) less than or equal to 0.01 GDP/r

It seems to me the long run effect is entirely due to the fact that the tax cutting planet has to pay more capital income to the other one. This places a limit on the sum of their trade deficits and extra capital accumulation

I think the limit on long run capital inflow is that hypothetical Mars (or the US in the real Solar system) can only owe the rest of the solar system liabilities which it can service. This is a long run limit — a statement about the new steady state.

In the really real world, I think current US current account surplues are not sustainable forever, so the sum over the next century can’t increase (or stay the same). So the long run effect of a profit tax cut is zero. But that’s just a guess.

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