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Can tax cuts increase economic growth?

5 Dec

The current “debate” about tax cuts (actually, there appears to be more hand waving than debate but my parents taught me the virtue of politeness!) revolves around a central assertion: Tax cuts will spur economic and job growth. This assertion is based on the assumption that corporate and income tax cuts (many small businesses pay income rather than corporate taxes) will be reinvested into the economy spurring job growth. This is not entirely clear ( but let us for the moment assume it will indeed happen.[1]

When businesses reinvest their capital, business grows and demand for labor goes up. Basic microeconomics does support this position. More capital increases labor productivity. Therefore, for a given supply of labor wages go up. Given the current tight labor market, this may indeed be the case. However, life is seldom static. The wage increase relative to the price of capital implies that new investment is likely to be capital intensive rather than labor intensive. This process actually exacerbates the current trend toward robots and away from labor. Thus, it is unclear if these tax cuts will increase job growth dramatically. In any case, these, fewer, new jobs will tend to benefit the sort of labor that can run robots and write algorithms. People with older/no skills will be left out in the cold. Such a scenario may create a permanent unemployable underclass if e.g. schools are unable to pick up the training slack.

The corporate tax cuts have other effects as well – particularly if these cuts lead to companies moving their tax headquarters back to the United States. This move will show up as a capital account surplus in the United States international balance of payments. This influx of foreign money increases the demand for USD and leads to an appreciation of the dollar relative to other currencies. The more expensive dollar makes our exports more expensive and our imports less expensive – thus increasing the trade deficit. This is not a problem per se but I have to scratch my head at the Trump administration’s inconsistency in pushing for a tax cut designed to increase the trade deficit when they want to reduce the trade deficit. To reiterate though, I do not think a trade deficit is a bad thing because foreign lenders MUST finance it. Therefore, it keeps interest rates low as well.  That can help future growth. Alternatively, if the US increased tariff/non-tariff barriers to cut the trade deficit the capital account surplus would have to go down – i.e. businesses would not bring capital into the country. This of course would cut off some of the growth benefits of the corporate tax cut.

Bottom line effects:

  1. If the corporate tax cuts lead to capital reinvestment (and this is a big if) then labor productivity and wages will rise. This will lead to economic growth. However, job growth may not happen since firms will substitute labor with cheaper capital.
  2. Jobs will be skewed toward specific skills. This will continue the current process toward jobs with specific skills and away from low-skilled/old-skill jobs.
  3. Any attempt to lower the trade deficit will reduce the growth potential of the tax cuts.

[1] The income tax cuts are temporary. This may actually increase the incentive to pay out dividends which may then be taxed at lower income tax rates today rather than wait to be taxed at a higher rate I the future.


Tenure: A meandering path to serfdom!

15 Mar

Tenure is part of the compensation package for college professors. However, college administrators view this as a privilege. In fact, the AAUP (effectively a professor’s union) tacitly agree because they make the case for tenure as an institution necessary for academic freedom with no connection to compensation.But let’s concentrate on the idea that tenure is about compensation. How should professors react when tenure is not part of a compensation package?

Consider what tenure does. It is part of a compensation package designed to reduce mobility. It is a barrier to exit in the college professor employment market. Thus it reduces bargaining power for the professoriate effectively by reducing any holdup costs. Professors cannot make a very credible threat to leave if they feel their working conditions are bad or wages are too low. This lack of credibility translates into reduced bargaining power when it comes to wages. This is, of course, a big reason behind the wage compression we see among professors relative to assistant professors. And if there is no way to bargain for higher wages or better working conditions why should the professoriate innovate? After all they cannot retain the fruits of their innovations. So what would happen if tenure went the way of Nineveh and Tyre?

The end of serfdom – similar to tenure insofar as it reduces the bargaining power of labor by restricting mobility – in medieval Europe may provide an object lesson. The reduction in the labor force wrought by the plague had differential impacts in Western and Eastern Europe. In Western Europe small institutional variations led to the end of serfdom as labor became more scarce. This jump started a secular increase in the share of output going to labor. Of course mobility and other institutional changes also promoted innovation and economic growth. In Eastern Europe, however, the problem of scarcity of labor was met with a strengthening of serfdom! The results are obvious and persist to this day.

In other words, removing tenure, like the end of serfdom, should increase the likelihood that the professoriate will innovate to keep themselves competitive and increase their wages. Of course there may be other problems based in agency theory. How will administrators gauge the productivity of the professoriate given the inherent information asymmetry that exists between the professoriate and college administrators? But that’s another post. Watch this space!

Taxes and…..

28 May

Alan Simpson told Fareed Zakaria that any one who thinks that the current deficit problem can be solved without raising taxes (in some form — either directly or indirectly through inflation and/or high interest rates) has rocks instead of brains. I like the salty rhetoric. But is it true? I suppose it depends on beliefs about the short and long run.

By and large most economists would believe that economies where the government has a light touch — creating and protecting basic institutions that promote economic freedom — are more likely to generate prosperity. Low taxes are part of this mix since taxes are how governments extract rents from creative individuals. Of course there is an optimum amount of taxation necessary to protect the aforesaid institutions. But this is a long term view. As of now we have increasingly an extractive political economy. Rising inequality in the US does not help. Some inequality is of course good since it provides an incentive to work (as a recent book by a Bain Capital colleague of Mitt Romney’s rightly claims). But as inequality increases it enables a class of wealthy individuals to capture the legislative process to their favor. This is a fundamentally anti capitalist process which starts a vicious cycle that reinforces both extractive political and extractive economic institutions (Acemoglu and Robinson make this case in their recent book “Why Nations Fail”). At any rate, the rising deficit also extracts wealth from the economy and the ROI on this deficit spending is at best unclear. But taxation is an extractive process as well. One obvious solution is to get rid of all transfers (social security, medicare, etc.) and gut military spending. But this appears to be politically unfeasible. Another solution is to raise tax REVENUES by simplifying the tax code and cut spending at the same time. This would reduce the power of extractive economic institutions. This is effectively the Bowles Simpson approach and the approach that President Obama claims as his own. Then there is the Mitt Romney approach — cut taxes on his first day in office and do very little for spending. Cutting taxes may appear to be a blow against extractive economic institutions. But runaway spending will continue. Remember that even Paul Ryan’s so called revolutionary plan merely limits the GROWTH of spending! Thus the deficit may be expected to rise. In other words the rise of extractive institutions will in fact be abetted by tax cuts! Current, stated, Republican policy may appear to disfavor extractive political institutions (the tax cuts) but in reality will increase their power (by doing very little for the deficit). Why?

One answer may be that the Republican party has been captured by wealthy interests who wish to capture the legislative process and jumpstart a system of extractive political and economic institutions. In other words, its not a question of rocks instead of brains. This is very intelligent rent seeking at work. I think I disagree with Mr. Simpson. Republicans are not stupid.

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