Friday, January 12, 2018

Right answer, wrong reason

Sometimes it is not good to get to the right answer for the wrong reasons. This thought comes to mind reading to recent WSJ articles, Walmart raises wages and Tax reform releases the bulls.
"Wal-Mart Stores Inc. said it would raise starting hourly pay to $11 for all its U.S. employees and distribute one-time bonuses, doling out some of the windfall it expects from the U.S. tax overhaul as it competes for store workers in a tight labor market." 
"Only 15 market days have passed since the Senate passed the tax bill, ensuring it would become law, and Wall Street analysts have already upgraded their consensus forward earnings for the S&P 500 by an unprecedented 4.6%. Is it any wonder that stocks have rallied?"
Two narratives compete for how corporate tax cuts might spur the economy: cashflows vs. incentives.  Washington and most pundits like to talk about cashflows, "trickle-down" if you will. Corporations (existing, large) don't have to give so much money to the government. So perhaps they will benevolently pass it on to their workers -- or perhaps political pressure is important to force them to this magnanimity.

Economists see the world through incentives. In this narrative, a lower corporate tax rate increases the incentive to invest, broadly construed -- to buy new investment goods, sure, but also to invest in worker skills, organizational improvements, new opportunities, and for new companies to spring up. That investment raises the productivity of labor and hence demand for labor. Competing to hire good workers, companies drive up wages. But companies no more voluntarily give workers bonuses out of extra cash than they voluntarily send money to the electric company on top of the bill.

The Walmart headline falls distinctly into the first category. If so -- if this is how the corporate tax reduction raises wages -- an economist would say it's pretty fragile. Benevolence fades quickly.

Fortunately the rest of the article, if you read it with these views in mind, supports more the economists' view of what's really going on.
"On Thursday, the company also announced plans to cut roughly 10,000 jobs by closing about 10% of its 660 U.S. Sam’s Club warehouse stores.... 
Chief Executive Doug McMillon cited the tax overhaul for the pay increase, which the Trump administration praised at the White House."
In our politicized economy, it is a good time to offer some worker-friendly PR! More deeply "investment" to "productivity" is the same thing as finding ways to do things with fewer, since competition means they must be higher-paid, workers.
"But the wage boost also comes as many U.S. businesses are contending with tight labor markets and rising wages. Retail rival Target Corp. recently lifted its starting pay to $11 an hour and Costco Wholesale Corp. starts hourly staff at $13."
So, Walmart is just catching up to the competition, really.
The labor market is tight and getting tighter,” said Mark Zandi, ...
To combat wage pressures, Wal-Mart has tried to save on labor costs by adjusting the number of workers per store and more recently by automating many rote tasks. It is adding more self-service registers and using robots to scan shelves for items that are out of stock. Last year, Wal-Mart had around 15% fewer workers per square foot of store than a decade ago, according to an analysis by The Wall Street Journal.
I.e. productivity-raising investments. Let us also remember that labor is not a spot market and keeping good workers is a good idea. It does make sense for wages to rise in advance of capital improvements if firms know they want to keep their good workers and know wages must rise in the future from competition.

In the PR battle, it will likely be hard to admit that the kind of productivity raising investments the tax reform is supposed to induce can reduce demand for labor for each unit of output at individual companies. It will read like automation scare. Where overall demand for labor rises is that output rises and new companies come in to being.


We (readers of this blog) all understand that every cent of corporate taxes comes from higher prices, lower wages, or lower payments to shareholders. There is a bit of debate about which, and my previous reviews concluded that lower wages and higher prices were much more important than payments to shareholders.

Opponents of the tax cut claimed it would just be a windfall to profits, which would create a windfall to stock prices, which would benefit wealthy shareholders. This is the prime argument that the corporate tax cut benefited wealthy people. (Note, stockholders get no permanent rise in rate of return. They just get a one time windfall when the tax cut becomes reality.)

Again, cash flows vs. incentives; static vs. dynamic economies. If companies are just money machines, faxing fixed prices, wages, customers, and workers, and shareholders get to keep 80% rather than 65% of the money, then indeed the price should go up. But if companies respond to incentives, they invest, expanding capital, expanding output, and thereby quickly driving wages up, prices down, and profits back to normal. There should be a small bump in stock prices as these investments take time, but competition and entry drive profits back to normal quickly. (I'm describing the Q theory of investment with taxes here.)

As evidence, I pointed to the fact that stock prices seem to have very little historic correlation with corporate tax rates. That's good. It means that tax cuts are not just passed to shareholders, and do result in higher wages and lower prices.   So if indeed this time the tax cut is just a boon to profits driving the stock market up, it will mean its antagonists were right, at least on the first of three links of their dubious chain to inequality.

I've done lots of work on P/E ratios, and I remain of the view that today's PE ratios reflect a low risk premium on top of a very low real interest rate. I also remain of the view that low risk premiums have nothing to do with central banks, QE, and the rest, but are perfectly normal in the eighth year of a very quiet expansion with very low volatility. Like all academics, I am fondly attached to my past papers, but habits does seem to do a pretty good job.


  1. Another possibility is the wages for non-corporates are depressed because of the differential tax effect. We have to hear from main street before judging.

  2. John (and commenting using my real name and you do know who I am),

    Very interesting post. Coming at this from the professional world that I live in and thinking about the contrarians who object, much of the argument from people on the economic left seems to be that yes, some small amounts may go to the rank and file, but the bulk of savings not going to shareholders will be awarded to top executives in incentive payouts are stock awards and grants as after-tax EPS increases.

    I know how I respond to that as a consultant and actuary, but curious as to your response as an economist.

    Thanks in advance

    1. John: Great to hear from you! As an economist, I'd say that in the end management is an input that gets paid its opportunity cost and no more just like inputs, labor, bond and stockholders, and the electric company. In politics and public discussion people tend to think of everything as a bilateral negotiation. Economists tend to think of everything as eventually pushed by competition in markets. If the decline in tax rate makes management more productive, and there isn't a flat supply curve of managers, then we should see management compensation increase.

  3. As a shareholder in Wal-Mart, I expect management to honor its fiduciary obligations and pay as little as possible.

  4. Thank you John (Cochrane),

    I am curuous as to why you put wages before prices in the following sentence: " ... my previous reviews concluded that lower wages and higher prices were much more important than payments to shareholders." Specifically:

    First, what is your best guess as to the percentage breakdown on where the tax-cut goes between decreased prices and higher wages.

    Second, given that high-skilled labor is less supply elastic than low-skilled labor, what is your best guess on the percentage breakdown on where the tax-cut wage-effect goes between high-skilled and low-skilled labor.


    Thomas Tenerelli

  5. I remember the argument advanced by Kenneth Arrow that with zero risk free rate and complete loss offset a decrease in capital income taxes will decrease gross investment as investors use less leverage to remain in their preferred position. I haven't seen this argument advanced recently and wonder why.

  6. This is off topic but I am trying to find the little test an economist gave: Would you rather live on a planet where everybody made $15K or on a planet where half made $15K and the other half made $30K? Or do I have that wrong? HELP!!

  7. As is the case with most things in life, the new tax bill is neither the disaster Democrats think nor the panacea Republicans think. However, I believe that strong economic activity is a desired end and that funding government is not a goal of such activity.

  8. "Wal-Mart Stores Inc. said it would raise starting hourly pay to $11 for all its U.S. employees and distribute one-time bonuses, doling out some of the windfall it expects from the U.S. tax overhaul as it competes for store workers in a tight labor market." ... And unfortunately this widely publicized press release ignores many issue:

    ** As noted they also quietly announced closing 63 Sams Club Stores which will put thousands out of work.

    ** Walmart employees are eligible for the $1,000 bonus only if they’ve worked at the company for 20 years. Those other employees will receive a smaller bonus based on seniority. Walmart didn’t explain exactly how the sliding scale will work.

    ** The one-time bonus Walmart announced this morning amounts to just over 2 percent of the total value of the tax cut to the company, which supports the opinion of the 'yeah it's more trickle down' pundits as the money is not generating jobs.

    ** The wage hike was likely necessary for the company to remain competitive with companies like Target and Costco — and, in some states, necessary to remain legally compliant.

    ** The ballyhooed minimum wage hike only affects those who have not had merit raises that put them over the minimum anyway.

    Lastly, just a note. Walmart's labor costs are 1% of total sales each year. If Walmart would just raise their prices by a measly 1% ($1.00 bottle of water now costs $1.01) .. The impact on buyers would be a shrug of their shoulders. Yet with that 1%, they could double every employees' salary .. The $10 cleark could now earn $20 p/h .. The $100,000 a year manager would earn $200,000 a year .. Over night. And the benefit to the US taxpayer? Reduced food stamps, medicaid and general welfare costs that we all bear so the Walmart heirs can pocket another multi billion each year.

    Forbes Magazine: Report: Walmart Workers Cost Taxpayers $6.2 Billion In Public Assistance

    1. What are Walmart's incentives to just overnight double its employees' wages for the benefit of US taxpayers (or increase wages by any amount out of pure benevolence for that matter)? John alluded to the fact that Walmart should be responding to its incentives to compete in the labor market for talented workers, but Walmart competes on many dimensions other than in the labor market. I think my favorite quote by Amazon's CEO Jeff Bezos is "Your margin is my opportunity." Even increasing prices by a "measly" 1% seems like a great way to provide Walmart's fiercest competition with a great opportunity.

    2. There is absolutely no incentive to double their employees salaries... And that's really my point. I provided several employers who valued the people that made them wealthy by returning some of the profit to their help. This is really what someone would expect is capitalism worked properly and ina free market environment...

      And the 1% figure would hardly dent Walmart's bottom line or allow other corporations to take advantage. Nobody would walk out of or abandon Walmart if a 99 cent bottle of water was suddenly $1. And in fact, if it was applied on a sliding scale, it would be considerably less that 1% anyway.. Give the people at the bottom a 25% raise, and those at the very top nothing. Everyone else between would get a portion of the 25%.. Price increases would be about 0.05% overall. A real nothing burger. What that would do is remove the burden the taxpayers (you and I) pay to support Walmart's workers with Medicaid and Food Stamps, etc.

    3. Would it be OK if I converted this comment into a stand-alone article for my website: WriterBeat (dot) com?

      There is no fee; I’m simply trying to add more content diversity for Writer Beat's community of authors/readers and liked what you wrote. I’ll be sure to give you complete credit as the author. If OK, please let me know via email:


    4. 1) According to this, at least, the math above doesn't work: In the 2015 fiscal year, Walmart made a profit of $16 billion. This figure, when divided among Walmart’s 2 million-plus employees worldwide only works out to an additional $7,355 per year, or $3.67 per hour (with bringing profit to $0)

      Read more: Wal-Mart's Biggest Liability: Labor Costs (WMT) | Investopedia

      2) John (Egan), making employees wealthy is not what someone would expect in a system where capitalism is working properly. Making shareholders wealthy is what you would expect. If, in order to make shareholders wealthy, employees needed to be compensated with stock, stock options, restricted stock, etc., companies and the market as a whole would respond by allocating some capital to doing so.

      That hasn't been the case historically at Walmart, whose shareholders and management team have collectively decided to do otherwise and built the third largest employer in the world after the US and Chinese militaries. Most markets are rational in the long run and in the aggregate, and the market for retail employees at the store level seem to be so, across a variety of concepts who feel the need to pay up or down based on the level of talent, retention percentage, training cost and other variables.

      My company pays a higher wage that some others in our space, but mainly because new employee training makes the higher wage a win for the overall profitability of the company, not because we're super nice people (even though we are!).

      3) That doesn't seem like you could double everyone's wage without feeling it. Claims like that always make me suspicious, especially since I don't think there are any retailers who only spend 1% on employee expenses (remember that salaries bring higher payroll taxes too). They don't appear to break it out, but my estimate from April 2017 Quarterly Report is that the sales expense, G&A and Op Ex line is that they are in the mid/high teens in payroll expense relative to their net sales. That's excellent for the industry, but it's not 1% and it's not trivial.

  9. Can I augment a sentence?
    "Note, stockholders get no permanent rise in rate of return. They just get a one time windfall when the tax cut becomes reality" which is equal to the present value of all the incremental future cash flows.
    So stockholders get all the benefit of tax cut now, while workers and consumers will get the benefit in pieces in the future.

    1. The tax cut is probably good for a 10% increase in EPS if it all went to shareholders but the pundits are predicting a 5% increase in EPS.

      It strikes me that in companies that must constantly fight for customers and regularly renew its capital investment, the benefit will ultimately go to the customers. On the other hand companies that have highly valuable brands or market positions, and do not need capital, the tax cut will go to the existing shareholders.

      Hazarding a quess, I think if we look back in 30 years we would find that overall 10% went to workers, 30% went to customers and 60% went to the existing shareholders.

  10. Economics, the dismal science. Not because it is dismal, it is because it gives you results you did not anticipate, which may make one grumpy.

  11. Weird question but maybe people don't realize this and the real value of the stock goes up but the perceived takes time to catch up?

    Tldr you found money

  12. What do you think about this new AER paper?
    (7) Do Higher Corporate Taxes Reduce Wages? Micro Evidence from Germany
    Clemens Fuest, Andreas Peichl and Sebastian Siegloch
    This paper estimates the incidence of corporate taxes on wages using a 20-year panel of German municipalities exploiting 6,800 tax changes for identification. Using event study designs and difference-in-differences models, we find that workers bear about one-half of the total tax burden. Administrative linked employer-employee data allow us to estimate heterogeneous firm and worker effects. Our findings highlight the importance of labor market institutions and profit-shifting opportunities for the incidence of corporate taxes on wages. Moreover, we show that low-skilled, young, and female employees bear a larger share of the tax burden. This has important distributive implications.
    Full-Text Access | Supplementary Materials

    1. I just saw it. The abstract looks really interesting. See also the great looking paper further down on mortgage interest deduction -- raises house prices, lowers homeownership, lowers welfare! I can't wait to read that one too. And don't miss the great finance paper by my colleagues Culp, Veronesi, and Yosawa.

  13. Re solar panels - Arnold Kling has noted that policy on a number of fronts, e.g., health care, housing, ..., is characterized by a combination of restricting supply and subsidizing demand, leading to predictable results.


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