Corporate U.S. tax cuts have different effect

The U.S. is late to the game of reducing corporate income taxes (CIT): almost all of the countries in the OECD have significantly lower corporate tax rates than they did 20 years ago. Canada included: successive federal governments have reduced the federal corporate tax rate by almost half, from 29.12 per cent in 2000 to 15 per cent today. One of the most remarkable things about these CIT rate cuts is that federal CIT revenues held steady at around two per cent of GDP throughout: if ever there were an example of a tax cut paying for itself, the Canadian CIT rate is it. But this is one of those cases where it’s important to remember that Canada is not the United States.

Economic policy analysis in Canada and in the United States is like North American football. At first and even second glance, the Canadian and American variants look like the same thing, and many of the tactics that work well in one country can be successfully transferred to the other. But there are differences, and policies that work well in one context don’t always work properly in the other.

The fundamental difference between the Canadian and U.S. economies is scale: Canada is, as economic jargon has it, a “small open economy.” The flows of goods, services and capital in and out of Canada are largely unconstrained, but Canada is too small a player to move world prices. The United States, on the other hand, is big enough to shift world markets. And the American market is so large that the (enormous) flows of goods and capital in and out of the U.S. can often be ignored for practical purposes, because they are dwarfed by the size of the domestic economy.

This difference is crucial for understanding the mechanics of corporate tax policy. Sometime the narrative is represented as a sort of income effect: lower CIT rates increase profits, and these profits are then used to finance new investment. This narrative may sound plausible, but the story as economists tell it is based on how CIT rates affect aftertax rates of return on investment. In an open economy, the after-tax rate of return is determined by the world supply and demand for savings, and a small open economy such as Canada must take this rate as given. Investment projects must offer the world after-tax rate of return (or more) to get funded. Lower corporate tax rates increase investment spending because they make it easier for investment projects to pass this test.

A more subtle implication of facing an after-tax rate of return fixed by the world market is that capitalists are, in the end, unaffected by corporate tax rates: they get the world rate of return. But for workers, the accumulated investment generates increases in their productivity and their wages.

For Canadian policy-makers — preoccupied as they were with Canada’s chronic under-investment, anemic productivity growth and low wages — the payoffs to lower corporate income tax rates were worth pursuing. Policymakers in the other small open economies in the OECD reached the same conclusions.

But these arguments are less persuasive for the United States: many international investors are happy to hold low-yielding U.S. assets simply because they are U.S. assets. One of the puzzles in international finance is that the U.S. is able to sustain a positive international income balance, even though the international investment position is negative, on the order of almost 50 per cent of U.S. GDP. In other words, the interest income generated by the $33 trillion in U.S. assets held by foreigners is less than the return generated by the $25 trillion held by U.S. investors overseas. The United States has never had any problem attracting capital. Indeed, if the United States is going to achieve President Trump’s goal of eliminating the trade deficit, it will want to reduce, not increase, net inflows of capital.

In the same vein, American workers shouldn’t expect much in the way of wage gains: the U.S. economy is so large that whatever capital inflows do materialize won’t have much effect on their productivity. (While there is evidence of U.S. workers’ benefiting from corporate tax cuts, the gains are produced by cuts in state-level taxes, where the competition for investment is stronger.)

While there will be some positive effects on U.S. economic growth, they will be nowhere near enough to validate U.S. Republicans’ claim that their tax cuts will pay for themselves. So why bother?

The rest of the tax package — heavily-weighted with benefits for those with very high incomes — suggests an answer. Lower corporate taxes mean higher aftertax profits and higher share prices. Since corporate executives’ compensations are directly tied to the value of the firms they are managing, their compensation will also increase. Many U.S. top earners will be getting a significant pay increase at the same time their taxes are reduced.

The Republicans’ tax package will represent a significant regressive redistribution of income — and a clear victory for the U.S. donor class.