Wednesday, December 27, 2017

Response to Williamson on taxes

Steve Williamson has an interesting new post on corporate taxes and investment, in which he claims that taxing corporate profits has no effect on investment.
What happens if the corporate tax rate goes up permanently, with the tax rate constant forever...? This has no effect on investment or on the firm's hiring decisions in any period. That is, if VB is before tax profits, then (1-t)VB = V, so maximizing VB is the same as maximizing V, and the tax rate is irrelevant, not only for investment decisions, but for the firm's hiring decision. In the aggregate, there is no effect on labor demand, and therefore no effect on wages. 
Basically, investment is an intertemporal decision for the firm. But the corporate tax rate affects per-period after-tax profits in exactly the same way in every period, so there is no effect on the after tax rate of return on investment the firm is facing. Therefore, the firm won't invest more with a lower corporate tax rate ...
Steve concludes
But, the tax bill is not about investment. The primary effect is redistribution. In the short run, the tax bill makes the rich richer and the poor poorer...
You can see there is a problem. If Steve is right, then why not a 99.999% capital tax rate? Per Steve, it won't distort any decisions, neither investment nor hiring nor starting companies, it will give a revenue bonanza for the government and it will transfer income efficiently. Surely if 99.999% corporate taxes had no disincentive effects, governments would have noticed? Surely not every single Republican is, as Steve implicitly charges, either lying through his teeth or an economic ignoramus when they state the goal of the tax cut is to spur investment, and thereby productivity and wages?

The answer is in a previous post on the burden of taxation, and Greg Mankiw's algebra but at the cost of repeating let's isolate the central issue. (The previous posts were too long, for sure.)

If you want equations, go back to  Greg Mankiw's algebra. There you see a model in which corporate taxes do distort the intertemporal incentive to invest.

The key difference: In his simple model, Greg defines profits as sales - wages. Then if the firm pays $100 to invest today, makes $10 out of it tomorrow after paying wages, but faces a 50% tax rate, it gets a 5% rate of return, while without a corporate tax it gets a 10% rate of return.

Steve defines profits as sales - wages - costs of investment. He effectively assumes that all investment is tax deductible. Then indeed a constant tax rate does not distort the rate of return. The firm gets the tax deduction on the investment made today, and that compensates for the lost profits tomorrow.

This is then the same argument that was floating around last time, (see posts for links) that full expensing of investment alone should solve the intertemporal distortions, and then tax capital at any rate you like including 99.999%.

What's the problem with that? Well, if you apply it completely, there is nothing left to tax. If a debt-financed firm can deduct from its sales all wages, inputs, investments, and interest payments, there is nothing left to tax.

The tax code seems to think payments to shareholders are "profits" which can be taxed without distortion and interest payments are "costs" like the electric bill that must be deducted. But there is no  fundamental economic distinction between debt and equity as a marginal source of investment funds. Dividends (and capital gains) are the returns you must pay to attract equity investors, just as interest is the return you must pay to attract bond investors.

So how do you deduct investment and leave something left over to tax? It rests on two ideas. First, that the tax code can distinguish "real" investments like buying forklifts from "financial" investments like buying stocks and bonds, and only deduct the former.

Second, that there is some pure "profit," some pure "rent," some "unreproducible input" (i.e. something that did not come from a past unmeasured investment), something like the classic "unimproved land" that can be taxed, without distorting any decision.  It goes hand in hand with the  complaints of greater monopoly.

But I find it hard to find and name a concrete source of profits that, once named, does not distort the decision to undertake some useful activity to make those profits. Starting, organizing, and improving a business, figuring out the intangible organizational capital that makes it a successful competitor, creating a product and a brand name, are all crucial activities for which  no investment tax credit will successfully offset a large profits tax.  "Intangible capital" is about all most companies have these days.

Aside the investment distortion, I see an important political economy argument against corporate taxes. Corporations have a lot of money, and really good lawyers and lobbyists. The higher the corporate tax rate, the more they will run to Washington to demand special credits, exemptions, and deductions. Like expanded investment deductions. Already, the corporate tax was effectively about 20% rather than the statutory 35%. I can't see any defense other than a lower rate, and tax people rather than corporations.

Two  final points of clarification.

First, Steve positioned his post as a response to my buyback fallacy post

"Here's John Cochrane, writing about the 'buyback fallacy:' 
'Many commenters on the tax bill repeat the worry that companies will just use tax savings to pay dividends or buy back shares rather than make new investments.' 
But, John concludes: 
'Investment will increase if the marginal, after-tax, return to investment increase...'"
The second point, which we are discussing here, has absolutely nothing to do with the first point, the buyback fallacy. Whether corporate taxes do or do not distort investment decisions, buying back shares has nothing to do with it. The buyback fallacy remains a fallacy even if Steve is right and 99.99% corporate taxes have no effect on investment.

Second, he writes
this has no effect on investment or on the firm's hiring decisions in any period.
Noone, not even Congressional Republicans, claimed that lowering capital taxes increases the incentive to hire directly. The reason is clear from the above -- in everyone's model, wage payments are deductible, profits = (sales - wages - ....), wages go inside the parentheses. The argument has always been that lowering corporate profits taxes increases the incentive to invest, and moreover to start new firms or reorganize them, that this investment would raise productivity, and that would lead to higher wages.

Steve didn't say otherwise, but you might have gotten the impression.  


  1. I think Williamson assumes that the firm has some shareholders who are receiving the dividends the firm pays out from its profits but is unable, for some reason, to raise any more capital through equity. In that case, reducing the corporate income tax rate doesn't lead to more investment, because it does nothing to debt financing and by assumption it can't do anything to equity financing. It's telling that his PV profits formula has no terms to account for share dilution in it, i.e it's not "PV profits per share". If you write down the model properly and allow the firm to issue new shares, then a corporate tax rate cut indeed raises the steady state capital stock. (How could it be otherwise?)

    In addition, it's worth mentioning that looking at actual firms and seeing that there's not much equity financing but a lot of debt financing (even if that were true) doesn't show that a corporate income tax cut wouldn't have much effect on investment since the Lucas critique applies.

  2. I think I agree with this post, although the nice thing about macroeconomic debates is no one is ever wrong. At least judging from the debates by rival PhDs that continue eternally....

    That said, investment was very strong in the 1950s-1960s in the US, with much higher personal and corporate tax rates. As high as 90% on the personal and 50% on the corporate (though dropping to 40% for most of the period). Economic growth was very solid also. Real wage gains were terrific, not matched since (indeed real wage growth has been anemic for a couple generations).

    History says tax rates, at least top marginal rates, are not that important.

    Usually, someone will say,"Oh, but there were exemptions in those days."

    Maybe so, but that still means the top tax rate is not important, if there exemptions that provide the right incentives.

    In the old, old days, one could hear the expression, "Invest it or lose it (to taxes)."

    However, the old days were before rampant offshore banking, and globalized business organizations. Or the near $5,000 in cash in circulation for every US resident.

    It may be that income taxes can be evaded these days. Which would again suggest the top rate is not that important...since corporate income taxes are largely avoided anyway....

    1. People who engage in 1950s nostalgia should acknowledge that the US was the only functioning industrial economy in the world during that era. All of its major contemporary competitors were absolutely crippled by the 2 World Wars, Communist Revolutions, and debt. Fortunately, a great deal has changed since then.

      Also, tax avoidance which is neither illegal, nor immoral*, must be distinguished from tax evasion, which is illegal, and which I am confident very few Americans engage in. In the 21st century it very hard to conceal taxable activities and the penalties for evasion are sever.

      *The aptly named Learned Hand (1872-1961) wrote:

      Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

      Comm’r v. Newman, 159 F.2d 848, 850–51 (2d Cir. 1947) (Hand, J., dissenting)

    2. Fat Man,

      Agreed, not to mention that labor force participation was a lot lower.

      1950-1959 - Employment to Population ratio hovered between 55% and 58%

      1960-1969 - Employment to Population ratio hovered between 55% and 58%.

      1970-1979 - Employment to Population ratio hovered between 55% and 58%.

      The trend was broken by 1985 and from 1987 to about 2007, it ranged from 60% to 65%.

      Obviously, with a larger portion of the population working, tax rates can be lower and achieve the same amount of tax revenue through base broadening.

  3. I think that a lot of this theorizing is from the view point of a parliament of rational, diversified shareholders, cruising at 45,000 feet. That is not the only possible viewpoint, and indeed probably not the most relevant one.

    Almost all of the decisions about the disposition of corporate assets are made by management (some combination of the directors and senior officers of the corporate entity). Management is, of course, only one of many constituents in the ongoing drama of corporate life. Others include customers, employees, vendors, creditors, shareholders, and taxing authorities.

    It is important that the least reciprocal of these constituent relationships are the last two. After all, the business gives customers products and the customers give it money. Employees give labor and are recompensed with money and promises of future money. But shareholders get money and give nothing back. The only things that can come from their direction are complaints and law suits. Taxing authorities are even worse. They are most pressing about money and the most they give back is not throwing you in jail.

    I view the corporation as a theater for negotiation. Management is in the middle, they have the pot of cash, and they must figure out who gets paid and when. If they are wrong they get thrown out of the theater.

    The corporate tax rate is one of the most important house rules in this game. By cutting back from 35% to 21%, the tax man has left management with 14 more to to play. Management has no intention of using that money to do what some outsider wants them to do. If they had their druthers they might just pocket it, but, as gamblers used to say, baby needs new shoes. Which baby, and which shoes cannot be determined a priori. It depends on the business, the business cycle, and management view of its opportunities and pitfalls.

    I would guess that few retail businesses are going to use money to add square feet. The labor market seems to be tightening. So some of it may go to raises or new hires. Yes, if management thinks they need to appease shareholders they will raise dividends. Banks that had to cut their dividends dramatically during the panic of 2008, may well do that. Tech companies that have never paid dividends may not start, but they may want to make strategic acquisitions.

    What congress did by cutting the corporate rate is to concede to the threats of managements to off shore, invert, or privatize. Congress acknowledged that managements had a point when showing that international competitors had an easier time. They must also be concerned about the dramatic erosion of the corporate tax base over the last generation, and the equally dramatic decline in the number of public corporations. Congress hopes that by cutting the government's take, they will allow the corporate sector to grow again. I think that Congress choice was rational, and maybe even correct.

    If congress made a mistake it was in giving a special deduction to pass through owners, who were not being treat unfairly by a reduction in corporate rates. Previously corporations were treated unfairly. Pass through owners were simply whining.

    Here is the backstory on that. Around 2003, shareholders were allowed to haircut dividends for tax purposes by 50% with the intention of relieving double taxation of corporate profits. Before that, corporations were taxed at 35%. If the corporation made $100, it could only pay out $65 in dividends. Out of that the tax man took ~40% or $26 giving the government 61% of the profits. After the 50% haircut on dividends, the government's take was reduced to $13, so the overall rate was 48%. Better but not idyllic. With a 21% rate and the dividend haircut in place, the government gets $21 from the corporation and (40% of one half of 79) ~$16 from the shareholders, which totals to 37, which is close to the rate paid by pass through owners.

  4. The assumption is that corporate taxes were cut, other taxes being equal. That assumption means more business activity will be conducted under the corporate charter than before.

    If entry and exit of business process is liquid in corporate world,then total tax income drops, the tax cut is spread to all business. The corporate sector gets big relative to private equity to partnerships.

    1. That is only true if tax payers don't have to pay taxes on dividends and capital gains. But, they do, so it is pretty much of a wash except that some pass through owners will be able to claim the new (and, IMHO, weird) deduction for pass through. YMMV

  5. Aren't start-ups another problem with relying only on expensing? I can deduct investments in a corporation that is already generating profits. But how do I do that in a start-up that might only generate it 5 years from now?

    1. This is why most start-ups are organized as pass throughs. Consult your accountant about the impact of the "passive activity" loss limitations.

  6. I made the same comment as "Anonymous" directly on Steve's blog. I think this was a "Christmas Spirits" post and should be ignored.

  7. Williams' take on taxes and investment is defective (for reasons Cochrane mentions and others). But, let's assume for a moment he's right about the effect on the overall level of investment.

    He is correct in his analysis that the corporate tax rate affects the decision of *where* to make that investment. As someone who spent an entire career in the area of international tax, I can safely conclude that even if Williamson is right as to the *level* of investment, it affects the *location*. Williamson correctly identifies this but then merely waves it away with the unsupported conclusion that other countries will follow suit (when? how long did it take the US to "follow suit"?). Americans should care very much about *where* investments are made (particularly if they are concerned as much about the "rich/poor" allocation of wealth as he seems to be).

    I'm also puzzled by his statement that the (only?) way to increase investment is through investment credits. Providing a tax credit is merely another way of reducing one's marginal tax rate, albeit here in a more targeted way. I guess he's comfortable with a tax policy that directs how companies should be encouraged to spend their funds (other uses, rather than investment in capital goods could be the hiring of more US labor). He notes, in respect to a marginal tax rate change, "there is no effect on labor demand". Yet, does an investment tax credit affect labor demand, and if so, how? Also, perhaps someone can explain to me how lowering the overall marginal tax rate has no effect on the investment level, but an investment tax credit (permanent?) somehow changes that over the long-term. If the credit is permanent, doesn't that not also have no effect in any period because the effective tax rate on investment would be always the same and thus affect the "per-period after-tax rate in every period in exactly the same way"? If he really means a temporary investment tax credit, then I guess we'll hand it over to Steve the decision not only how companies should allocate their funds, but when. Also, if he is arguing for a temporary investment tax credit, he seems overly concerned about temporary effects of investment location decisions ("other countries will follow suit"), but is quite impressed by the temporary effects of a temporary credit.

    Finally, I'm not at all convinced the effect of these business provisions is to "make the poor poorer and the rich richer". His sole support for this is the following assertion:

    "Permanently lower tax revenue has to show up, in the long run, as permanently lower government transfers and lower spending on government-provided goods and services. This will hit the poor disproportionately. So, this isn't tax legislation that appears to work on marginal anything - it's just wealth redistribution."

    Aside from the effect of corporate taxes on wages (a different debate), I can think of quite a number of ways that the very moderate reduction of tax revenues from the lower corporate rate would not inevitably be recovered on the backs of the poor, e.g.:

    1. Lower spending in areas that have nothing to do with spending on "the poor". We spend quite a bit on the middle class and above and we waste a lot, too;

    2. Quite likely any necessary recovery of "lost revenue" would be recovered from those who, in the future, will pay the taxes. If the recent history is any guide, this has not been "the poor".

    The CBO scored the business tax reduction portion of the bill (including tax on flow-thru's) and net of international provisions at about $50 billion per year over ten years. If such a gap would need to be filled in the future, I suspect even our Congress would have more imagination than Williamson as to how to do that other than sticking it to the "poor".


  8. Yes with full investment expensing the tax burden as well as the expected present value of tax revenues is essentially zero, and the only reason to levy the tax is to close the loophole of people incorporating and then paying zero taxes on their labor income.

    Following Meade committee terminology, full expensing can be done either as a cash flow tax on the firm (the R+F base), or on a firm's shareholders (the S base), see chapter 12 of

    I personally favor an S-base system, since 1) it transparently taxes individual consumption in a progressive way, and 2) moving from our current system toward an S-base tax is much easier than, say, introducing a VAT.

  9. I believe the US tax rate compared to other countries is also essential to consider. (1-t)VB = V does not take into consideration repatriation choices by companies. With a higher US rate profits will be kept over seas and there will certainly be a difference in capital allocation decisions. When looking at this equation from the US's lens (or Congress's actions) the tax rate could affect the value in the US.


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