Samuel Cohn: Global Social Trends

Tax cuts are intrinsically dangerous. They are popular. The middle class wants them. Business wants them. Republicans like to enact tax cuts whenever they are in power. But they are nevertheless dangerous, especially for a world power.

Tax cuts reduce the funds available for military readiness. Tax cuts reduce the funds available for education. Tax cuts reduce the funds available for scientific research. Tax cuts reduce the funds available for infrastructure such as roads and airport. All of this reduces economic growth. A nation without a strong military cannot protect its interests overseas. Nations without education or research cannot be technological leaders. Nations with weak highways and infrastructure have lower rates of economic growth. Reducing a government’s ability to make needed public investments reduces GDP and slows job growth.

This would not be a problem if tax cuts produced jobs. The standard argument for why tax cuts increase GDP is that reducing taxes takes money away from wasteful government bureaucrats and puts it in the hands of businesses who invest. More investment equals more growth and more jobs. If the United States has higher taxes than other nations, businesses will invest overseas and the American economy will suffer.

This argument sounds appealing on the surface. However, on closer examination, it falls apart for five different reasons.

I. In a Globalized Economy, There is No Guarantee That Proceeds From Tax Cuts in the United States Will Not Be Invested Overseas

A tax cut in the United States can produce more jobs in China than in the U.S. All modern economies are globalized. Corporations have affiliates and subcontracting relationships all over the world. Rational businessmen will invest any windfalls in whatever nation offers the highest return – which is often not the United States.

George Bush instituted two major tax cuts, in 2001 and 2003. This should have induced a burst of investment in the United States. However, the Congressional Research Service found that American investment in foreign countries increased dramatically in the period after the tax cut. European firms sent LESS out of their countries than we did! The outflow of American investment dollars did NOT go to tax havens like Singapore. They generally went to Europe which generally has high tax rates. (Congressional Research Service 2012) So our tax cuts neither attracted foreign money to us nor kept our money in the United States.

II. In Both Microeconomic Theory and Real Life, Firms Do Not Always Lower Employment When Taxes Are High or Raise Employment When Taxes Are Low.

Economic theory generally does not support the argument that high taxes reduce employment. The literature on public finance maintains that taxation produces two contradictory effects on investment and employment, one an income effect and the other a substitution effect. The claim that taxation reduces investment involves a substitution effect, an implicit argument that lowered profitability induces capitalists to move capital to other investments or to prefer to hold cash.  However, however this is counteracted somewhat by the income effect. In the face of a tax, entrepreneurs who have a given goal of making a fixed amount of money increase their investment to compensate for their lost revenues. It is difficult a priori to specify which of the two types of effects are likely to predominate. Stiglitz suggests that without a theoretical specification of the relative magnitude of income and substitution dynamics, the effect of taxation on business activity becomes almost impossible to predict. (Musgrave 1959, Stiglitz 1988)

Actual studies of firms undergoing tax increases do not show that raising taxes lowers employment. Vroman (1967) found that American employers react to tax increases by raising prices rather than cutting jobs. In other cases, employers simply tolerate lower profit margins. In others, the increased cost pressure from taxes stimulates technological innovation and greater productivity. A study of textile firms in Morocco showed that a tax increase actually improved the long term survival of the industry. Firms had been in a comfort zone using stagnant outdated technology. The tax increase was a wake-up call inducing Moroccan companies to upgrade. The new machinery was acquired; the firms became more profitable and employment levels stayed high. (Currie and Harrison 1997)

III. Tax Breaks and Tax Evasion Reduce the Impact of Cutting Tax Rates

Almost nobody pays the full on-the-books tax rate on their income. Legally, both individuals and companies are entitled to deductions. People take a lot of these. The Huffington Post reports a number of major U.S. corporations that legally pay no corporate income tax whatsoever. (www.huffingtonpost.com) In poorer countries, companies solve the tax problem by simply not paying their taxes. Tax evasion is widespread in Southern Europe, Latin America, Sub-Saharan Africa and much of Asia. (Bird 1992). If, whether legally or illegally, companies are avoiding taxes, cutting the rates won’t have much of an effect on corporate profits.

IV. Most Business Failures Are Caused By Something Other Than Taxation

High taxes do not drive firms out of business. There is a literature studying the cause of corporate bankruptcies and firm closings. The methodology is simple: when a firm closes, you ask the owner what caused the firm to die. The two most common cause of corporate death are insufficient sales, and inability to get credit. Taxes are mentioned as being a problem in very few cases. (Ames 1983)

V. Taxes Are Not the Biggest Determinants of Corporate Success

Taxes are actually a fairly minor component of total costs. The two biggest expenses that companies face are raw materials and labor. It is far more important to obtain cuts in the prices paid to vendors or the salaries paid to workers than it is to reduce taxes. When companies move to China, they do not do so to get breaks on taxes. They are trying to obtain cheap Chinese labor.

Sometimes, what matters is not how much you pay, but whether you get the critical inputs you need. California is a high tax state. But if a software company wants the best programming talent, it had better locate in Silicon Valley. A theatre company can pay fewer taxes if it locates in Birmingham, Alabama and not New York City. But if the company wants a big Broadway hit, New York is where it has to be. Raising taxes is not going to drive software companies out of California or theatre companies out of New York. Paying fewer taxes will be less important than creating a must-have program or creating a blockbuster show.

What Does the Statistical Data Say?

Do statistical analyses support or refute the claim that tax cuts create jobs? Frankly, the statistical literature is a mess. About one third of the studies show tax cuts creating jobs. About one third of the studies show tax cuts having no effect or actually destroying jobs. The remaining third has indeterminate findings. Even more frustrating, many of the conflicting analyses involving rival economists analyzing the same datasets and reaching opposite conclusions due to subtle differences in their methodology. (Wayslenko 1997) The Wayslenko citation may be over twenty years old, but nothing has changed recently. Virtually every study that comes out of the Tax Foundation, a conservative think tank, shows tax cuts create jobs. Virtually every study that comes out of the Center for Budget and Policy Priorities, a liberal think tank, shows tax cuts have no effect.

This kind of chaos is generally associated with a variable having no real effect. When a relationship is strong, it shows up robustly in study after study. The number of negative studies is small. Changing the methodology has little effect on the findings. If tax cuts had a strong effect in creating jobs, it would show up in most of the studies rather than a minority of them. The effect would not disappear when methodologies change. The inconsistencies in statistical results suggest that if tax cuts had any effect at all on creating jobs, that effect at best would be very weak.

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So why don’t tax cuts produce job growth? Because some of the proceeds from the cut are invested overseas, some employers choose to respond to the tax savings by spending on other things than expanding the workforce, the effect of the tax cuts are diminished by the presence of deductions and tax avoidance, and the tax savings don’t affect any of the really important components of corporate success such as raw material prices, wage rates and having a quality product.

But if the effects of tax cuts on employment are negligible, the effects of revenue loss on government effectiveness is considerable. The price of tax cuts is a weaker defense, weaker schools, weaker technology and infrastructure that does not work. Those factors have a huge effect on economic growth. Cutting fundamental causes of economic growth to pay tax cuts in the short term is an utterly economically dangerous policy.