Paul Krugman
February 08, 2018

Late last year Republicans enacted a huge tax cut, mainly for corporations. They then seized on some seemingly supportive data points – investment announcements by some major corporations, bonuses paid to some employees, an uptick in some measures of wage growth – as evidence that the cut was already benefiting workers. But while there is a case for cutting corporate taxes, the logic of that case says that any benefits to workers should unfold gradually over time, not show up in a few weeks.

And there is also a case against corporate tax cuts, even aside from the fact that revenue must be raised somewhere, and getting less from profit taxes means either raising other taxes or cutting spending.

The purpose of this note is to lay out a stylized framework for thinking about these issues. There exist carefully specified general-equilibrium models for tax incidence, but my sense is that there’s not enough intuition in these models for them to play as large a role in the discussion as they should. So, I’m going to present a slightly different approach, one that I described in a somewhat disconnected series of blog posts over the course of the tax debate. Here I try to collect it into a unified, comprehensible narrative.

1. The simple analytics of trickle-down

Imagine that we had a one-sector economy with no monopoly power, open to inflows of foreign capital. In reality, the economy is characterized by considerable monopoly rents, most of the capital stock isn’t in the corporate sector, and most of GDP is nontradable. These complications all weaken the extent to which corporate tax cuts trickle down to wages. But let’s give some hostages here, and consider the most favorable case.

Such a stylized economy would look like Figure 1. The downward-sloping line is the marginal product of capital, which is equal (in this model) to the pre-tax rate of return r. The after-tax return is r(1-t), where t is the tax rate. Given an initial capital stock K, GDP is the integral of the area under the r curve up to K. Of this, rK goes to pre-tax profits, of which the government takes a share t and the rest goes to after-tax profits. What’s left, the triangle at the top, is wages.

Figure 1

Now, the key justification being offered for corporate tax cuts is that the U.S. is the international mobility of capital: reducing U.S. taxes will, supposedly, draw in investment from abroad, either from U.S. corporations bringing money home or foreign corporations buying into the U.S. economy. We can capture this effect by adding a supply curve for capital, as in Figure 2.

For a small open economy, this supply curve would be horizontal in the long run. It is, however, surely upward-sloping for the United States.

Now suppose the corporate tax rate is cut to a lower level t’. This raises the after-tax rate of return for any given capital stock. Over time the capital stock rises to K’. This in turn leads to higher wages.

Figure 2

The crucial words, however, are “over time.” For a variety of reasons, it would take a number of years for the capital stock to rise to its long-run level.

What are these reasons? One is that adjusting the capital stock would take time even if purely domestic factors were involved: a large increase in capital formation would drive up the wages of construction workers, the rent on construction equipment, the prices of commodities used in construction, etc. This is why we don’t expect Tobin’s q to be one all the time.

Beyond this, we’re talking about capital inflows here, which would have to have as their counterpart an expanded trade deficit, effected via a temporarily strong dollar. And this temporary strength of the dollar would in itself be a deterrent to capital inflows, since investors would expect it to go back down again.

The bottom line is that the short-run supply curve of capital should be more or less vertical; full trickle-down should happen only in the long run, where this run is measured in a number of years. Whatever cherry-picked good news comes in the first few weeks after a corporate tax cut is, almost by definition, irrelevant to the case for that cut.

2. Long-run welfare effects

Since the capital stock is effectively fixed in the short run, the short-run incidence and welfare effects of a corporate tax cut are simple: no change in real income, all the gains go to owners of capital. In the long run, however, the capital stock does rise. So, what are the effects?

Again, as a starting point we can think of a downward-sloping demand for capital, reflecting its marginal product. We can also think of an upward-sloping supply of capital, with the upward slope reflecting both the size of the US — we’re probably around half of the world’s capital market not subject to capital controls — and the imperfect nature of capital mobility, even now.

For current purposes it’s helpful to focus not on the corporate tax rate per se but rather on the wedge corporate taxes place between the rate of return to capital before taxes — which is assumed equal to its marginal product — and the after-tax return received by investors. This does not mean changing the model, it’s just a way of presenting the picture that bypasses some messy algebra that can (and has) led some economists to make errors. So, we think of the corporate profits tax as being kind of like an excise tax on capital, as shown in Figure 3.

Figure 3

Notice that I’ve indicated here the reality that a significant fraction of the current capital stock is owned by foreigners. This is a big deal: gross U.S. liabilities to the rest of the world are around 1.7 times GDP, and around 35 percent of corporate equity is foreign-owned. As we’ll see in a minute, it matters for the welfare analysis.

What happens if we cut corporate taxes? We reduce the size of the corporate tax wedge, which brings in more capital from abroad and raises GDP. But it doesn’t raise GNP – the income of domestic residents – by the same amount, for two reasons. First, the additional capital doesn’t come free: we have to pay foreigners for the use of the additional capital (or get less income from investments abroad if it’s U.S. capital coming home.) Second, we pay a higher rate of return on the foreign capital already here. So net international investment income falls, offsetting at least part of the rise in GDP. In fact, the fall in investment income could be larger than the rise in output, so that national income actually falls.

Figure 4 tells the slightly intricate story, for a small change in the tax rate (so we can ignore triangles):

Figure 4

The lower tax rate shrinks the wedge, leading to a higher capital stock, lower pre-tax rate of return, and higher wages. The green rectangle at the top is the part of the tax cut that’s passed through to increased wages. As long as the supply curve for capital is upward-sloping, it also leads to higher after-tax returns to capital, with the gains partly accruing to domestic investors, partly to foreign investors. These gains are offset by a loss of revenue.

The possibility of overall gains to the U.S. economy comes from the fact that we started with a wedge: the rate of return on investment, equal to the pre-tax return on capital, was larger than the cost of capital from abroad, equal to the after-tax return. So, bringing in more capital produces a net gain equal to the change in the capital stock times that wedge – the yellow rectangle at the right.

Notice, however, that this is a lot smaller than the rise in GDP, which is the whole pre-tax return times the rise in the capital stock. Since the initial tax rate was 35%, the gain to the U.S. should be only 0.35 times whatever gain we get in GDP.

And that’s without taking into account the extra payments to foreign capital already here – the red rectangle at the lower right. Back of the envelope calculations suggest that once we take that into account, any net gains are very small, and maybe negative.

One way to think about all this is that because the U.S. is a big player in world capital markets, and already effectively employs a lot of foreign capital, we effectively have considerable monopsony power in world capital markets. When we cut corporate taxes, we end up attracting more foreign capital but paying the capital we already employ more. This analysis shows that it is not at all clear that the cut in corporate tax rates works in our favor, which makes the case for the tax bill just enacted look remarkably weak.

Andreas Kakolyris
January 30, 2018

On November 15, 2017, the City University of New York Graduate Center and the Stone Center on Socio-Economic Inequality co-hosted a presentation by Richard Reeves, Senior Fellow at the Brookings Institution, on the topic Dream Hoarders: Is the Upper Middle Class Leaving Everyone Else Behind The presentation focused on the widening gap between those in the top quintile of the income distribution and the remaining 80 percent and was based on Reeves’ latest book Dream Hoarders: How the American Upper Middle Class is Leaving Everyone Else in the Dust, Why That is a Problem and What to Do About It. The presentation was followed by a panel discussion with panelists Janet Gornick, Paul Krugman, and Leslie McCall of the Stone Center and Miles Corak of the University of Ottawa (who will be joining the faculty of the Graduate Center Economics Program in January).

Reeves opened the event with a summary of the key points in his book. He argued that the United States has a class system that, unlike the United Kingdom, is not widely recognized. Class consciousness can help the members of a society become more aware of class divisions and create more political room for tackling inequality. A second point is related to the more traditional division between the top one percent of the income distribution and the bottom ninety-nine percent. The author claims that the focus of the inequality debate on this gap is unhelpful and allows people belonging even to the 99^th percentile of the income distribution to believe that inequality is the fault of rich people, more specifically, of an ambiguously defined set of people; the people who are richer than them. In his work, Reeves defines the upper middle class as those in the top quintile of the income distribution. He emphasizes the important role of education in replicating class inequality and the sense of entitlement and the hoarding of opportunities by those in this upper quintile, including exclusionary housing zoning, legacy admissions, and internship opportunities. He stresses the need for change in the U.S. political culture that allows a system of entitlement at the top of the society. Reeves uses the example of the squelching of the attempt made by President Barack Obama to limit the tax benefits of a savings plan (520 plans) that helps families pay for the cost of college as an illustration of the political power of the American upper middle class. This group of people, which is in the top quintile of household income, is well organized and numerous enough to be a serious voting bloc and able to control many critical institutions. In his concluding remarks, Reeves spotlights the dimensions of well-being that play a role in class reproduction, among them wealth, health, parenting, life expectancy, neighborhood, and education.

Following the presentation, panel moderator Janet Gornick raised a number of questions related to the zero-sum framework where in order for someone to win, someone else has to lose. Whereas Gornick agrees with the problematic focus on the top 1%, she expresses her concern regarding the right place to draw the fault line and whether the top quintile is the basis of the “elite” group. She also suggests more attention should be given to the intra- and inter-generationally absolute income mobility, and how to tackle class inequality and move the framework from a zero-sum game. The expansion of the middle class, defined as those whose income falls in a band around the median, would make a contribution to this end. In addition, she raises the issue of whether there are policies that could support the increase in the share of households whose members enjoy the other “positives” associated with the top fifth, such as access to quality health care and education. She also emphasizes the large difference in the United States compared to other countries between the 20^th and 80^th percentiles of the income distribution.

Miles Corak presented data on the issue of the relationship of dream hoarding and inter-generationally income mobility. He presents geographically disaggregated income mobility data that show that in communities where the probability of being born in the top quintile of the income distribution and staying there are high, it is more likely for poor people to become rich. On the other hand, in communities where the inter-generational cycle of poverty is high, we observe that is really hard for poor people to become rich. The challenge is really how to break out of the bottom of the distribution. He also brought up the issue of changes in peoples’ behavior resulting from the observation of groups of people who are much better than them as well as groups of people who are much lower than them. As the last point, Corak wonders whether the political agenda proposed in the book is utopic, for example, is there a political program that could support the people of upper middle class to not only fight for the best for their children, but also to have their energy and drive help others.

Paul Krugman addresses the issue raised by Gornick about the right setting of the fault line that would define an “elite” group in the society. He doubts the existence of such a line due to the growing inequality between any two points of the income distribution and raises the question of whether the group of people from 80^th to 99^th percentile could be considered as a unique social class. He presents data that show a strong pulling apart of the income distribution at the 99^th percentile, and above, and also expresses some doubts about the political dominance with an example showing that the current tax legislation increases the relative amount of taxes paid by dream hoarders.

Leslie McCall sheds more light on the political dimension and characteristics of the upper middle class. She agrees with the expansion of the political focus to a broader group than the top 1%, and proposes to shift attention from the white working class to the middle/upper class, that according to her is the real impediment to greater equality. McCall also proposes the political agenda to be focused on opportunity-enhancing policies rather than general tax and transfer policies. She concludes that the reduction of market inequality would reduce economic anxiety that feeds dream hoarding.

Reeves made several points in response to a number of the issues raised by the panelists. First, he continues the discussion about the answer as to the appropriate measurement of the inequality gap. He refers to a graph used by Krugman which shows that, although the average annual growth of income for the 80^th percentile is roughly equal to the average, the pulling apart of the distribution starts there. Reeves notes that Corak’s comments showing the important features of geographic inequality is very interesting and takes an interesting perspective, as presented in the book, on the zero-sum framework.

In a follow-up comment, Krugman reiterates a point made by other panelists that extreme inequality as observed for income, access to health or access to good education create a war feeling in our society. Thus, the hoarding of the dream can be thought of as a reaction to the extreme inequality of the society in that the alternative for not hoarding the dream can be costly.

Reeves closed the event by taking questions from the audience.

The Economic Studies Group
November 30, 2017

The recovery of activity following the Great Recession got off to a slow start compared to previous cycles. The recession was characterized by deep declines in output (GDP) and the largest increases in the unemployment rate since the 1930s, and it wasn’t until six years into the recovery that the level of aggregate real GDP returned to its potential. In this post, we look at the growth of output in individual industries since the recovery began. While the performance has varied, many industries have also shown a relatively weak recovery, particularly when compared to previous cycles. The analysis indicates that industries are in quite different situations as the economy enters a period of rising interest rates.

The Aggregate Economy

The figure below plots an index of annual real GDP from the formally designated start of the recovery in 2009 (year 0 in the chart) to 2016 and, for comparison, a similar index of real output in the first seven years of previous recoveries. The figure shows that seven years since the downturn ended real GDP is up only 15 percent from the trough. This growth is relatively weak compared to the recovery from the early 2000s recession and to an average of the recoveries in the 1980s and 1990s.

Data Source: Federal Reserve Bank of St. Louis and ESG Calculations

All cycles are different, of course, and the recent recession was preceded by a buildup of unsustainable levels of debt, particularly housing debt, and the subsequent need for a deleveraging of business and household balance sheets. The period was challenging for policy as well. The Federal Reserve (Fed) initially turned to reductions in the Federal Funds rate in an effort to stimulate the economy through the transmission of these lower rates to other short-term market rates. Despite the Federal Funds rate in the range of 0.0 to 0.25 percent, the economy failed to pick up significantly. The Fed turned to what has been described as an unconventional monetary policy, quantitative easing, whereby it purchased bonds, mainly U.S. Treasury and housing agency securities, to help smooth the operation of credit markets. This recovery was notable for the lack of stimulus through fiscal policy. Stimulus packages were passed during the downturn in 2008 and 2009, but fiscal stimulus was far less expansionary in the recent recovery compared to historical averages.

By the end of 2015, the Fed began to increase the Federal Funds rate and by 2017 the economy was showing a number of signs of strength. But the deep recession and slow recovery had been experienced to different degrees across industries.

Industrial Performance

Below we show the recent output growth rates in the recovery (2009 – 2016) in a group of 19 industries that together make up the economy. The industry definitions and the corresponding production data are both based on the NAICS (North American Industry Classification System). The list of industries and the growth in their output over the past three years are shown in the figure below.

Data Source: Federal Reserve Bank of St. Louis and ESG Calculations

The top performers include the Information industry, which consists of both traditional publishing firms and electronic publishing outlets as well as firms in the relatively newer areas of data hosting and web service portals, the business-oriented Professional, Scientific and Technical service industry and the more consumer service-oriented Arts and Entertainment industry. Modestly above-average growth is seen in the Healthcare and Social Assistance, Retail Trade (which includes traditional department stores as well as electronic shopping) and the Accommodation and Food Service industries. Weaker growth is seen in the Manufacturing, Educational service and Finance and Insurance industries, and Government.

How does the recovery in these industries compare with past recoveries? To answer this question we select several industries. The figures below use the same technique used in the graph of GDP to examine the relationship of the performance of these industries in the current recovery to past recoveries.

Data Source: Federal Reserve Bank of St. Louis and ESG Calculations

The figures show that while the recovery of output in the Professional, Scientific and Technical Services, Accommodation and Food Service and Retail industries was quite strong and roughly on par with the 2000s recovery, in all cases output growth was considerably weaker than in the combined recoveries in the 1980s and 1990s. After a slow start, the growth of output in the Healthcare and Social Assistance industry has matched its growth in the 1980s and 1990s but it is still less robust than its recovery during the 2000s. Both the Manufacturing and Finance and Insurance industries are experiencing the weakest recovery of any of the past cycles.

Going forward, interest rates are projected to rise and the monetary accommodation through quantitative easing to be reduced. How vulnerable these industries are to a monetary tightening will depend on their exposure to a variety of factors:

• The level of corporate debt: Higher interest rates carry risks for industries as they raise the cost of new borrowing as well as the cost of existing debt service thus leading to pressures to curtail operations and put off investments.
• Consumer spending. Higher rates can affect consumer spending as the availability and terms of consumer finance are key factors, particularly for relatively big-ticket items such as automobiles and other durable goods.
• Housing demand. Mortgage interest payments and availability of credit are a key influence on housing affordability.
• International trade and exchange rates. In theory, higher interest rates on U.S. assets increase the demand for dollars and lead to a dollar appreciation. As a result, exports become more expensive in dollar terms abroad and, correspondingly, imports become less expensive to U.S. residents. These effects can be particularly important for U.S. manufacturers of consumer and capital goods that face stiff competition in foreign markets, as well as industries related to travel and tourism.

Thus, we anticipate that sectors such as construction and manufacturing that require big projects consisting of purchases of equipment, machinery, and land will be vulnerable to interest rate hikes for two reasons. First, the cost of undertaking such projects will be higher. Second, the demand for their products depends on consumers’ borrowing that will be impacted by high rates. Manufacturing also has a large export component that is likely to be hurt by potential loss of competitiveness. Sectors such as retail and services sectors are unlikely to be severely affected by interest rate changes since these sectors neither invest in costly long-term projects nor have a demand that require consumer borrowing.