Why tax cuts don't always boost GDP
Lessons from US economy
At a recent event in Dhaka, Dr Mirza Azizul Islam, the former finance adviser to caretaker government, identified a key dilemma that policymakers often face. He voiced his frustration at the lack of credible research on the impact of tax holidays in Bangladesh. Needless to say, important policy decisions, both in developing and advanced countries, have to be grounded on good data and measured analysis. Unfortunately, in a developed country on the other side of the globe, we can now see that a massive policy overhaul is in progress without much "evidence-based analysis," to quote Dr Islam.
The debate in the USA surrounding President Donald Trump's proposed tax plan, which will cut down corporate tax from the current maximum rate of 35 percent to 20 percent when it is fully implemented, hinges on whether or not the changes in the tax code will increase economic growth and create more jobs. On the one side are Jeffrey Sachs of Columbia and Larry Summers of Harvard, who have expressed serious doubts about its effectiveness. Aligned against them on the opposite side are Martin Feldstein of Harvard and Larry Kotlikoff of Boston University. These two camps are at loggerheads over a very basic and fundamental question: will the reduction in corporate tax provide an incentive to business owners to boost investment and accelerate GDP growth, create jobs, and increase wages? This is not the first time that economists have disagreed over fiscal or monetary policy matters. However, the current debate is unique in that both sides agree on most issues, but the divergence centres around when and how. When will the reduction in tax rates boost investment and job growth, and what is the mechanism for this to happen?
The practice of providing tax incentives to lure new businesses to invest in a country or in a certain industry is an age-old trick. Who gains and who loses if only the rich get tax breaks is another matter. Those in favour of lower taxes for businesses often argue that what's good for business is good for the economy since "a rising tide lifts all boats," as some would like everyone to believe. However, evidence on the efficacy of tax breaks to spur investment is mixed. The last major tax cut in the USA happened in the late 1980s when President Reagan signed the Tax Reform Act (TRA) of 1986 with bipartisan support. Reagan was a big champion of a hypothesis first proposed by an economist named Arthur Laffer to justify lower taxes. Laffer is considered by some as the guru of supply-side economics, and the eponymous Laffer Curve that bears his name shows that if a government taxes the corporations at a high rate, the actual tax revenue goes down since employment goes down along with it and tax evasion becomes prevalent. And vice versa, i.e. if you lower the corporate tax rate, even though there might be a short run drop in tax collections, lower tax rate motivates businesses to invest more, thus raising employment, income, and eventually government revenue.
Ironically, in 1991, while he was testifying before the US Congress, Donald Trump the real-estate businessman strongly condemned Reagan's tax reforms as a disaster, and fumed that "this tax act was just an absolute catastrophe for the country." However, while his recent about-face only shows that President Trump has changed his mind, economists have a much clearer assessment of the results of TRA. According to estimates made by the World Bank, after the implementation of TRA, while GDP growth witnessed a short spike in 1988, US economy was soon hit by a recession during 1990-1991 leading to the defeat of Republican incumbent George Bush. According to the study, "the recession was blamed in part to the 1986 tax reforms, which busted the real estate boom, resulting in sinking property prices, lower investment incentives and job losses."
What is the moral of the above story? A tax cut might give the economy a shot in the arm but only under certain unique circumstances! Would it work under present conditions? Let us look at the more recent past for some clues. Evidence from the George W Bush-era tax cuts and the 2008 financial incentives reveals that businesses don't always expend the additional revenue from a tax cut on creating jobs. Instead, they save it, send it out to stockholders as dividends, repurchase their stocks, or invest overseas. Once again, Arthur Laffer's predictions did not quite pan out.
President Trump's tax plan includes, besides the reduction in corporate tax, a reduction in taxes across the board, especially for working and middle-income Americans. Now, here is the catch. Trump has also railed repeatedly against the growing national debt levels, and it needs to be seen if his tax plans, infrastructure building, and other expenditure measures can all be accomplished without a sky-rocketing national debt level! Federal Reserve chief Janet Yellen had already warned Congress earlier that Trump's plan would stoke inflation and create massive debt problems.
Some of the uncertainties surrounding the current tax plan boil down to a few unknowns:
1. What will be its impact on budget deficit and how might that affect the financial market and cost of borrowing?
2. Would it dissipate the "lock-out effect," i.e. the practice of US companies to stash their profits overseas in tax haven to avoid US tax?
3. Will the additional revenue on their bottom line force the US companies to change their behaviour and coax them to invest more rather than save it?
4. Are US companies investing less because investment is not profitable and/or are they starved of adequate resources/profits to reinvest?
To answer these questions, powerful and complicated models have cropped up in every university and government departments to project how key variables such as tax revenues, the federal deficit, and other key macroeconomic variables would track over the next ten years. At this juncture, the most elusive model is one that would predict the most desirable outcome, i.e. "the tax cut will pay for itself." Republicans and advocates for Trump tax cut use a model known as "dynamic scoring models" popularised by Alan Auerbach of Berkeley to show that tax cuts generate more revenue and growth, by extending the time horizon in the calculations. They also argue that the USD 1.5 trillion tax cut over the next 10 years will not increase the national debt.
Another unknown is the behaviour of Fortune 500 companies such as Apple, Microsoft, Cisco, Oracle, and Google which have USD 2.6 trillion stashed away overseas. There are sceptics who doubt that Apple or Microsoft will repatriate these profits to reinvest in the USA. Two economists have estimated that corporations might lose 7 percent of their profits if they keep it hidden in Bahamas or the Cayman Islands, out of reach of the Internal Revenue Service, but that is still less than the 20 percent they would pay if the tax reforms go through, and might not eliminate the lock-out effect altogether. When President George W Bush offered a tax holiday for funds that were repatriated from overseas, firms reported an estimated USD 300 billion of additional profits in 2005. However, investment did not increase and the profits were used for other purposes, mostly for dividends and share buybacks. According to economist Josh Bivens of Economic Policy Institute (EPI), there is no evidence that rising corporate profits beget growth in real wages. And most interestingly, two economists of the prestigious National Bureau of Economic Research (NBER) have argued that there is increased monopolisation in the US, resulting in a drop in investment. The two researches, Germán Gutiérrez and Thomas Philippon of NYU, argue that big monopolies do not have any incentive to invest if they do not face any competition in the marketplace!
Dr Abdullah Shibli is an economist and Senior Research Fellow at the International Sustainable Development Institute (ISDI), a think-tank based in Boston, USA.