No, look for businesses’ ‘extra cash’ to go to stock dividends, not capital investment

p03 BelasenBelasenBy ARIEL BELASEN
    On Nov. 14, National Economic Council Director Gary Cohn met with several dozen CEOs and asked for a show of hands whether they would increase capital investments if the corporate tax rate was cut. Very few hands went up. Bewildered, Cohn asked, “Why aren’t the other hands up?”
    Here’s the answer: Right now, U.S. corporations are sitting on more liquid assets (predominantly cash) than at any other time in history, to the tune of nearly $2.5 trillion. If capital investments were a priority they would have been reinvesting some or all of that cash already as opposed to sitting on it. But economically that would be a mistake. Companies produce to meet demand, not to exceed it. When supply is too high, overflowing inventories drive down prices. Increasing capital investments or hiring additional workers, therefore, becomes a financial liability to these companies.
    All in all, that means tax cuts are unlikely to stimulate any sustainable economic growth.
    So where will the money go? The CEOs that met with Cohn mentioned potential stock buybacks; dividend payouts; performance bonuses; or simply keeping more cash on hand. The reality is that large companies work to maximize PBT (profit before tax). While they will happily pay a lower tax burden, taxes are typically not considered during the strategic operational decision-making process. If anything, raising tax rates may cause those firms to consider reinvesting revenues so as to reduce their bottom line taxable profits.
    But those were all large-company CEOs. What about small businesses? When small businesses make expansionary moves, they put themselves at a higher risk. Take, for example, a small restaurant considering an expansion with its additional net profit through the tax cut. If net PBT is $200,000, the additional 10 percent to 15 percent in after-tax profit is just $20,000 to $30,000, which means the restaurant would find itself needing a loan to fund the bulk of the expansion. But what if additional customers don’t come? The growth move may end up sinking the entire business.
     In general, the problem facing many small businesses right now is that consumption (money spent on goods and services) growth is relatively flat among taxpayers who would stand to benefit from the Republican Tax Reform because their incomes are high enough that they have already met their wants and instead have a high propensity to save. This means demand is unlikely to increase even if these individuals have more income in their pockets.
    The taxpayers most likely to increase their spending at small businesses? Individuals earning less than $75,000 and households earning under $150,000. Middle- and lower-income individuals have a much higher propensity to consume and a lower propensity to save because their incomes are not high enough to meet all of the wants and needs. Unfortunately, the tax reform is likely to increase the tax burden of those individuals, thereby reducing household expenditures.
    Consumption makes up nearly 70 percent of annual GDP. The other 30 percent comes from investment, government expenditures and net exports. We’ve already seen why investments are unlikely to increase. And net exports are unlikely to be affected by the tax reform one way or another, so that leaves government expenditures as the only other potential source of economic growth. But the tax reform law slashes government spending — mostly in health expenditures to prevent the tax reform from increasing deficits too much. These spending cuts mean that the government expenditure contribution of GDP will be shrinking.
    Proponents of the tax reform argue that private spending will fill the void. This is true, but do we really want people spending a larger portion of their incomes on health-care costs? That leaves them with less disposable income to be spent at small- and medium-sized businesses.
    Proponents of the reform also like to point out that the Reagan tax cuts increased tax receipts in the 1980s. But as many economists have pointed out, tax receipts would have likely increased even more without those cuts. The Reagan administration leaned on an economic policy known as “Supply-Side Economics,” which relies on the theory of something called the Laffer Curve. The Laffer Curve states that if tax rates are set at 0 percent, the state will collect $0 in taxes. But if tax rates are set at 100 percent, the state will also collect $0 in taxes because of the absolute work disincentive. In between these two rates is an arching curve that peaks at the point where tax receipts are maximized and shows us the relative impact of shifting tax rates on public revenue.
    The optimal strategy for a government would be to cut taxes if the current rate is greater than that optimal point and to raise taxes if the current rate is less than the optimal point. For example, if the corporate tax rate was 90 percent, a prospective entrepreneur may opt against starting a business. However, at a lower tax rate, that individual may throw his hat in the ring. And as tax rates fall lower more individuals will join in. This, in turn, boosts tax revenues – up to a point when rates are so low that rate cuts no longer serve as an incentive for private sector growth. At that point tax receipts will fall.
    So, what is that point? Research by Piketty, Saez, and Stantcheva (2013) found that the optimal marginal tax rate (to maximize receipts and to reduce inefficiencies caused by economic inequality) is between 70 percent and 75 percent! Thus, while the Laffer Curve is fundamentally correct, the interpretation that cutting tax rates from 35 percent to 20 percent is absolutely incorrect.
    Ariel Belasen is the undergraduate director and an associate professor of economics and finance at Southern Illinois University Edwardsville. He received his undergraduate degree from Cornell University and completed his graduate studies at SUNY Binghamton. He has been engaged in economic research for more than a decade and has had publications in the American Economic Review and Journal of Human Resources, among others.