Accounting Versus Economics

Trump is moving ahead with his tax plan.  Strategically, it’s smart to do this now because everyone in America just paid taxes.  I guarantee that no one will report it correctly no matter what their political bias.  People look at tax cuts with the green eyeshade of an accountant.  What do I mean by that?  You will hear statements like, “How are you going to pay for that?”  Or, “This tax cut is paid for by cuts in X.”

In budget math, it might be like this:   Last year, we had a tax rate of 35% and realized $XXXmm in revenue.  If we decrease the tax rate to 15%, we won’t realize the same amount of revenue.  The budget people just imply a 15% tax rate on the same numbers as the 35% tax rate.  On spending, they do the same thing. If something was budgeted to grow by 5%, and it’s cut to grow by 2%, they scream.  Spending is still growing.

Intuitively know that accounting tax math is incorrect.

Taxes are incentives for behavior.  If I decrease a tax, I get more of that behavior.  If I increase a tax, I get less unless the demand for that good is inelastic.  Cigarettes, fuel, and other goods are examples of things that have relatively inelastic demand curves.

When tax rates are reduced, there are changes at the margin in behavior.  At the end of the day, more aggregate revenue will accrue to the government.  Revenue will make its way to the government through other means, like personal income taxes or social security taxes. It’s not a zero-sum game.

Corporate behavior is very elastic despite the rigidness of corporate cultures.  Dropping the rate to 15% from 35% will create a totally different set of incentives.  Internally, it will also create very different hurdle rates to undertake projects, do mergers and acquisitions, and bring cash back to the US from other countries.  The incentive to offshore and change a corporate charter to Ireland or another tax haven will be gone as well.

It’s important to remember that corporations do not pay taxes.  They aggregate them.  They charge a higher price for their goods and services with higher taxes and remit that higher price to the government.  If we decrease corporate taxes, we won’t see prices drop immediately.  But, we will see more competition that long term could lead to lower prices.

I don’t think the point about competition is stressed enough.  When taxes drop, competition heats up.  It allows new entrants to markets.  Entrenched competitors bitch about high taxes but know they are a barrier to entry.  As Milton Friedman observed, when taxes are lowered it returns freedom to the marketplace and decreases centralized government influence.

Corporations will have decisions to make internally on their new found producer surplus.  They could pay their employees more, or increase salaries to attract better talent.  They could pay a dividend to shareholders.  They could plow the windfall back into their businesses and expand.  Or, they could just simply drop prices and turn over the surplus to consumers.  Odds are it will be a combination of all of them.