In defense of the corporate tax cut

Savannah Guthrie, interviewing Paul Ryan on the Today Show, posited for a gotcha with “What they [CEOS] are planning to do is stock buybacks, to line the pockets of shareholders.”

Peggy Noonan, in an otherwise thoughtful column, did the same with: “Big corporations can take the gift of the tax cut … and do superficial, pleasing public relations sort of things, while really focusing on buying back stock and upping shareholder profits.” (Just how taking less of your money is a “gift” is a question for another day.)

They are wrong. Their statements are political. They have used the wonderful fallacy of composition, that actions of one company mirror actions of the economy as a whole. It also touches the  fallacy of “paper investments” vs. “real investments.” That distinction can apply to a company, but not to the whole economy.

Suppose company 1 gets a tax cut

but it doesn’t know what to do with the money, on top of all the extra cash the company may already have, as it doesn’t have very good investment projects. It sends the money to shareholders.

What do shareholders do with it? 

They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and sends it to that company.

One company’s “cash” is a short term loan to another company, which the latter uses it to make real investments.

Every asset (paper) is also a liability, backed by an investment. We must track the money

We have to ask “OK, and then what do they do with the money?”

  1. If company 1 doesn’t have any good investment ideas, even after the tax cut, and company 2 does have good investment ideas, made even better after the tax cut, the economy needs to get money from company 1 to company 2
  2. Company 1 could buy company 2
  3. Company 1 could invest in company 2 by buying its stock or buying its debt
  4. Company 1 could return money to shareholders, and the shareholders could invest in company 2

Investment in the whole economy has nothing to do with the financial decisions of individual companies

Investment will increase if the marginal, after-tax, return to investment increases

Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by “giving companies cash” which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake.

But, there are second-order effects and frictions. Perhaps due to “agency costs,” internally generated cash is a cheaper source of investment funds than cash obtained by issuing stock or borrowing. In that case, financing decisions do matter.

Good economic analysis always starts with the relevant budget constraints. Ms. Guthrie nor Ms. Noonan had such a second order financing friction in mind.

Returning cash to investors who quietly put it in better companies is economically efficient

The end?