Wednesday, June 04, 2008

Greg Mankiw's Blog: Really Good Idea?!

In Japan, my home country, an economic policy aiming to cut the corporate income tax is popular among business society, policymakers and economists.

Business society like low corporate income tax because they don't have to pay high tax. Policymakers, and worse, economists also like it because they can get more political and financial support from the business society.

However, I don't understand why this kind of policy is so popular. Greg Mankiw, my favorite economist of Harvard, posts a readable article in the NY times.

He says, "Don’t laugh. I’m serious." It seems worth reading. Shall we listen to him? Why does he support a cut in the corporate income tax?

There are three main points:

(1) The corporate income tax promotes long-run growth in American living standards.

The idea is so simple: a cut in the corporate tax would boost after-tax profits and stock prices, which results in a stronger stock market and more capital investment. More investment would lead to greater productivity, which leads to higher wages for workers and lower prices for customers.

This kind of idea is so-called "supply-side economics": if the tax on company decreased, many companies would increase their production and employment, and thus profit and income. Increased income should go to workers, that is, consumers and they should buy more consumer goods and become happier. The tax cut strengthens not only the supply side(production), but also the demand side of the economy(purchase).

It sounds reasonable, but do increased profit and income really go to consumers? That's the question.

It may sound Marxian, but it doesn't seem to me that increased profit goes to workers and consumers. Increase profit may go to stockholders, not to workers. Stockholders are generally rich and may have relatively lower propensity to consume than that of workers(That's why rich people hold stocks).

In addition, more people are not stockholders but workers. Thus, less workers spend much and more stockholders spend less. As a result, low corporate income tax doesn't boost up well the demand of the economy.

Mankiw raises this problem in his introductory textbook of economics as an example of Kennedy's tax cut in 1963. This tax cut was not the cut of the corporate income tax. Moreover, it was so Keynesian and aiming to stimulate the demand side.

However, it also raised the supply side of the economy. The production was up.

In the 1960s, the America seemed to have really a bright future (people thought they could become happier than yesterday) even though there were some serious political risks like the Cuban missile crisis and the Vietnam War.

If people (consumers) thought they could become happier than yesterday, they would purchase more in the store and would get higher living standards. But if the reverse happened, what would happen? They should save more of their income and cut their living expense just as a safety precaution.

Good expectation makes people behave like a bull, but bad expectation doesn't. Mankiw doesn't seem to think about a role of people's expectation on the future.

(2) The ultimate payers of the corporate tax are the individuals who have some stake in the company on which the tax is levied.

Mankiw raises some nice researches: William C. Randolph of the Congressional Budget Office concludes that domestic labor bears slightly more than 70 percent of the burden of the corporate tax.

Wiji Arulampalam, Michael P. Devereux and Giorgia Maffini conclude that a substantial part of the corporation income tax is passed on to the labor force in the form of lower wages, adding that in the long-run a $1increase in the tax bill tends to reduce real wages at the median by 92 cents.

These researches are persuasive and I agree on this point.

Mankiw also writes about this point, raising an example of the tax on rich people: high tax on luxury goods seems a good way to tax rich people more heavily, but in reality the reverse would happen: it taxes not rich people.

More precisely, high tax on luxury goods is imposed on producers of the luxury goods and, maybe, the workers of the producers. The workers at the company which produces luxury goods are generally not rich.

The luxury good tax sounds nice for the sake of equity, but it lies heavy on not rich people.

(3) The distortions that the corporate income tax induces are large compared with the revenues that the tax generates.

This point seems more important than the above 2 points. Tax distorts incentives. Tax affects the people's behavior and changes the economy to a Pareto-inferior equilibrium (brings the deadweight loss).

Mankiw points out, "compared with other ways of funding the government, the corporate tax is particularly hard on economic growth." Reducing these distortions would lead to better-paying jobs.

I also agree on this point but we have to keep in mind that tax affects the people's behavior.

Mankiw gives an example of Mr. Randolph’s analysis, the role of international capital mobility: low corporate income tax lures foreign investors.

Savings search the highest returns in the world capital market. The domestic capital owners can escape most of the corporate income tax burden when capital is reallocated abroad in response to the tax.

Following this line of the argument, if the corporate tax decreased, more capital would come in from abroad and thus more investment and more production would be realized. It sounds reasonable, but is it true?

As you know, a famous research conducted by C. Horioka and M. Feldstein shows high correlation between domestic investment and savings, which means that capital doesn't move more freely than we imagine.

Investors in one country do not need the funds from domestic savers and can borrow from international markets at world rates. By the same token, savers can lend to foreign investor the entirety of the domestic savings. So low correlation between them might be observed, but in fact it isn't.

This result is seen as evidence of low capital mobility and is so-called Horioka-Feldstein puzzle.

Corporate income tax distorts people's incentives and thus it's very serious in terms of economic welfare. However, the high gasoline tax as Mankiw proposes also distorts incentives.

Low corporate tax and high gas tax look a very nice combination, but what does this combination of tax bring?

High gas tax reduces gas emission and traffic jam, which leads to better living environment. But it taxes drivers, not gasoline itself?

I think that a Pigouvian tax is a good idea but I would like to keep in mind that this tax would also hurt drivers' (people's) economic welfare and convenience as well as the corporate income tax would do.

(1) Feldstein, Martin & Horioka, Charles (1980), “Domestic Saving and International Capital Flows”, Economic Journal 90: 314-329

(2) The Pigou Club Manifesto, Greg Mankiw's Blog, Friday, October 20, 2006.

(3) Corporate Tax Rates, Greg Mankiw's Blog, Wednesday, May 03, 2006.

Greg Mankiw's Blog: Cut the Corporate Income Tax

1 comment:

Anonymous said...

It was very interesting for me to read this article. Thanks for it. I like such topics and anything connected to them. I definitely want to read a bit more on that blog soon.