The series of documents published by the White House Council of Economic Advisers indicate that President Donald Trump’s Tax Reform will end up being his economic growth policy. The most persuasive pitch behind the corporate tax cut is that lowering taxes to corporations will foster economic investment thereby economic growth. Further, the political rhetoric refers to GDP growth estimates of a tax-cut-boosted 3 to 5 percent growth in the long run. In supporting the corporate tax cut, the White House Council of Economic Advisers presented both a theoretical framework and some empirical evidence of the effects of tax cuts on economic growth. Even though the evidence presented by the CEA is sound and right, after reading the document, any analyst would promptly notice that the story is incomplete and biased. In this blog post, I will briefly point to the incompleteness of White House CEA’s tax cut policy justification. Then, I will show that the alleged “substantial” empirical evidence meant to support the corporate tax-cut policy is insufficient as well as flawed. In third place, I will make some remarks on the relevance of the tax-cut as a fiscal policy tool in balance to the current limitation of monetary policy. Finally, I conclude that despite the short-term benefits of the corporate tax cut, such benefits are temporal as the new normal rate settles, and at the end of the day, given that tax policy cannot be optimized, setting expectations from the administration is a policy waste of time.
The very first policy instance that CEA stresses in its document is the fact that corporate tax cut does affect economic growth. Following CEA’s rationale of current economic conditions, the main obstacle to GDP growth rates above 2 percent is low rates of private fixed investment. CEA infers implicitly that the user cost of capital far exceeds profit rates. In other words, profit rates do not add up enough to cover for depreciation and wear off capital investments. Thus, if private investment depends on expected profit as well as depreciation, simply put I_t=I(π_t/(r_t+ δ)) where the numerator is profit, and the denominator is the user cost of capital (Real Interest rate plus depreciation), the quickest strategy to alter the equation is by increasing profit through lowering on fixed cost such as taxes. CEA’s rationale assumes correctly that no one can control depreciation of capital goods, and wrongly thinks that no one (including the Federal Reserve which faces serious limitations) can control real interest rate, currently.
CEA fetched some data from the Bureau of Economic Analysis to demonstrate that private sector Investment is showing concerning signals of exhaustion. The Council sees a “substantial” weakness in equipment and structures investments. More precisely, CEA remarks that both equipment and structure investment have declined since 2014. Indeed, both variables show a decline in levels of 2 and 4 percent respectively. However, and although CEA considers such decline worrisome, those decreases seem not extraordinary for the variables to develop truly policy concerns. In fairness, those variables have shown sharper decreases in the past. The adjective “substantial,” which justifies the corporate tax cut proposal, is fundamentally flawed.
The problem with the proposal is that “substantial” does not imply “significant” statistically speaking. In fact, when put in econometric perspective, one of those two declines does not appear to be statistically different from the mean. In other words, the two declines look perfectly as a natural variation within the normal business cycle. A simple one sample t-test will show the incorrectness of the “substantial” reading of the data. A negative .023 change (p=.062), in Private fixed investment in equipment (Non-Residential) from 2015 to 2016, is just on the verge of normal business (M=.027, SD=.097), when alpha level is set to .05. On the other hand, a negative .043 change (p=.013) in Private fixed investment for nonresidential structures stands out of the average change (M=.043, SD= .12), but still, it is too early to claim there is a substantial deacceleration of investments.
Thus, if the empirical data on investment do not support a change in tax policy, then the CEA tries to maneuver growth by policy expectations. Their statements and publications unveil the desire to influence agents’ economic behavior by reckoning with the “after-tax” condition of expected profit calculations. Naturally, the economic benefits of corporate tax cuts will run only in the short term as the new rate becomes the new normal. Therefore, the benefit of nominally increasing profits will just boost profit expectations in the short term while increasing the deficit in the long run. Ultimately, the problem of using tax reform as growth policy is that tax rates cannot be controlled for optimization. Unlike interest rate, for numerous reasons, governments do not utilize tax policy as a tool for influencing either markets or economic agents.