The Impact of Tax Cuts on The Economy

There is a lot of bad information circulating out there on the effect of tax cuts on the economy. Today I’m going to explore the knock-on effects of a corporate or income tax cut.

General Impacts of Tax Cuts

Something to keep in mind, nothing in this post is meant to evaluate specific tax cut bill being deliberated (or potentially  by the time this posts, passed). To be honest the rules will likely change ten times before they pass, which means I will write a post on that only when things are fully signed. No, this post is about the general impacts of a tax cut and whether we should be doing one now.

There are different areas of tax cuts. I’m going to try to split this post into the different types and aspects while giving you a flavor for their potential impacts. The key area I’ll try to explore is whether tax cuts will create jobs. Hint before we start, the answer is not black and white.  We’ll start with Corporate tax cuts.

Corporate Tax Cuts

I recently read a bunch of articles on this subject that honestly are utter nonsense. The question that always comes up is will corporate taxes increase employment. The answer here is not as clear cut as you would think, and heavily depends on the current financial situation of the country.

Impact of Corporate Tax Cut on Corporate Profit

Imagine for a minute we cut corporate income taxes by 10%. The impact here is an increase in corporate profit after taxes of 10%. But what does that mean? No, it doesn’t mean that most employers will go hire employees equal to an extra 10% profit. However, that has nothing to do with whether it results in hiring.

What do Corporations do With Profits?

Corporations have 3 choices for what to do with their profit. Each one has different economic impacts:

1. Reinvest the money in the business via R&D, operations, etc. These are the expenditures most likely to result in an increase in hiring at a specific company. More R&D means increased consumption paid to other businesses that must hire someone to produce the raw capital materials. Additional R&D means potentially future products with the associated increase in staff to support those products. Increasing operations simply mean more facilities or people to produce more cheaply. Both directly tie to hiring more employees in the economy though perhaps after some lag period.
2. Return the money to shareholders either via share buybacks or dividends. Both provide money to shareholders. One gives it to the shareholders it purchases stock from, the other spreads it around all holders. But in either case someone outside the company gets the money. What they do with that money defines whether it leads to hiring. I will explore this further under personal income tax cuts.
3. The final option is for the company to leave the money in the bank as cash reserves. This can also result in hiring. The bank will take a portion of that money and loan it out to other people. That lending will at least in theory lead to more investment or consumption elsewhere in the economy. How much is the question? We’ll explore this question more under personal income tax cuts as well.

Corporate Tax Cut Fairness

There is a lot of talk in our current tax environment in the context of corporate tax cuts and fairness. The thing that needs to be remembered, as stated before, is a corporation is just a pass-through entity for shareholders. As such any profit for a corporation that is not reinvested, held, or used to buy back shares gets taxed twice. Once for the corporation directly and once for the shareholders capital gains. I won’t comment on what level of corporate tax is fair. However, I will point out that you need to combine the two rates to get an accurate picture of the tax rate on corporation owners, i.e. shareholders.

Personal Income Tax Cuts

Personal income tax cuts have similar impacts to corporate tax cuts with respects to shareholder cash return or bank reserves. Any money that goes to an individual can be used for one of three things:

1. Invest: The person invests in another company or in something like starting a business. In many cases this starts the cycle again until someone consumes the money. In some though the investment leads to new jobs and new consumption. This would be the case with new corporate issuances, self-employment investments, or other areas besides existing share purchases. In theory this would also represent a net job growth.
2. Consume: They spend the money. Consumption is good, the more we consume the more people must work to produce things. The more production needed the more jobs.
3. Save: As discussed previously the bank takes a portion of the money and lends it out to other people. The lending leads to consumption by other individuals, investment by individuals, investment by companies, or any number of other things.

Tax Cuts are Not that Black and White

The concept above is known as Fiscal Stimulus, and all economists agree at least on the surface that tax cuts stimulate the economy. So far it sounds like I am telling you that tax cuts will lead to an increase in consumption and jobs. That’s because they will initially. But how much is a major question, and will it be sustainable. It’s not all together clear that the job growth will be representative of what was spent. Also, other areas may be impacted. You see, more money in the economy in terms of lower taxes does increase spending/investment. But there comes a point where there is too much money in the economy. At this point all the good reasons to get a loan are already fulfilled. At that point there is an excess of funds in the economy which ultimately causes two things: Inflation and malinvestment.

• Inflation: A glut of funds can increase inflation due to supply and demand. An oversupply of cash devalues currency, making it less valuable. Why, because cash is merely a store of value. Production is really the value in an economy, and increasing the currency over the long run, if it does not increase production, will simply increase the cash proportionate to the same level of production. If this occurs job growth will also likely decline over the long run as goods in the economy increase in price and consumption declines in response.
• Malinvestment:  A glut of investable funds will ultimately result in an increase in poor investment due to the abundance of funds. This wasted investment will ultimately not lead to a net benefit to society. It also may eventually lead to lessening consumer confidence and a down turn that would eventually wipe out any initial employment increases.

So Which is it? MalInvestment/Inflation or Job Growth?

This is a harder question to answer as it depends on the current state of the economy and how it will respond to an increase in finances. The CBO has stated the bill will result in a loss of revenue for the government and nowhere near the amount of job growth the administration references.  The CBO, honestly, is still subject to the biases of the people who make up the organization. So at least on the face of it this is not the end all word. Also at least statistically no one has enough information of our economy, given how complex it is, to truly predict the full impact of such tax cuts. As such no one can truly tell you for sure…

What is my Opinion?

But.. I will still give you my opinion since you’ve read this far. It’s my opinion and I have no crystal ball so I don’t make any guarantees. In general, there is a concept in economics called the Phillips Curve. This theory states that inflation and unemployment are related. As inflation increases unemployment decreases and vice versa. Early versions of this theory postulated you could inflate yourself to full employment. However later it was determined that this only held in the short run. In the long run inflation did not help with unemployment, but was an independent variable.

Within this modern interpretation of the Philips Curve there is a point considered the natural state of employment in the economy. This is the point of employment expected in a stable economy, beyond this point additional inflation is expected as well as an unstable equilibrium in employment with a tendency to return to the natural state. Historically that point has been much open to debate.  I tend to agree with most economists that this point sits somewhere between 4-5%. We are already in the ballpark of this percent. As such at least on the face of it there is nothing indicating our current economy would benefit from a stimulus either monetary or fiscal now. A stimulus would briefly increase employment before the economy snapped back to stable, leaving us only with inflation. The current level would seem to indicate more stimulus would cause malivestment or inflation. As such I am lead to the conclusion that this is not the best time for a tax cut for the economy.

What is your opinion on Tax Cuts and the Economy?