Why Didn’t the Trump Tax Cuts Work?

I actually agree with Paul Krugman’s latest New York Times column, at least at a high level. In detail I have some quibbles. His latest column is a reflection on “Trump’s signature policy”, i.e. his tax cuts. One of my quibbles is that I don’t think that was his signature policy or, at least, it was only one among a number of signature policies. If you had to pick one, solitary signature policy for him, I think it would have to be “the Wall”, about which I shrugged. I agree that there’s a problem; I just never thought that a wall could solve it or even mitigate it. But that’s a digression.

In considering why the tax cuts failed, your first step is to demonstrate that they did, indeed, fail, and IMO the evidence that Dr. Krugman presents is sufficient:

The rationale for the corporate tax cut was, however, quite different. It wasn’t about individual work effort; instead, it was about incentives to invest in the United States as opposed to other nations. That’s clearly a real issue in a world of mobile capital. And the tax cut’s advocates argued that lower profit taxes would bring higher investment here, leading over time to faster growth and higher wages.

At the time I accepted this logic, at least as a qualitative matter. I still thought the tax cut was a bad idea, but that was because I believed that the inflow of capital would be smaller and take much longer than the plan’s advocates claimed, and as a result wouldn’t be enough to compensate for the loss of revenue.

But I was, it turned out, being too generous. As a 2019 analysis by the International Monetary Fund found, the Tax Cuts and Jobs Act ended up having no visible effect at all on business investment, which rose no more than you would have expected given the growth in demand.

at least for the cut in the corporate income tax. The evidence he produces for the failure of the cut in the personal income tax to incentivize higher personal productivity is mostly hand-waving—another quibble. Since I was always skeptical that the beneficial effects of the cut in the personal income tax rates would outweigh the adverse effects of increasing the debt, I don’t feel any need to defend it.

He goes on to sketch several explanations for why business capital investment showed little increase that wouldn’t have happened without the tax cuts include:

• A tax on profits isn’t a a tax on capital
  

  Imagine a company considering whether to borrow money to invest in some new project. If there were no profits tax, it would proceed if and only if it expected the rate of return on the project to exceed the interest rate on the loan. Now suppose that there is, say, a 35 percent tax on profits. How does this change the company’s decision? It doesn’t.

  Why? Because interest on the loan is tax-deductible. If investment is financed with debt, profit taxes only fall on returns over and above the interest rate, which means that they shouldn’t affect investment choices.

  OK, not all investment is debt-financed, although that itself poses a puzzle: There’s a clear tax advantage to issuing debt rather than selling stock, and the question of why companies don’t use more leverage is subtle and hard. The immediate point, however, is that the corporate profits tax isn’t a tax on capital, it’s a tax on a particular aspect of corporate financial structure. Analyses — mine included! — that treat it simply as raising the cost of capital are being far too generous to tax cutters.

• Business investment isn’t that sensitive to the cost of capital, anyway
  

  Suppose we ignore the deductibility of interest for a moment, and consider a company that for some reason finances all its investment with equity. Imagine also that investors know they can earn a rate of return r in the global marketplace. In that case they’ll require that the company earn r/ (1-t) on its investments, where t is the rate of profit taxes. This is how advocates of the Trump tax cut looked at the world in 2017.

  Under these conditions, cutting t, by reducing the required rate of return — in effect, by cutting the cost of capital — should induce corporations to increase the U.S. capital stock. For example, the Tax Foundation predicted that the capital stock would rise by 9.9 percent, or more than $6 trillion.

  But these predictions missed a key point: most business assets are fairly short-lived. Equipment and software aren’t like houses, which have a useful life measured in decades if not generations. They’re more like cars, which generally get replaced after a few years — in fact, most business investment is even less durable than cars, generally wearing out or becoming obsolete quite fast.

  And demand for short-lived assets isn’t very sensitive to the cost of capital. The demand for houses depends hugely on the interest rate borrowers have to pay; the demand for cars only depends a bit on the interest rate charged on car loans. That’s why monetary policy mainly works through housing, not consumer durables or business investment. And the short lives of business assets dilute the already weak effect of taxes on investment decisions.

• Monopoly
  

  Financial industry types often talk about the FAANGs: Facebook, Apple, Amazon, Netflix, Google — tech companies that loom large in the stock market. These companies look very different from past market leaders like General Motors in its heyday; it’s much harder to link their value to the tangible assets they own.

  True, there are more of those assets than are visible to the naked eye. For example, Amazon’s warehouses employ a vast number of workers. Still, the value of these companies mainly reflects their market power, the quasi-monopoly positions they’ve established in their respective domains.

  There are many issues relating to this market power, but in the current context what matters is that taxes on monopoly profits are as close as you can get to revenue-raising without side effects. They certainly don’t deter investment, because monopoly profits aren’t a return on capital.

  And the profit tax is at this point largely a tax on monopoly or quasi-monopoly profits. Officials I’ve spoken to cite estimates that around 75 percent of the tax base consists of “excess” returns, over and above the normal return on capital, and that this percentage has been rising over time. Loosely speaking, this means that most of a corporate tax cut just goes to swelling monopoly profits, with any incentive effects limited to the shrinking fraction of corporate income that actually reflects returns on investment. That I.M.F. study of the Trump tax cut suggested that rising monopoly power might help explain its lack of impact.

Of those three I think that the third is by far the weakest for a simple reason. 99.999% of companies aren’t FAANG companies and aren’t monopolies. But it does support something else I said: I think the tax cuts should have been much more narrowly crafted, more targeted than they were.

And I think the second point is by far the strongest. The correlation between business capital investment and company profits (and therefore taxes on company profits) is empirically weak. Not to mention that established companies tend to do relatively little capital investment while start-ups do a lot but, since they don’t have any profits to tax, cutting the corporate tax rates have little effect on that investment.

My reasons for supporting the cut in the corporate tax rates were two:

• Our higher taxes placed the U. S. at a competitive disadvantage not just with the Irelands but with the UK, France, and Germany.
• The corporate tax is an inefficient tax.

Cutting corporate taxes was a success in both of those but only in those.

But what about the increased incomes among the poor and minorities during Trump’s term of office (I hear someone ask). I attribute that entirely to the tighter labor market during the period which had a lot to do with his immigration policies and little or nothing to do with the tax cuts.

As you might expect Dr. Krugman is overly sanguine about the prospects for the Biden Administration. What I think will happen is that, just as Trump’s tax cuts were insufficiently targeted, so will whatever tax increases the Biden Administration puts into place and for analogous reasons.