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Thursday, December 21, 2017

New Progressive Strategy: Telling Half-Truths About Corporate Tax Reform

Measurement bias renders short-run comparisons of financial gains irrelevant to proving opponents’ “tax cuts for the rich” claims.

As corporate tax reform gets ever-closer to becoming a reality, opponents are shifting their strategy. Rather than asserting, as Senate Democrats wrote in a letter to Republican leaders, that “tax reform cannot be a cover story for delivering tax cuts to the wealthiest. We will not support any tax reform plan that includes tax cuts for the top one percent,” they will soon turn to “proving” that tax cuts benefit the rich at the expense of the rest of us, to use in future campaigns, even if it is not true.

Everyone Will Benefit Over Time

One indispensable part of their efforts will be to studiously ignore the inconvenient fact that, when economic arrangements are voluntary, they benefit all participating bodies, or individuals would not participate. In the absence of fraud or coercion (the first being government’s failure to protect citizens against criminals and the second being a government invasion on citizens’ rights), a person’s self-interest guarantees that benefit, regardless of what some imperfect measurements may say. 

It will take time for the positive effects on workers’ circumstances to appear.

Another part of their strategy will be ignoring the many clear mechanisms by which the rest of us gain from improved incentives for capitalists to use their resources for others.

Corporate tax reform hikes after-tax rewards for capital investments which provide tools for increasing worker productivity and earnings, as well as for innovation, advancing techniques and improving technology, risk-taking, and entrepreneurship, each in service of the rest of us as workers and consumers.

However, a major error accompanies such omissions but has gotten far too little attention. It takes time for owners of capital to fully respond to improved incentives so that it will also take time for the positive effects on workers’ circumstances to appear. Consequently, opponents who can get people to focus their attention on the short run, before the positive labor effects appear in the data, can lead them to overlook those benefits, almost all of which appear in the future.

In contrast, the benefits to capitalists appear immediately in the data. By comparing the limited benefits to workers in the present to both the present and future benefits to capitalists, opponents of corporate tax rate reductions give the appearance of proving that reform is essentially just “tax cuts for the rich,” even if the vast majority of benefits actually accrue to workers over time (which is economists’ most modern view of corporate tax rate cuts).

Short-Run Measurements Only Show Half the Picture

When the tax burden that is applied to a class of assets, such as corporate stock, is reduced, that will lead to an immediate increase in those assets’ prices. The asset price increase will not only reflect current period gains to their owners, but also capitalize the expected increased after-tax profits that can be expected in the foreseeable future. And the more durable the improvements are likely to be, due to future effects, the greater the asset price surge will be.

The cumulative effects are very large, even when their immediate effect is small.

Since most financial resources are owned by those who have greater current measures of wealth and income, by focusing only on the short run, the results can be made to appear as huge asset gains to “the rich,” with almost no effect on American workers’ financial well-being. Such results let opponents assert that their claim has been proven. In fact, this largely reflects the impacts of age, as older households have had more time to convert unmeasured earning capacity into measured financial wealth.

Unfortunately for opponents’ supposed proof, the improved incentives of higher after-tax returns are the mechanism which produces increased worker productivity and real earnings over time. Those cumulative effects are very large, even when their immediate effect is small. But unlike financial market assets, there is no marketplace in which the higher real earnings of workers in the future (which economists call human capital, for its analytical similarities to physical capital) get capitalized into an easily-observed current asset price increase.

So when public discourse focuses on short-run measurable effects, it compares the capitalized future effects on financial assets into easily measured price increases with the effects on workers, for whom the benefits lie in the future, but which are not similarly capitalized into present values. That huge measurement bias renders short-run comparisons of financial gains irrelevant to proving opponents’ “tax cuts for the rich” claims.

Electoral Ammunition

Consider an analogy to similar mismeasurement in education. Suppose a university found a way to improve its educational performance by 20%, at an increased cost of 5%. It then raised its tuition by 6% to improve its financial position. Who gets the measured financial benefits? The university, whose revenues grow relative to its expenses, not students yet to enter the labor force, whose current incomes change very little. But who actually gets most of the benefits over time? Students would capture by far the lion’s share (roughly 14/15 of the improved efficiency) of the university’s innovation.  

A short run focus is a massive misrepresentation.

As proponents of “taxing the rich” see their prospects for a political win evaporate, they will shift to “proving” their claims with data from the cuts that do take place. This will be used for future electoral ammunition.

How do we know? Because they have done it before. But a short run focus is a massive misrepresentation which diverts attention from the fact that improved incentives reveal themselves over time, and offers little more than a sleight-of-hand that is incapable of proving their case.

  • Gary M. Galles is a Professor of Economics at Pepperdine University and a member of the Foundation for Economic Education faculty network.

    In addition to his new book, Pathways to Policy Failures (2020), his books include Lines of Liberty (2016), Faulty Premises, Faulty Policies (2014), and Apostle of Peace (2013).