Why Tax Cuts are Great Even if They Don’t Improve X

This article is in specific rebuttal to a recent WaPo piece complaining that the Trump Tax Cuts aren’t going to work. I briefly review the claims in the article, the tax plan itself, and some general theory.

I. The Claims in the Article

  1. “Why are businesses investing so little when profits are so high? … It has been average at best.”
    1. First of all, this is the wrong question to ask. Business investment is not a great measure of economic health. In theory, an efficient market optimizes on Total Surplus. In practice, GDP per capita is the usual best-proxy for efficiency. This is closely related to average income, which O’Brien deals with a bit, so we will revisit.
    2. Secondly, you need to compare the US to other countries. The US doesn’t exist in a vacuum and trade effects matter, in particular given all of the weird shit the Trump administration is doing with trade and foreign policy. See Image 1 below, where you will notice the US has been slaying.
    3. Third: O’Brien is plain wrong on the facts. Businesses are investing quite heavily. Businesses are investing at higher-than-pre-Great-Recession levels. Not quite at the all time high rate of Q1 2015, but natural variance is a thing. Yes, consolidation has been proposed to explain this variance. Yes, that’s plausible. But the variance isn’t much to begin with.
    4. Fourth: O’Brien didn’t link business investment. He linked “Private Nonresidential Fixed Investment/Gross Domestic Product,” which is a highly inappropriate, bordering on cherry-picked, chart to show. Why is he looking just at nonresidential? What if that is the sector where investment is mainly happening?
  2. “Economists aren’t entirely sure, but one explanation that makes a lot of sense, and has quite a bit of evidence to support it, is that monopolies are choking off growth…Companies, in other words, might be making so much money not because they’ve discovered a big, new market, but rather because they’ve cornered an old one. But that’s not a reason for anyone to invest money in it, least of all the monopolist.”
    1. O’Brien has butchered the literature here. Yes, the share of labor is concentrating, but that is causing economic growth, not choking it.
    2. According to the paper O’Brien cites, “Possible explanations for the growth of winner take most include [new technology] or increasing competition…” Not consolidation in the number of firms.
      1. The idea here is that some firms can substitute machines for people, lowering their costs and enabling them to grow market share. Think about McDonald’s or Walmart replacing people with machines. Notice that neither of these firms is a monopoly, and their choice to use machines is actually lowering prices for customers and increasing wages among the employed. In theory, you might be concerned about massive layoffs, but in the real world this is not happening and employment is really strong right now.
      2. There is good reason to think prices, wages, etc, are competitive, even when a few firms have a large market share. See, for example, Cournot competition or Bertrand competition. Basically, a large firm maintains its market dominance by not abusing its position. As soon as it tries to charge a higher price, the competition “swoops in,” to use O’Brien’s phrase.
      3. This is exactly the market force which Jeff Bezos claims forces Amazon to act as a benevolent monopoly. He said, for example, “In fact, sometimes we’ve done a price elasticity studies, and the answer is always we should raise prices. And we don’t do that because we believe– and again, we have to take this as an article of faith– we believe by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term.”
      4. Eventually, new technologies become commonly used and these firms would lose their advantage unless they came up with an even newer technology. So yes, large firms like Amazon, Google, Facebook, Walmart, etc, generally must continue to invest in new technology to maintain their market position. This is completely fair. These companies are fueling innovation and earning temporary profits as a reward. That’s exactly how market incentives for innovation are supposed to work.
    3. If capital is cheapening more quickly than labor, firms will spend relatively more on labor in order to prevent excess capital deepening, eg too many machines and not enough people to run them. This is consistent with the extremely strong labor market right now: High employment and good wages. See claim 3.
    4. If the opposite had happened then the New York Times would be complaining that Companies Spend on Equipment, Not Workers. You can always pick some factor X to complain about, even in an overall good economy.
    5. If the opposite had happened, firms would be making a bad investment by overspending on capital and underspending on people. Production costs would be higher, raising prices, and income would also be lower. Total surplus as well as per capita GDP would have been lower in that case.
    6. The number of firms is increasing, not decreasing, since 2011. So monopoly pressure is getting smaller, not larger. See BLS data on firm birth and death here.
    7. Big firms get all of the attention, but person-to-machine substitution has occurred in small business too. Over half the US population is employed by a small business. There are more than 10x as many sole proprietorships as corporations, and more partnerships than corporations.
  3. “The entire rationale for them is that slashing corporate taxes will increase profitability enough that businesses will increase their investment, which, by making workers more productive, will eventually increase wages as well. But what if bigger profits won’t make a company put any more money back into its business, because it’s a monopoly that doesn’t need or want to expand?”
    1. O’Brien is actually completely right to bring up this potential issue, but his answer is totally wrong, as one might expect from a journalist citing Krugman.
    2. First, Trump’s cuts are not just corporate tax cuts. He also cuts income tax and creates a pass-through deduction, things which benefit the whole private sector. See the discussion on the plan for more on that.
    3. So the real answer to O’Brien’s question is: “Companies might reinvest more, or they might pay higher wages, and they will probably do a bit of both.” I’d say none of that is a bad thing. It’s funny because, again, usually the criticism is that corporations aren’t paying enough, but when they do now they get criticized for not investing enough. What else do you expect corporations, or any kind of business, or any kind of person to do? Those are the only two possibilities!
  4. “Hassett is sure that [wages will go up] even though that hasn’t been the case for a decade now…They’ve all spent the past 38 years proclaiming that tax cuts for the rich work in theory…”
    1. First, wages have been going up. Mean, median, and total domestic income have all increased. Real median household income is at it’s all time high in the latest FRED data from 2016.
    2. Growth in the top quintile hasn’t even been different from growth in the fourth quintile. Growth in the fifth quintile is more than double the rate of GDP growth. Yes, the top 1% has seen it’s income grow rapidly, but this is not from stealing from the poor. Their income has gone up further than if they stole 100% of the income from the poor. Instead, this profit is likely due to a mix of consolidated government spending and genuine innovation – ie crony capitalism.
      1. Notice that even under crony capitalism, while not ideal, quality of life is still improving across the income spectrum. Image 2 memes this pretty well.
    3. Again, the tax cut is not just for the rich. See the next section where I cover what’s actually in the tax plan.

Image 1 – The US has been slaying in Great Recession recovery. Even compared to Germany, the tits of Europe’s economy. Click to zoom. Source: World Bank.

 

Image 2 – Your meme of the day

II. What’s in Trump’s Tax Plan Anyway?

  1. An effective income tax cut for everyone except the rich.
    1. Yes, you read that correctly. Defining the rich as the top quintile of the income distribution, the average rich person will see their income tax move from a range of 33-35% to always 35%.
    2. The middle class has a clean reduction, and the super-rich (top 1%) see a reduction from 39.6% to 37%.
    3. The lowest income group has the income tax held constant, but they have their income deduction doubled, leading to an effective tax reduction.
  2. It reduces the maximum corporate tax rate from 35% to 21%, although analysts think it will only reduce the effective rate from 18% to around 14%.
  3. It creates a 20% pass-through exemption, with some caveats. This allows pass-through entities such as LLCs to lower their effective tax rate. See this article for more details.
  4. It increases exemptions for large equipment purchases. This is a benefit to businesses of all sizes. This should stimulate business investment, driving down some of O’Brien’s concern.

III. Some General Theory

  1. Taxes do not prima facie strengthen or weaken the economy. They are transfers from private custodians to the government. The effect on the economy is a second-order effect determined by the efficacy of public vs private custodians. To that end, private-sector custodians are known as more efficient agents of allocation because:
    1. Government is subject to rent-seeking, special interests, and regulatory capture.
    2. Central planners are subject to the economic calculation problem.
    3. Robust political analysis of government decision-making includes the relaxation of the assumption of benevolence.
    4. Market monopoly or oligopoly does not preclude efficiency. Unregulated monopoly can produce larger surplus than regulated monopoly.
  2. Empirical considerations
    1. My own research and Friedman’s law indicate that government expenditure has an inefficiency multiplier of about .5.
    2. If Trump is a moron, why give him more money? We looked at the relatively low, 3.9%, rate of income growth of among the very poor in the private sector in 2015, but that’s more than double the 2018 average income growth of 1.9% awarded by Trump in the public sector!

In conclusion, the average human, let alone American, doesn’t and shouldn’t care whether business investment has gone up recently. They care whether they are more or less effectively able to meet their own needs. The best way to benefit the average bro or sista is to increase their income and decrease their expenses. This has been happening in the US. I’ll be the first to admit these improvements are driven by technological gains created by a small subset of all firms, but that’s how technological growth has always been. I hardly think Trump’s tax proposal is revolutionary, but I think it’s obviously a marginal improvement over what we have today.

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