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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 (https://www.bloomberg.com/news/articles/2017-11-29/trump-s-tax-promises-undercut-by-ceo-plans-to-reward-investors) 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.

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Political Economy of Trump’s “jobs” policy — A scenario.

17 Nov

President elect Trump says he wishes to “Prioritize the jobs, wages and security of the American people” (https://www.donaldjtrump.com/policies/immigration). But what would his restrictive immigration policy do for jobs? The question is complex but the most obvious analysis suggests that it would not help unskilled workers or workers with outdated skills.

Let’s start in the labor market. Immigration restrictions will reduce the supply of labor. That should raise wages for American workers. However, that wage rise will also impact how American businesses hire workers. A higher wage might make labor relatively more expensive than capital. Businesses would then substitute capital for labor where they can. Such substitutions may be harder in agriculture (machines have a harder time picking fruit without bruising them) than in say automobile manufacturing (already quite capital intensive). Nevertheless that kind of substitution would be incentivized by the rise in the price of labor relative to capital. Of course, these higher wage jobs would also require specific skills since employers will pay higher wages only to more productive workers. Thus workers with low or outdated skills may continue to be unemployed.

A President Trump has also promised higher infrastructure spending. So that will also spur the growth of construction and construction jobs. But here too higher wages (increase in the demand for labor) will also require higher productivity. In short these jobs will require specific skills since these jobs will be part of a capital intensive production process. Once again, folks with low or outdated skills may not see the benefit they hoped for.

In fact President elect Trump’s  desire to reduce the trade deficit could further complicate matters. Reducing the trade deficit through high tariff barriers would of course have long term negative effects on innovation and growth. But even in the short term a reduction in the trade deficit would imply a reduction in foreign investment into the US and foreign lending in the US’s capital account. Keep in mind the US’s national accounts have to balance so a reduction in the trade deficit will also result in a reduction in the capital account surplus. This process will be correlated with a stronger dollar and higher US interest rates. This also suggests less investment in the future, lower exports, and generally a higher cost of capital.

To conclude, as both wages and the cost of capital rise in a US protected from both foreign workers and foreign capital, US economic growth and power will diminish in the medium to long term. Of course, the reader will note that there are many moving parts to this scenario. It assumes for example that other countries will not react to US policy changes or that there will be no internal changes in the skill distribution in the US. Nevertheless, the analysis above is pretty straightforward and seems loaded against unskilled workers or workers with outdated skills.

 

The impact of Republican intransigence on passing the budget and raising the debt ceiling

4 Oct

It should come as no surprise that our country finds itself in yet another internecine squabble regarding questions about how much to, or maybe even if we should, fund governmental operations.  It is a source of national embarrassment that the United States hasn’t passed a full slate of Appropriation Bills since Fiscal Year (FY) 2008.  Looking back to FY 1977, there have been 17 funding gaps of at least one day or more (Congressional Research Service). The funding gap in Fiscal Year 1997 was, until now, the most highly publicized funding gap.  In FY 1997, the U.S. Government shut down from 15 December 1996 until 6 January 1997.  While our current shutdown commands the attention of the vast majority of the press, the effects of a shutdown are mostly temporary; they do not extend much past the lost productivity of government workers. There may be very real impacts in specific sectors of the economy. Closed national parks may affects tourism related businesses, closed Headstart facilities would affect the working poor, and closed licensing authorities may affect whether businesses get certain permits or not. However, this could be balanced against the economic activity created by people who substitute their vacation dollars away from national parks or by depending on friends and family for daycare. Moreover, the impact of the shutdown will begin to be felt – even in these sorts of affected sectors – only if the shutdown drags on. Thus, it is hard for us to get overly excited about another crisis of artificial proportions.

The bigger issue associated with yet another game of brinksmanship played by two kids who can’t play nicely on the playground, is the issue of a possible link between this fight and the yet-to-be-had fight over raising the debt ceiling.  Even without the current intervention by the Federal Reserve, the United States dollar enjoys reserve currency status, which allows the U.S. to borrow at very low interest rates.  Certainly artificially low interest rates hurts U.S. savers, but it is a boon for the U.S. in terms of lessening the burden of servicing the fast-growing U.S. debt.  Now, though, we are quickly approaching the date when all extraordinary financial measures will be exhausted and the U.S. will default on its legal obligations.  This date is widely believed to be 17 Oct (side note – just approaching the debt-ceiling deadline in 2011 caused the U.S. to suffer a downgrade to its heretofore sterling credit rating; an actual default will potentially have long-lasting implications, as it will most likely raise borrowing costs substantially and it will make asset valuation harder because treasury bonds will not be risk free anymore), but the first large, default-inducing payment comes on the 1st of November when benefit checks are due.  Currently there are no indications that countries are actually worried about a default; in fact, the yield on the 10-year U.S. Treasury bond closed unchanged on the first day of the shutdown, which suggests there isn’t any panic selling as of yet.  But let’s do some back-of-the-envelope calculations to get an idea of what may transpire.  As of 31 August 2013 (latest data available from Treasurydirect.gov), there is $16.7 trillion of total U.S. Treasury securities outstanding.  The average interest rate now is 2.4 percent; this equals about $400 billion a year in interest payments.  Assuming that a simultaneous credit rating downgrade and a limited default causes a one percentage point increase in the average interest rate from 2.4 percent to 3.4 percent (a rate last seen in August 2009), interest payments will increase by $170 billion a year.  To put this in perspective, last year’s Fiscal Cliff deal is projected to raise $617 billion in new revenue over 10 years; all of this new revenue will be subsumed by increased interest payments in less than four years.

A less obvious but more pernicious consequence is the uncertainty that results from nearly five continuous years of partisan gridlock.  Businesses and individuals cannot plan if they do not know whether a law will exist or not. This puts a damper on economic activity and job creation. Moreover, to the extent larger businesses have more resources to deal with uncertainty, partisan bickering serves as a tax on small job creating businesses.

— Commentary provided by me and Jeff Smith.

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