It is not often I agree with Cowen or academics in general. But sometimes they get it. Cowen is largely on target when he says Yes, a Corporate Tax Cut Would Increase Investment.
A common criticism of the current Republican tax plans is that they will not boost private investment. While I have major reservations about these plans as a whole, this particular objection is oversold.
The evidence on investment behavior is fairly clear. When companies have more “free cash” at hand, they tend to invest more, and this effect is distinct from any effect of the tax cut on expected rates of return. So, in other words, when critics call the corporate rate cut a “giveaway” to business, that is precisely the mechanism that tends to boost investment.
Furthermore, while these investment boosts are strongest for companies that are cash constrained, they also seem to occur for the companies that have a lot of cash on hand, as is often the case with today’s profitable corporations.
A related worry is that companies will take their cash windfalls and simply return them to investors in the form of dividends and cash buybacks. First, the evidence doesn’t support this fear.
More generally, sending money back to investors doesn’t have to mean no new investment. What if those investors take the money and put it in a venture capital fund or invest it in some other manner? The whole point of capital markets is to recycle resources into the most profitable new opportunities, and that may or may not involve the companies that initially earned those profits.
Many economic effects operate without all of the participants knowing exactly what is driving the final result. For instance, more cash in corporate coffers could induce managers to develop more good project ideas for the CEO. The CEO might feel he or she is responding to the higher quality of project ideas, rather than to the corporate rate cut per se.
More importantly, let’s take the extreme scenario where companies simply take all of the proceeds from the tax rate cut and put them in the bank, never increasing their own investments as a result. Well, the banks now have more funds to lend out, and so investment still is likely to go up, even if this happens somewhere far and wide from the original corporation earning the new profits.
Whoa! Stop Right There
Until that paragraph, Cowen was 100% spot on.
Where is Cowen wrong? The answer is banks do not lend from reserves or excess reserves.
I discussed this in Are Banks Hoarding Cash? Debate Over “Free Money” Interest on Excess Reserves.
Professor Steve Keen agrees.
Please consider BIS Working Papers #292 Unconventional monetary policies: an appraisal, page 19.
The level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.
The main exogenous constraint on the expansion of credit is minimum capital requirements.
An expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. (emphasis by Mish).
Cowen Conclusion Back on Track
Just to be clear, I think the currently circulating versions of the tax plan are unwise. They increase the deficit too much, don’t have the right kind of distributional consequences to prove stable, and they might eliminate the Obamacare mandate without a planned stabilizing replacement. Those and other more technical reasons are enough to bring at least parts of these proposed laws back to the drawing board.
But when the critics allege that corporate tax rate cuts won’t boost investment, that’s going against basic economics.
One of my readers was upset with me last week when I agreed with a bunch of EU academics regarding Catalonia. The reader's objection was that I agreed with a bunch of academics.
I asked the reader what that they said that he disagreed with. He could not come up with anything other than I was siding with academics.
I see the same thing all the time in politics. People are anti-Trump and will mock him just because he is Trump. The same thing happened with Obama.
It's important to put politics aside and look at what people say.
I did not think I would be agreeing with Cowen on much of anything. But here we are. Cowen nailed the essential idea even though he got a bit off base on one of the reasons why.
Mike "Mish" Shedlock