One problem with tax cuts in the current environment is that it's hard to commit to making them permanent. Even John McCain's economists think that overall tax rates have to go up --- due to the large entitlement spending that our government has to do over the next 30-40 years. And if businesses expect tax rates to go back up after the current crisis is over, then they won't respond (as much) to a current tax cut.
Here's some present value math on that:
Businesses decide whether to invest by following the net present value rule. Consider a project that costs $7.5 this year, but will pay $1 in revenue annually starting next year. If the tax rate on those revenues is zero and the interest rate is 10%, then this project has a positive net present value.
The present value of a $1 perpetuity is $10, and so the present value of $10 exceeds the present cost of $7.5.
If the tax rate is 30%, then this is a negative NPV investment --- the after-tax NPV is $7, which is less than the cost.
If we permanently cut the tax rate 20%, then the the after-tax NPV rises to $8, and the project is positive NPV. The firm will invest today, which will create jobs and stimulate the economy.
But what if the owner of the firm doesn't think the tax cut will be permanent? In particular, what if the business owner thinks the tax rate will be 20% next year and the year after, but will return to 30% after that?
Then the after-tax NPV of the investment is $7.17. So no investment!
What this means is that expectations of future tax rates matter a lot for the stimulative effect of tax cuts.
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4 comments:
What about borrowing the 7.5 and using debt payments as a tax shield? Doesn't that lower the effective tax rate? This assumes that cash can be borrowed.
Debt is a tax shield, but if firms could perfectly shield income from taxes, then the corporate tax rate wouldn't affect investment at all. There is evidence that at least some firms pay at least some tax. So cutting the tax rate has the potential to boost investment, and expectations of future taxes matter.
What tax cuts does do is avoid government rent seeking activities on the large sums of "Free" money. It also seems that there is still a lot a debate if Keynesian stimulus has any real demand creating ability. Don't businesses understand where the money is coming from and therefore know that is not sustained. It seems difficult to justify increased hiring and more capital expenditures if you don't trust the increased demand will continue. Is there any way to resolve that? I don't think that a system built on trying to fool people will be very successful.
I would never argue that governments spend money efficiently. They don't! And this is why monetary policy --- which works by boosting private investment in firms --- is usually the best way to manage the business cycle. But unfortunately we don't have that option right now.
I wouldn't say that the stimulus bill is designed to fool anyone --- and I agree that any policy based on fooling people is likely to fail.
Firms surely do anticipate that government spending is on, say, infrastructure is short run. But business cycles are short too --- the typical recession lasts only 18 months. (Wishful thinking: Only 5 more months?) I think the idea is to use the stimulus to boost actual short-run demand, which will mean unemployment will not rise as much, which will mean that growth will resume faster.
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