In 1979, I was working in New York City as an economist at Merrill Lynch. One day, the chairman of the firm, Donald Regan, descended from his 55th-floor executive suite to the 32nd-floor offices of Merrill Lynch Economics, where we, the macro-model scientists, toiled away. Regan had a special assignment for us.
Back in 1979, the top federal income-tax rate stood at 70 percent. Regan had been approached by House Rep. Jack Kemp and Sen. William Roth to produce some credible economic evidence favoring a drop from 70 percent to 50 percent in that top tax bracket. We, in the economics department, complied and simulated the results in our huge and expansive (at the time) macro econometric model.
The results were not especially positive. One of the most glaring features of the proposed tax cut was a mushrooming of both deficits and income inequality. When we had “finished” our work, the chairman came down to review the results.
In retrospect, I can plainly discern that I was clearly a callow and naive economist. For when our chief macro-economist, the well regarded Gary Ciminero, showed the results to Regan, I expected that the proposed Kemp-Roth tax plan would be shelved or redrawn. To my unsophisticated surprise, Regan flew off the handle, punctuating his protests with some classic, time-tested expletives, and commanded that we come up with better data — data suitable to support the proposed tax cut.
Christian doctrine holds that all humans must receive baptism by proper priesthood authority for entrance into the kingdom of the Almighty. I suppose that I received my baptism into the world of distortionary economic analysis that day on Wall Street. Needless to say, I was not pleased to be received into that particular kingdom, and left shortly thereafter.
Since other models verified that this particular tax cut would drive up federal deficits, a savior (or perhaps anti-Christ — you decide) appeared on the scene in the form of Arthur Laffer. He is credited with concocting the so-called Laffer Curve, an economic argument which we on the 32nd floor referred to as the “Ha-ha Curve.”
The curve or chart is an upside “U” that suggested that as tax rates go down, tax receipts rise. How does this happen? The “theory” is simple. A tax cut is so stimulative to the economy that even though tax rates are lower, tax receipts rise through increased economic activity brought about by the tax cut itself. Brilliant marketing! Faulty economics!
I have reason to put quotes around the word “theory.” As in any science, economists look at the world, make observations, and then create and test theories to explain what they see. Unfortunately, the Laffer Curve was and is not a theory of this sort. Economists have little to no evidence of the Laffer phenomenon. Instead of observing reality and originating an explanation, Laffer created a theory to promote a political agenda.
We have been suffering from his work ever since. Although mainstream economics has countless times examined in detail the Laffer Curve and rejected it, and although the idea that lower tax rates will produce greater revenues has been shown to be nothing more than a myth, this zombie myth rises from the dead each and every time our legislators wish to lower taxes but need to squelch the screams from deficit hawks.
But not only do we have the specific problem of the Laffer Curve to confront as economists, we also must contend with the growing tendency to present sloppy scholastics that fail to enlighten but are produced to promote a policy that would otherwise be rightfully rejected.
A more recent case in point concerns the proposal to lower the corporate tax rate from 35 percent to 20 percent. I should point out that this could actually be a very good idea within certain contexts, which we can examine another day. But for now, let us examine what President Trump’s economic team has suggested.
As mentioned last week, the team has sold the corporate tax cut as a means to give to workers from $4,000 to $9,000 per annum. They assume that for every one dollar of tax reduction, workers will receive $5.50 in higher wages. This is remarkable. This is amazing. This is fantastic. This is unlikely. Someone on the council is missing their home button.
Many tax economists have weighed in on this particular tax cut. The mainstream economic community is united on the topic. These are the main points to note:
For middle income wages to rise, four things need to happen. First, the lower taxes on profits must bring a huge increase in capital to the U.S. from abroad. Second, this influx in capital must be invested in plant and equipment. Third, the new plant and equipment must be such as to increase worker productivity. And finally, workers must receive the value of their higher productivity in the form of higher wages.
How likely are these? First, U.S. corporations are generally sitting on large cash piles, which they have not invested. They apparently have not found profitable ways to expand. So having an influx of more cash is unlikely to result in more actual investment spending. If it miraculously does, the investment spending is more likely to be used to buy labor-replacing equipment such as high-skilled robots. This will not help middle-income wage earners.
But if by some fluke of nature new investment is made and investment spending does, in fact, raise workers’ productivity, how likely is it that workers actually receive that value? For the past 35 years or so, corporate leadership has demonstrated the ability to hold down workers’ pay increases and capture productivity gains in the form of higher executive payouts.
And economists have likely helped the process to some degree. We are the guys who have focused so much attention on cost-of-living increases, which keep wages even with inflation but leave wages lagging behind productivity gains. For decades, wages have become decoupled from profits as well as advances in output per worker.
Two final caveats might be of interest. First, in reality, the profits tax has been shown to be almost entirely paid by shareholders. If the tax is reduced, shareholders will receive almost all of the reduction. Given that roughly 35 percent of our equity market is held by foreigners, a cut in the profits tax will help make foreign shareholders great again.
Second, if the tax cut does bring a large influx of offshore capital, that flow of capital will bring an increase in the trade deficit to balance the flow. That will also help make foreign manufacturing greater than ever.
By the way, the Kemp-Roth tax cut became law in 1981. The Ha-ha Curve trumped the facts. Next week we move on.
(Marcus Hutchins is a former economist, treasury-bond arbitrage trader, and hedge fund manager. He retired to Southport in 1997, where he resides with his wife, Andrea, and youngest daughter, Abbey. He welcomes feedback at email@example.com.)