Yes, a Corporate Tax Cut Would Increase Investment

A common criticism of the current Republican tax plans is that they will not boost private investment. While I have major reservations about these plans as a whole, this particular objection is oversold. The most likely result is that lower corporate tax rates will lead to more investment projects and thus more aggregate economic activity.

The evidence on investment behavior is fairly clear. When companies have more “free cash” at hand, they tend to invest more, and this effect is distinct from any effect of the tax cut on expected rates of return. So, in other words, when critics call the corporate rate cut a “giveaway” to business, that is precisely the mechanism that tends to boost investment.

Furthermore, while these investment boosts are strongest for companies that are cash constrained, they also seem to occur for the companies that have a lot of cash on hand, as is often the case with today’s profitable corporations. Admittedly, these results may be puzzling in terms of pure theory, but they have held up in studies. So for all the talk about the Republicans not being an “evidence-based” party, in this particular debate they seem to have the science on their side.

A related worry is that companies will take their cash windfalls and simply return them to investors in the form of dividends and cash buybacks. First, the evidence doesn’t support this fear. When all variables are measured properly, it seems major companies are paying out to shareholders about 22 percent of their net income. It’s therefore unlikely that new profit, as might follow from lower corporate tax rates, will simply be drained out of the corporation.

More generally, sending money back to investors doesn’t have to mean no new investment. What if those investors take the money and put it in a venture capital fund or invest it in some other manner? The whole point of capital markets is to recycle resources into the most profitable new opportunities, and that may or may not involve the companies that initially earned those profits. In some cases, investors might feel that not all of the past winners are going to be the future winners.

Recently Gary Cohn, President Donald Trump’s chief economic adviser, spoke to a group of CEOs and asked how many of them would increase investment if the corporate tax cut goes through. The resulting show of hands was underwhelming, and many critics have seized on this episode as a “gotcha” against the tax plans. But that is the wrong conclusion to draw.

The first and most general rejoinder is simply that asking business people is not our best or most reliable source of information about policies. For instance, business people often believe, and will testify accordingly, that increases in the minimum wage will boost unemployment significantly. There is an extensive debate in the economics profession about this question, but the testimony of business people is hardly taken to be decisive, even though they are the ones doing the hiring.

Many economic effects operate without all of the participants knowing exactly what is driving the final result. For instance, more cash in corporate coffers could induce managers to develop more good project ideas for the CEO. The CEO might feel he or she is responding to the higher quality of project ideas, rather than to the corporate rate cut per se.

More importantly, let’s take the extreme scenario where companies simply take all of the proceeds from the tax rate cut and put them in the bank, never increasing their own investments as a result. Well, the banks now have more funds to lend out, and so investment still is likely to go up, even if this happens somewhere far and wide from the original corporation earning the new profits.

Or you might think the banks won’t lend the extra funds, but will instead deal with some other financial intermediary. The flows can be confusing, but try to see behind the veil of cash and finance. If those funds are not taken out of the financial system and used to fund consumption, the real quantity of investment in the economy should rise.

Another scenario is that the new corporate profits are placed in Treasury securities. Even then, that would lower borrowing rates for the U.S. government, freeing up money for government programs or at least limiting the degree of painful austerity that eventually will be required.

Just to be clear, I think the currently circulating versions of the tax plan are unwise. They increase the deficit too much, don’t have the right kind of distributional consequences to prove stable, and they might eliminate the Obamacare mandate without a planned stabilizing replacement. Those and other more technical reasons are enough to bring at least parts of these proposed laws back to the drawing board.

But when the critics allege that corporate tax rate cuts won’t boost investment, that’s going against basic economics.

Source;-.bloomberg