Mar 01 2012

At the LSE: cutting corporate taxes right now is insane

Posted by: Nick Shaxson in: Thoughts

The London School of Economics’ blog invited me to write about corporation taxes in the UK, to respond to an article by Tim Knox, director of the Center for Policy Studies. You can either read the shorter version on the LSE blog or take a look at my longer version below.

The corporation tax is under attack. It must be defended

British corporations are awash with cash: according to Deloitte, non-financial companies held £731.4 billion in the third quarter of 2011, the highest ever. Britain also faces soaring fiscal deficits. And the two issues are related.

Corporations have all this cash because they are not investing: the opportunities are not there. They are hunkering down, spending less than their income running large surpluses and building up the cash pile. Meanwhile the government, spending more than its revenue (and thus running deficits), is filling the gap. Martin Wolf explains in the Financial Times:

“If the fiscal deficit is to disappear, offsetting adjustments must occur, above all, in the foreign and corporate sectors.”

How to shift this ugly picture? In order to reduce huge government deficits, surpluses must fall elsewhere. The external sector isn’t going to do it, given the crisis in the Eurozone. There are various ways for this to happen – but cutting corporate tax rates  – further pumping up those bloated, dormant corporate cash piles obviously isn’t one of them.

If stimulus is your recipe for growth, then, cutting corporate taxes is the least effective of the possible options. As the U.S. Congressional Budget Office noted in 2008:

“The most effective types of fiscal stimulus (delivered either through tax cuts or increased spending on transfer payments) are those that direct money to people who are most likely to quickly spend the bulk of any additional funds provided to them. . . . a cut in corporation taxes is not a particularly cost-effective method of stimulating business spending.”

(The U.S. is in a similar situation to the U.K., with corporates there sitting on an estimated US$1.7 trillion cash pile.) Other studies find exactly the same result; and Paul Krugman concludes bluntly:

“If corporations already have plenty of cash they’re not using, why would giving them a tax break that adds to this pile of cash do anything to accelerate recovery?”

Corporate taxes transfer money away from a sector (corporations) that is letting money sit idle, into the hands of a sector (government) that puts it straight to work, educating children, building roads and so on: investing in the future.

Corporation taxes are therefore exactly what Britain needs right now.

And cutting corporate tax rates are therefore exactly, precisely, the wrong thing to do. The same, of course, goes for new tax loopholes – which the UK government appears to be in love with (Accountancy Age last year reckoned the cost of recent moves – see here for the populist version or here for the more technical one – at a disastrous £6.7 billion in corporation taxes, just in the near term.)

Other tax cuts, such as a cut in regressive VAT rates, would a far better idea, and would put money into the hands of people who will spend it.

Now if austerity is your recipe for growth, because you are worried about deficits (and you believe, against all the evidence, that the Confidence Fairy will work its growth magic if you drastically cut government spending,) then corporate tax cuts constitute a direct train to greater deficits. Again, exactly the wrong direction to head in.

In light of all of this, it is puzzling that Tim Knox, Director of the Centre for Policy Studies, argued in a recent LSE blog for a cut in the corporation tax rate.  Not just a cut, but a massacre: from 26 percent to as low as 10 percent.

In making this astonishing pitch, he wheels out some hoary old myths.

Exhibit A: the cranky and discredited U.S. economist Arthur Laffer.

We have heard this story before: cut tax rates and revenues will miraculously rise. Knox says:

“Cutting the rate of Corporation Tax does not necessarily lead to a fall in the revenue it generates for the Treasury. Indeed, the main rate of Corporation Tax has fallen from 52% in 1982 to 26% today. This halving of the rate of Corporation Tax has been accompanied by an increase in the revenue it has generated for the Treasury.”

To be fair, Knox does subsequently allow for the possibility that corporate tax cuts in the UK will reduce revenue. But with this particular quote his words look close to being an endorsement of Laffer.  The basic concept here is simple enough. At a zero tax rate and at 100 percent you will raise no revenue – and somewhere between the two is a ‘sweet spot’ of maximum revenue. It seems sensible, at first.

But the Laffer Curve (see what it looks like here) has been comprehensively (and repeatedly) debunked as a guide to policy, especially for a large economy like the U.K’s. President George H. W. Bush rightly called it “voodoo economics,” and Professor Gregory N. Mankiw, former head of George W. Bush’s Council of Economics Advisers, denounced its adherents as ‘charlatans and cranks.’

If the Laffer curve exists, then it is essential to know whether an economy lies on left of the sweet spot (where tax cuts reduce revenue) or on the right. The U.S. economist Bruce Bartlett reviewed estimates of where the sweet spot’ lies, and all suggested (or read this) that tax rates on both labour and capital would have to rise significantly from current levels to reach the spot – as high as 83 percent.

In short, tax cuts reduce revenue. John Christensen provides further insights on Laffer here.

Tax rates also seem to have little impact on economic growth either (p33-35). And why should they? Taxes do not go up in smoke: they are a transfer, from the private to the public sector. For an economy to grow, both are needed.

The next Knox myth concerns this woolly weasel word ‘competitiveness.’

It is important to get one thing straight.

The process of competition between firms in a market bears absolutely no economic resemblance whatever to ‘competition’ between jurisdictions on tax. The former is generally beneficial, while the latter is always harmful.

Think about it like this. When a company cannot compete it goes bust and another, better one, takes its place. For all the pain involved, this ‘creative destruction’ weeds out bad firms and is a source of capitalism’s dynamism. But what do you get if a country cannot “compete?” A failed state? As Wolf (again) puts it, “the notion of the competitiveness of countries, on the model of the competitiveness of companies, is nonsense.”

Countries do ‘compete’ in meaningful ways, however. The World Economic Forum (WEF)’s Global Competitiveness Report ranks countries on 12 ‘pillars’ of competitiveness such as infrastructure, healthcare, education, technological readiness and more – factors that depend heavily on tax revenues.  Of the WEF’s four most ‘competitive’ countries in 2011, two – Sweden and Finland – are among the world’s highest tax countries; and in general, the less competitive (developing) countries tend to have the lowest taxes as a share of national income.

There is no clear empirical link between corporate tax rates and true economic competitiveness either. This stands to reason: investors’ prime concerns in a country are usually things like political and economic stability, access to sizeable markets, infrastructure, or a healthy and educated and workforce. Surveys regularly show that tax comes some way down the list of factors.

This kind of “competition’ between jurisdictions is always pernicious. Here is why.

This ‘competition’ constantly puts governments under pressure to cut taxes on mobile capital (such as on corporations), for fear it will shift elsewhere.  But it is the wealthiest sections of society that realise their income and gains in this form. So tax ‘competition’ inevitably implies lower taxes on the wealthy.  Poorer sections of society must then make that up for them, either through higher taxes or poorer services.

Moreover, if corporate tax rates (big and small) are cut far below the top rate of income tax, then wealthy individuals will shift income into forms that will attract the lower corporate tax rate. So this increases pressure on governments to cut top income tax rates, further compressing the tax system away from the wishes of the electorate and from Adam Smith’s principle of basing tax rates on ability to pay. The poor pay more, the rich pay less.

In these times of soaring inequality, which is harmful in its own right, corporate tax cuts are therefore particularly worrisome.

The coalition government’s stated desire to “create the most competitive corporate tax regime in the G20” is therefore based upon an economic howler: woolly and ideologically-charged thinking, founded upon a basic confusion between the two diametrically opposing meanings of the word ‘competitive’.

It is astonishing that so few commentators call them out on it.

One more thing. Tax cuts and tax loopholes typically don’t create jobs. Chancellor George Osborne recently told Radio 4’s Today programme that Britian would keep cutting corporation tax, and, following a particularly dangerous move last year to provide juicy five percent tax rates for corporations that shift certain types of income into tax havens, Osborne stated that “there is evidence that busninesses are coming to Britain more than they were . .  creating factories and jobs.”

Really? Private Eye heard the programme and asked the Treasury to provide this evidence. The Treasury came up with . . . . precisely nothing. So far, two big companies appear to have been persuaded to relocate back to the UK as a result of the tax moves: Aon and WPP. Aon is expected to create 20 new jobs. WPP is likely to provide none. Accountancy Age estimated the short-run costs of the stealthy offshore tax-cut plan at £6.7 billion, and concluded that Osborne was “paying a lot of money for very good PR.”

Additionally, IMF research has found that while tax cuts and tax holidays may boost investment in some countries, it does not seem to boost growth (which is the end goal of policy.) And, given that corporate tax cuts boost inequality, crude aggregate GDP growth figures understate the problems for the middle and poorer classes.

There is yet more. Knox also provides a graph showing corporate tax rates falling sharply for the past 30 years. What he fails to mention is that the quarter century before that, when corporation tax rates in the UK were higher (around 40 percent in the UK for much of the time) is now known as the Golden Age of capitalism, when taxes were high and growth was high around the world. The period of tax-cutting ushered in an era of lower economic growth, soaring inequality and stagnating wages. Correlation isn’t causation, but this episode proves that higher corporation tax rates can be compatible with growth.

Knox’ article ends with a rather sad plea for an end to ‘banker-bashing.’ The City of London Corporation provides a lot of misleading information about its tax ‘contribution’ to the economy. But if you factor in all the costs associated with the bailouts, the hit to growth from the financial crisis, the implicit taxpayer subsidies to the big banks, and the fact that much if not most of the tax revenue comes from the ‘utility’ part of the financial sector (about which nobody is arguing) then clearly the ‘casino’ side of banking has been a large and net consumer of tax revenue, not a contributor.

A different argument is therefore in order: stop mollycoddling those ‘casino’ bankers, and take the gloves off.

But that is a topic for another day.

P.S. I provide further arguments about the corporation tax here.

5 comments so far

[…] the corporate tax trough — is based on economic quack medicine. As I noted on the LSE blog recently, this course of action is quite insane. UK government policy making appears to have been taken over […]

George DeMarse 3nd March, 2012 10.34 pm

This is the best article I have seen on the political winds of the corporate tax and why the current billowing masts are runnin’ afoul matey. It blasts the usual conservative shiboliths of the Laffer curve, supply side nonsense that hasn’t worked as advertised for 40 years. It does a balanced report on what “competition” means in the private and public sectors, where conservatives argue they mean the same thing–when they do not. The article also blasts the idea that corporations need “more money” from tax cuts when indeed they are sitting on piles of cash–the misguided concept that once government “gets out of the way,” magically all this growth and money happens. It does happen–to the top 1% who sit on it more.
All of this information is great–and informed citizens will take it into account come voting time. Unfortunately, the uninformed and the “ideological” will be swayed by conservatives arguing “tax cuts mean jobs,” when they don’t.

[…] TJN writers were on the LSE blog explaining the economic folly of corporate tax cuts. For example: “British corporations are awash with cash: according to Deloitte, non-financial companies […]

[…] Against all the evidence, and all the economic pointers. […]

[…] the economic illiteracy that lies behind corporate tax-cutting. It followed my LSE blog, my longer Treasure Islands blog, and Liberal Conspiracy article, along the same lines. (As I’ve mentioned, this argument […]

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