Hassett on Tax Cuts and Growth, by David Henderson

October 16, 2017

On October 5, Kevin Hassett, the new chairman of President Obama’s Council of Economic Advisers, gave an excellent talk at the Tax Policy Center. The topic was taxes and economic growth. The transcript of the talk is here. The video is here.

In the talk, Kevin gave some estimates of the effects of cuts in marginal personal and corporate income tax rates on growth. Drawing on the literature, he came up with substantial estimates of both.

A few excerpts follow.

First, his own background on this issue:

Perhaps the reason I hold these beliefs is that I started graduate school back in 1984, and was taking Alan Auerbach’s public finance class when the 1986 Tax Act was enacted. At the time, I began working on how the 1986 reforms would affect business capital spending. The literature surprisingly found little effects of tax policy on the economy, often suggesting that tax and interest rate variables did not drive capital spending. But Alan and I noticed something funny in the data. Politicians tended to pass Investment Tax Credits in recessions, then let them expire when the recession was over. Thus it appeared that the economy partly drove tax policy, even if to [sic] tax policy also affects the economy. However, because recessions induced tax-cuts, any analysis of how tax cuts affected the economy would need to separate this out to not wrongly conclude that tax cuts caused recessions. When Alan and I discovered a way to overcome this problem, we found very large effects of tax policy on investment behavior. Since then, there has been a veritable scientific revolution of papers that use different methods to identify tax effects, and like our first study, they have found again, and again and again, that tax policy is a major driver of economic growth, if one does the science correctly.

His summary of the literature:

I don’t have time to go into the scientific methodology in great detail, but have done so in more detail in a number of recent review articles. But for thinking about the broad-brush growth impact of the President’s proposals, a number of recent papers published in top journals provide a guide to the possible scale of the growth effects. Romer and Romer (2010), utilize narrative history to separate out tax changes with motivations unlikely to be driven by the business cycle; they estimate that a 1 percentage point reduction in the total tax share of GDP increases GDP by 1 percent on impact, and by between 2.5 and 3 percent over three years. Cloyne (2013) and Hayo and Uhl (2014) apply the same approach using data from the United Kingdom and Germany, and obtain almost identical estimates. Other authors, such as Mertens and Ravn (2013), have extended this work with more sophisticated methods and find that a 1 percentage point reduction in the average personal income tax rate raises real GDP per capita by 1.4 percent in the first quarter, and by up to 1.8 percent after one year. They further find that a 1 percentage point cut in the average corporate income tax rate raises real GDP per capita by 0.4 percent in the first quarter, and by 0.6 percent after a full year. Using a similar approach, Mertens and Olea (2017) find that in the first two years following a tax decrease of 1 percent, GDP is expected to be higher by about 1 percentage point.

Applying the estimates from the literature to Trump’s proposed cuts:

Applying these estimates to the proposed reduction in the statutory corporate income tax rate from 35 to 20 percent and the simultaneous introduction of full expensing requires calculating the effect these changes would have on federal tax liabilities, which will depend on the bill’s final details. But just to illustrate the scale of these effects, a rough preliminary estimate of the combined revenue effect of the corporate tax proposal, combined with these macro elasticity estimates, implies that tax cuts of this scale would lift GDP per capita by approximately 4 percent over the first year. Although there are a number of reasons to expect that the actual impact of the reform would be much smaller than that, including the fact that we are currently near full employment, the potential for a significant growth effect is still very reasonable and empirically valid. (emphasis mine)

The effect of the current high corporate tax rates in the United States on transfer pricing and, therefore, on the current account deficit:

The authors correct for this mismeasurement by “reweighting” the amount of consolidated firm profit that should be attributed to the U.S. under a method of formulary apportionment. Under this method, the total worldwide earnings of a multinational firm are attributed to locations based upon apportionment factors that aim to capture the true location of economic activity. The authors use equally weighted labor compensation and sales to unaffiliated parties as proxies for economic activity. Applying the formulary adjustment to all U.S. multinational firms and aggregating to the national level, the authors calculate that in 2012, about $280 billion would be reattributed to the U.S. Given that the trade deficit was equal to about $540 billion, this reattribution would have reduced the trade deficit by over half in 2012.

Extrapolating the 2012 findings to subsequent years shows that transfer pricing continues to account for at least half of the trade deficit over 2013-2016. Here is where it gets interesting. There is also a literature that looks at the relationship between tax rates and transfer pricing. That literature implies that a corporate tax cut to 20 percent would dramatically reduce the trade deficit and increase GDP accordingly. Note that this effect happens totally within the current account (for those into NIPA accounting), and thus should be thought of as a change that would be part of a static score. The growth effects mentioned in previous paragraphs would be additive to this.

The amazingly high estimate of the effect of the proposed tax cuts on workers’ real income:

Based on the scientific evidence, to me at least, it therefore seems prudent to adopt these reforms. Over the course of the Obama administration, U.S. corporate profits rose by a healthy 11 percent per year. But workers’ pay didn’t keep pace, and median wage growth was a paltry 0.6 percent per year. This disconnect between profits and wages is a radical departure from previous economic norms. Workers used to get a 1.1 percent raise for a 1 percent increase in corporate profits. Now the pass-through to workers is closer to 0.4 percent. Why did it change so much? Because the profits are offshore, benefiting other nations’ workers. In 2016, U.S. firms kept 71 percent of foreign-earned profits abroad. What would happen if they didn’t do that? A simple back-of-the envelope calculation suggests U.S. workers in 2016 would have received a raise of nearly 1 percent. What if these firms didn’t do that for the next 8 years? The median U.S. household would get a $4,000 real income raise.

Or, look at it another way, we know from several studies that high corporate tax rates serve to depress the wages of workers over the long-run, through a combination of disincentives to bring profits home to invest, and a reduced impetus for domestic investment in general. Those effects are felt across the income distribution, resulting in lower wages for higher- and lower-skilled workers alike. For the median household in the U.S., a top corporate marginal rate cut from 35 to 20 percent would boost wage growth almost four-fold — from the current 0.6 percent per year to as much as 2 percent, providing up to $7000 of additional income. It’s time for a bipartisan consensus to use tax policy to fix wage growth.

Kevin’s theoretical argument is strong–lower tax rates on accumulation of capital lead to more capital, and more capital per worker leads to higher marginal product of labor, which implies higher real wages. I was a little surprised by how high the magnitudes were, but he did draw on the literature to come up with his estimates.

In the discussion afterward, Scott Hodge, the head of the Tax Foundation, asked Kevin whether he didn’t think the tax cuts were too tilted toward high-income people.That question might have made sense before Kevin’s talk, but it didn’t make sense after. Kevin’s point, which he said a number of times in various ways in the talk, is that changes in tax rates have real effects and not just on the amount of tax people pay. Possibly Hodge was just giving Kevin a slow pitch so that Kevin could emphasize the point of his talk.

HT2 Greg Mankiw.

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