Commentary from Project Syndicate
PHILADELPHIA – We are living in worrisome economic times. One year ago, I observed that US President Donald Trump’s bullying of companies and individuals who get in his way is reminiscent of Benito Mussolini in the 1920s. Like Mussolini, Trump poses a clear danger to the rule of law.
My subject here, however, is the tax legislation that Trump signed into law in December, on the promise that reducing the rate at which corporate profits are taxed will help an ailing US economy.
POLITICAL RESPONSES TO THE MALAISE
For several decades, the US economy has exhibited various symptoms of economic malaise. Now, we have a political upheaval on our hands. While real (inflation-adjusted) median wages have been nearly stagnant for decades, private saving from profits and enormous capital gains have continued apace. As asset prices – to say nothing of the wealth-wage ratio – have climbed to vertiginous levels, established wealth has grown more powerful, and wealth managers have done well.
Worse still, in industries hit hard by foreign trade or automation, many jobs have been eliminated, and real wages have actually declined. As these new developments continued over the past few decades, they placed increasing pressure on society as a whole. Ultimately, there was an electoral realignment, marked by a shift in voting patterns among key economic constituencies.
Remarkably, neither Democrats nor Republicans seemed to register these economic and social ailments, or the consequences they could have. When Hillary Clinton launched her 2016 presidential campaign with a speech on Roosevelt Island, she focused heavily on achieving social justice for marginalized groups. She did not address the fact that, some six decades ago, the US economy lost the sustained growth it had been generating since the 1820s, despite depressions and inflationary cycles.
While Democrats became increasingly fixated on notions of “fairness” and what academics call the “just economy,” they apparently didn’t notice that the country had been operating for decades without a good economy. Countless people have had little or no chance of feeling fully included in economic life. They have been deprived of jobs that are actually engaging, and of opportunities to feel that they have succeeded at something.
As the renowned Columbia University philosopher David Sidorsky recently pointed out to me, ancient philosophers spoke of “the good and the just” (boni et aequi), not “the just and the good.” Clearly, the Democrats put the cart before the horse. First, we need a good economy. Only then can we devise a just way to reward participants for contributions that the economy empowers them to make.
AN ATTEMPT AT A CURE
After securing the presidency – in addition to both houses of Congress – in 2016, Republicans have tried to run the ball through the opening left by the Democrats. Throughout 2017, they pursued a range of reforms to address weak investment and stagnant wages, and ended the year with the newly enacted tax legislation, which cuts the tax rate on corporate profits from 35% to 21%.
Economists who support the Republicans’ tax legislation have relied on a textbook growth model to claim that it will boost investment activity. According to their model, investment will drive up the capital stock until it reaches the steady-state level where the after-tax rate of return falls to the level of the real interest rate. The real interest rate is exogenous, and reflects investors’ time preferences, world interest rates, and other factors. The point where the rate of return intersects with the real interest rate is shown in Figure 1. (A more classical case, in which the rate of return is pulled down by capital accumulation, is shown in Figure 2.)
Supporters of the tax legislation reason that if the tax cut pushes up the after-tax rate of return, investment activity will increase, and the capital stock will expand, boosting productivity until the capital stock reaches a new steady state, which they calculate will happen in around ten years.
But, as is always the case with supply-side economics and more radical forms of Keynesianism, this approach is profoundly short-sighted. After ten years, there is no reason to think the faster growth will continue.
Without the same level of indigenous innovation that was achieved during the golden era of high growth rates, from the 1820s to around 1970, the Republican tax law will amount to nothing more than a stop-gap measure. And even over the next decade, it will not deliver truly rapid growth.
THE PROBLEM WITH MODELS
More fundamentally, we ought to ask whether it is right to expect tax cuts to translate into higher productivity growth. I would argue that, because the tax package will add to the annual fiscal deficit and the public debt, it might actually block investment, and thus derail a productivity pickup.
When I was a young economist working on my 1965 monograph, Fiscal Neutrality Toward Economic Growth, I would have looked at today’s favorable short-term conditions and actually called for a tax increase across the board, in order to stanch the federal government’s fiscal hemorrhaging. A tax hike might push down bond yields, and thus bring about higher share prices and a considerable drop in interest rates over the entire yield curve, provided the US Federal Reserve didn’t offset the move by unwinding its bond holdings.
Thinking back even further, to when I was a young student, I can remember congressional Republicans voicing their opposition to fiscal deficits, and President Harry Truman, a Democrat, enacting a run of fiscal surpluses aimed at mopping up the federal debt. These policies, helped by inflation (which lowered the real value of the debt), did not lead to a depression. There was only the 1949-1950 recession.
Nowadays, a crude form of Keynesianism is so deeply ingrained in voters’ minds that any program aimed at achieving a fiscal surplus, or even balance, has become unthinkable. Yet one wonders if the new tax law will arouse worries about the sustainability of the growing federal debt, which is already high after the presidencies of George W. Bush, a supply-sider, and Barack Obama, a Keynesian. If so, such concerns would push up interest-rate risk premia in anticipation of a depreciating dollar. Yes, the Republican plan does include some provisions to raise revenue or cut spending, but that is not entirely reassuring.
Of course, those who support the law would argue that the supposed increase in investment activity will immediately push up the dollar’s exchange rate, and that the dollar’s real value would then depreciate gradually to where it had been. Otherwise, no one would want to continue holding foreign capital. This points to a paradox in the law. Trump ran on the promise of boosting American exports, but in standard models, an appreciating dollar will depress export demand.
On the other hand, a stronger dollar will prompt domestic firms in import-competing industries to cut their markups so that potential foreign rivals will be less inclined to invade the US market. As a result, wage rates might be pulled up along with the amount of labor supplied. These particular industries, then, would experience an expansion of output and employment.
AN UNCERTAIN PROGNOSIS
But for those who do not share the perspective of the law’s supporters, this scenario is hardly a sure thing. After all, who’s to say if the tax package will drive up business investment until the marginal productivity of capital has fallen enough to raise substantially the marginal productivity of labor? That scenario might be possible; but it is in no way assured. As New York University’s Roman Frydman and I argued in a commentary last month, the real-life US economy is not a “mechanical system in which changes in tax parameters and other inputs explain exactly why and how investment occurs and the economy grows.”
Unfortunately, the economics profession has ignored the potential implications of human agency. If far more people were to start conceiving and creating innovations, investment and wage rates might rise well beyond what the textbook model would have predicted. By the same token, if fewer people engage in innovation, investment and wages rates may rise less than expected, or even fall.
In other words, the innovation factor could very well dwarf the effect of the cut in the corporate-tax rate over the next ten years. By that point, we might not have enough evidence to determine if the tax cut was effective, or merely an inconsequential drop in the bucket.
And the uncertainty goes deeper than that. The problem is not just that the traditional model’s disturbance terms may be so large that they overshadow the effects of the tax cut, but also that the coefficients for measuring the tax law’s effect on investment or wages might not even be knowable. The innovators driving (or failing to drive) gains in productivity cannot be certain ahead of time what form their new products or methods will take, or whether they will be adopted at all. How, then, could economists ever foretell precise changes in investment patterns as a result of a tax cut, or what effects new investments will have on the marginal productivity of labor?
As I suggested in November, what we call the “natural” unemployment rate can be affected by insecurity and fear. Similarly, if an unfunded tax cut conjures visions of insolvency, corporate executives might be wary of making new investments. Or they might decide to invest predominantly in labor-saving technologies, which could actually reduce wages and eliminate jobs in some industries. Given that possibility, one cannot be sure whether the tax law will have a positive or negative effect on wages, employment, or productivity.
None of this is to say that we should avoid new departures. Certainly, we must keep trying in the hopes of making progress. Or, as Candide (in the musical) tells Cunégonde after they have both endured many difficulties, “We’ll do the best we know.”
About the Author:
Edmund S. Phelps, the 2006 Nobel laureate in Economics, is Director of the Center on Capitalism and Society at Columbia University and the author of Mass Flourishing.
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