It turns out that capital has become a commodity and much of it isn't even used. The big question is how to activate it if we really want to improve economic performance.
We roughly know what trickling down is; it's the idea that slashing taxes and regulatory burdens on job creators (rich investors and companies) will increase the incentives to invest and hence produce higher economic growth.
While there is an undeniable logic, there isn't actually much evidence to support that claim:
- Reagan's tax cuts are often held up as prima facie evidence, but it's often overlooked that inflation interest rates tumbled fast from record highs (15%+) and growth in the 1980s wasn't actually higher than in the 1970s.
- Bill Clinton's tax increases didn't tank the economy (as many predicted). In fact the opposite happened.
- Bush's tax cuts in the early 2000s failed to unleash the economy and their partial expiry a decade later failed to derail the economy.
- It's too early to say anything on the Trump tax cuts (see previous article).
- On a state level, there is the infamous Kansas example where tax cuts went horribly wrong and had to be partly revised.
Serious research isn't much friendlier either:
The second report (the CRS one) was actually withdrawn as a result of Republican pressure, something quite unprecedented.
One might wonder why that is. Here are a few thoughts:
- Taxes (like interest rates) do not matter all that much unless they are at extreme levels. That is, they made more sense when marginal rates were much higher, or in places like Italy, but not all that much in present day US.
- Few corporations were actually paying the statutory 35% corporate tax rate.
- Corporate tax cuts are overwhelmingly going to share buybacks, which produce little overall benefits for the economy.
But here is another interesting thought, capital is simply not scarce but abundant. Here is Bain, the inventor of this concept:
Bain's Macro Trends Group estimates that global financial capital has more than tripled in the last three decades and now stands at roughly ten times global GDP. Bain suggests this growth will continue, albeit at a slower rate, for the foreseeable future as a result of: sluggish economic growth; maturing financial markets in emerging economies; and an expanding number of "peak savers" - those 45-to-59 year-olds who are critical in determining the level of savings (vs. consumption) in the global economy.
"Taken together, these factors lead us to conclude that for the balance of the next decade - at least - markets will continue to grapple with superabundant capital," said Karen Harris, managing director of Bain's Macro Trends Group. "Too much capital will be chasing too few good investment ideas for many years, requiring a fundamental shift in how companies implement their business strategy and manage capital."
Indeed. The tax cuts, Trump's tax cuts especially, free up lots of money to corporations and expect that they will spend this on things like capital equipment and wages, boosting economic growth.
But what if US corporations already had access to all the capital they wanted to invest and then some. This is actually pretty likely:
- Profits are at record highs
- Corporate cash balances are at record highs
- Interest rates are still close to record lows
The whole problem with the trickling down tax cut approach is that it assumes that capital is scarce. It isn't.
So capital isn't scarce; corporations were awash in it. Here is venture capitalist Nick Hanauer:
The problem isn't that corporations and investors don't have enough after-tax cash; it's that they're not productively spending or investing the cash they already have.
While corporations weren't capital constrained (Hanauer also invokes Bain & Company's thesis of capital superabundance), corporate tax cuts still increase the profit rate of investment projects, which should boost investment at least a little, so it's not entirely nonsense.
However, if the effect of interest changes is anything to go by (investment is rather interest rate insensitive), not too much should be expected of this.
Money has become much less productive. A dollar in circulation changed hands on average 17x before the financial crisis, but this has been reduced to just 5x after it.
That is, a dollar in circulation funds about 70% less economic activity than it used to 10 years ago, and Hanauer cites a St. Louis Fed blog post blaming this on increased private sector hoarding.
Hanauer blames this on a massive shift in income from low savers to high savers. And indeed, there is something to be said for this. Profits as a percentage of GDP has doubled from 5% 40 years ago to 10% today, and wages have fallen by the same 5% of GDP.
Within wages, there has been a massive shift to the top:
Here is Hanauer:
Over the same period, the top 1 percent's share of total U.S. personal income has more than doubled, from under 9 percent in the mid-1970s to 22 percent in 2015-another $2 trillion a year that used to go to people like you, but now goes to rich people like me. As a result, the top 0.1 percent's share of total household wealth has more than tripled, from about 7 percent before Reagan took office to about 22 percent today. In fact, the top 0.1 percent (really rich people like me) now own more wealth than the bottom 90 percent of Americans combined. And this gets to the real cause of our nation's chronically slow growth in wages, jobs, productivity, investment, and output: our accelerating crisis of economic inequality...
It is likely that the diminishing returns on tax cuts for those who don't face capital nor liquidity constraints are likely to be induced into much additional spending or capital expenditures.
And another problem is that corporate tax cuts go overwhelmingly to share buybacks, which is liable to add to inactive capital, rather than diminishing the problem.
How to activate dormant capital?
We see three approaches:
- Classical trickle down incentives in the form of tax cuts
- Tax and spend, or trickle up
- Changes in corporate governance
We have already discussed the first effect where lower tax rates increase the incentives to invest, but this might be partly or entirely cancelled out by most of the funds going to buybacks, which could very well add to the stack of inactive capital, rather than reduce it. This approach suffers from the basic assumption that capital is scarce. It isn't.
Hanauer himself argues that top tax rates have to increase in order to activate the non-productive capital that is accumulating dormant on corporate balance sheets and private bank accounts.
That would be an interesting experiment, and in principle, there seems to be a good deal of logic to it. Hanauer:
Cutting our taxes will make us richer, but it won't incentivize me or my venture capital partners to spend or invest more than we already do. What's holding us back isn't a shortage of cash, but rather a shortage of demand.
But the outcome would be very much dependent how it is used. Hanauer:
Raise taxes on the rich, and almost anything the federal government does with the revenue will pump more money through the economy than what the wealthy are doing with their hoarded cash today. Tax the rich to put money back in the hands of the American people through middle-class tax cuts, and corporations will expand production and payrolls to meet the resulting spike in consumer demand. Tax the rich to invest in roads, transit, bridges, health care, schools, and basic research, and we will create millions of good-paying jobs while building the physical and human infrastructure on which our collective prosperity relies.
If it somehow can be activated into public investment in infrastructure, education and R&D, stuff that has historically provided excellent returns, there could be something in it.
But a substantial part of the political class in the US doesn't believe in public solutions, or any trickle up; they are still firmly rooted in trickle down, so unless there is a political earthquake, this isn't likely to materialize anytime soon.
It doesn't necessarily have to be tax and spend; it could also be to make the tax code a little fairer, that is, reducing inequality. Here is Hanauer again:
Let's treat all income equally. For example, eliminate the cap on payroll taxes, apply it to all income, and then slash the rate, increasing the spending power of most Americans. Rich people like me make most of our money from dividends and capital gains, and it's just plain crazy that I pay a lower tax rate on investment income than a truck driver or schoolteacher pays on their hard-earned wages or a small businessperson pays on her hard-won profits.
He also noticed that corporate tax revenues have steadily declined as a percentage of GDP despite record profits. Indeed, the effective corporate tax rate has gone down significantly even before the latest tax cuts:
And indeed the steady decline in corporate tax receipts as a percentage of GDP:
Part of this is due to the emergence of corporation like entities that do not pay tax like pass-through entities, real estate investment trusts, and limited liability companies. Another part is due to the internationalization of US business.
There is actually some evidence from the OECD that reducing inequality boosts growth. From its 2014 study Trends in Income Inequality and its Impact on economic Growth:
Here is the explanation (our emphasis):
For each country, it also reports the actual rate of growth and a counterfactual figure, obtained subtracting the estimated impact of inequality from actual growth. This latter figure is to be interpreted as the growth rate that would have been observed in the country had inequality not changed (and holding all other variables constant). Rising inequality is estimated to have knocked more than 10 percentage points off growth in Mexico and New Zealand. In the United States, the United Kingdom, Sweden, Finland and Norway, the growth rate would have been more than one fifth higher had income disparities not widened.
That's roughly 9% GDP growth that disappeared, a very large effect, even if over two decades. However, this is just one study (which finds most negative effect in declining incomes at the bottom which leads to less human capital formation, not focusing on "dormant capital"), which is a little too less to base very firm conclusions on, but nevertheless.
In today's American economy, much of executive pay has been made contingent on stock performance, with predictable results:
And most of the spoils of the company are going to shareholders:
The simple fact is that these beneficiaries are, on average, likely to be more wealthy and have significantly higher savings rates:
So this arrangement is likely to add to the stock of dormant capital, not activating it.
One way to deal with this possible increase in dormant capital is to let more people share in the wealth more evenly within corporations. This could be done for instance by making the compensation of most employees more dependent on corporate performance.
Or better still, on performance measures over which they can exert some control, like efficiency increases in a process known as gain-sharing. In that way, not only more of the dormant capital is activated as more of it ends up in the pockets of people who don't save 40% of their income, but also productivity itself might even get a (modest) boost.
There are lots of other ways, part of corporate profits could be set aside mandatory for stuff like employee training, apprenticeships, pensions (to the extent that this doesn't already happen), education vouchers or stuff like maternity leave, enabling more women to work.
Tax cuts for investors and corporations (job creators) aren't likely to do much because most of these are not capital constrained; in fact they have plenty of capital or access to capital at relatively low cost.
Once you realize that capital is not scarce but abundant, the problem changes in how to activate this growing stock of dormant capital. Here we briefly discuss three ways:
- Trickle down tax cuts will increase the incentives to invest but likely add to the stack of dormant capital.
- Trickle up tax and spend could activate much of dormant capital but only if it's well spend on stuff like fundamental research, which has provided excellent returns in the past.
- Changes in corporate governance could also be enacted as to activate more of the dormant capital.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.