Company tax cuts won’t work in the US, and they won’t work here
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So, the Republican majority in the US Congress have passed a massively regressive package of tax cuts, with a cut in the rate of company tax as its central feature. Unsurprisingly, this news has produced a revival of the Turnbull government’s proposal to offer similar cuts here.
The primary claim put forward in support of company tax cuts is that they will lead to an increase in investment, or at least prevent the loss of foreign investors to the lower-tax regime being proposed by Trump and the US Republicans. According to Treasurer Scott Morrison, quoting research from the Commonwealth Treasury, if we fail to follow the US lead we will be a less competitive destination for foreign investment.
The obvious question is whether higher foreign investment will benefit Australia or simply generate additional profits for the overseas investors. Unfortunately, the research findings quoted by Mr Morrison tell us nothing about this question. The headline result is that lower company tax will lead to higher gross domestic product, but GDP is irrelevant in this context.
That’s because GDP takes no account of the flow of earnings to foreigners (that’s where the D for Domestic comes from) or from the additional depreciation needed to service a larger capital stock (that gives us the G for Gross). And of course what matters in the end is not output (P for Product) but income and consumption. To sum up, there are only three things wrong with GDP as a measure of economic welfare: it’s Gross, it’s Domestic, and it’s a Product. As far as the national accounts are concerned, the relevant measure is net national income, the income that is actually received by Australian households.
There’s nothing new about this point. I made it in response to the Henry Review of the Tax system, back in 2010. More recently, the same observation has been made by former Reserve Bank Deputy Governor Stephen Grenville and, in the context of the Republican Party’s proposed tax cuts, by leading US economist Paul Krugman. Such repetition of long-refuted errors is characteristic of the zombie phase of neoliberalism which began with the global financial crisis.
Yet the main Treasury analysis of cuts in company tax rates focuses mainly on GDP. The headline result is that company tax cuts, funded by a hypothetical “lump sum” tax would raise GDP by 1.2%, or more than $20 billion a year. Careful reading however, shows that the vast majority of this increase would be lost, either as profits flowing overseas or as costs incurred in maintaining a larger capital stock. Moreover, the notion of a “lump sum” tax is nonsense, used by modellers when they want to avoid specifying how a tax cut will be paid for, but non-existent in practice.
Buried in the report we find a more relevant model run, that of a company tax cut financed by an increase in personal taxes and a more relevant measure of benefits, the percentage increase in household welfare. This is estimated at a mere 0.1%, a couple of dollars a week for a household on $100,000 a year.
All of this is based on a model of long-run outcomes in a smoothly functioning economy, where capital investments adjust in response to the company tax cuts, leading to increases in labour productivity, which in turn flow through to households in the form of higher wages. There are an awful lot of steps in that process, leading to the question: how long is the long-run?
The Treasury modellers don’t even attempt to answer this question, but the redoubtable Paul Krugman has tackled the first one, for the case of a typical developed economy (he’s talking about the US, but his parameters work for Australia). Krugman estimates that the rate of of convergence of the capital stock at around 6% a year. That means that about half the adjustment will be completed 12 years after the tax cut is introduced, and around 75% after 25 years. Given the minimal expected increase in Net National Income, it’s only after this point that we could anticipate any net gain for Australia.
The second part of the process raises even bigger problems. For most of the 20th century, increased labour productivity generated higher wages exactly as the Treasury assumes. But the experience of the 21st century has been markedly different. Productivity has risen but wages have not.
In the unlikely event that everything works the way the Treasury modellers expect, the mythical average Australian will be better off by an undetectable 0.1% in 25 years or so. Meanwhile, the corporate beneficiaries of the tax cut will be massively better from day one, before they invest a dollar more or hire a single additional worker. It’s not hard to see who the government is working for, here or in the United States.