Untying the Gordonian knot

First of all, today’s top Globe story on corporate income tax cuts not leading to increased investment is a nice example of “you heard it here first”, so a big pat on the back to Relentlessly Progressive Economics. As we like to say: tomorrow’s conventional wisdom, today.

I want to take issue with Stephen Gordon’s response, an effort to torture the data into his preferred conclusion: that lowering corporate income tax leads to increased investment. Because the straight-up data move in the opposite direction, this is quite a challenge, and Gordon uses two approaches: one is to re-do the calculation based on real numbers for GDP and investment. This requires two separate price deflators to be calculated and applied to the actual data. There are big methodological issues about how those deflators are calculated, and whether that is an appropriate comparison.

Moreover, the point still stands that Canadian corporations are not re-investing a large chunk of their profits, and it would be good policy to force that stockpile back into increased demand through increased investment or failing that taxing it and using the proceeds to build infrastructure and invest in services.

Second, Gordon claims a consensus in the empirical literature that he is right, based on efficiency arguments and incidence arguments. In terms of efficiency, I think it is fair to assume that ceteris peribus, lower CIT rates would lead to increased incentives for investment — what is at issue is the magnitude of response. And it is also true that Nordic countries, as open economies like Canada, have kept CIT rates relatively low in order to prevent capital flight. For Gordon, it leads to an iron-clad ideological position that Canada must cut taxes; for me, I think it is more about making sure that corporate taxes are not way out of line.

Is there reason to believe that if Canada further lowers its CIT rate, it will be rewarded with higher investment? Simply put, no.

First of all, there are lots of other things that influence corporate investment. The single most robust finding in the empirical literature is that strong demand drives investment. That is, businesses invest when the prospect of making a big return is present, and that means people have to be out there spending money; if people are not spending, lower CIT rates are going to have a negligible effect. Most of the time, these demand conditions totally swamp the micro-efficiency gains that the literature is honed in on.

But even on the supply side of the equation, there are many other things that affect business investment. Access to resources is one. If you are a multinational oil and gas company, Canada is one of the only places in the world that you can invest because we have the resources and we allow foreign investment – increasing taxes in this sector back to 2000 levels is not going to drive away investment. Another is access to markets — Wal-Mart can only make money in Canada by investing in Canadian stores. Another is access to skilled labour — which requires public expenditure. Another is the cost of electricity, a cost factor that may be even more important to bottom lines than CIT rates, especially for energy-intensive production practices — but economic models never consider it. Another is value of the Canadian dollar (in his real GDP versus real investment comparisons, Gordon may be conflating CIT cuts with a higher dollar that makes imported machinery and equipment cheaper).

Corporate investment is in reality a lumpy and risky process. You can develop a business plan with scenarios, but you don’t really know how much money you are going to make until you do it. And then you pay tax on the proceeds if you are successful. It is really that simple, but by assuming perfect markets, we get caught up in all of this supply-side nonsense. Perhaps there is an example of a company for which lower CIT was the difference between investing and not investing — I’d like to hear that anecdote — but in pursuing that marginal investment through across-the-board tax cuts we provide windfalls to all the other companies that already made investments based on the higher tax rate.

We also should consider what sectors of the economy are attracting investment, rather than look at broad macro aggregates. Because of looming climate change, more investment in the oil and gas sector is not what the world needs, but that seems to be what Canada is primarily delivering with its “low tax plan for jobs and growth”. This is true, even if you buy the Gordon’s argument about lower CIT.

On tax incidence, Gordon argues that if Canada were to have higher than average CIT rates, then the portion above the “world rate” would be paid by passing on those costs to labour or consumers. Plausible, yes, and I’ve entertained those ideas myself. But really a moot point since Canada’s CIT rates are below the US rate and in the lower part of OECD countries (most of which are clustered pretty tightly together anyway). In any event, these studies (especially quasi-empirical methods like CGE modeling) are pretty suspect, and seem to derive “conclusions” strongly linked to their underlying assumptions.

A final thought: should Canada be playing this game of peeling off layers of clothing in order to attract foreign suitors (no matter how dirty their deeds)? I’m not knee-jerk opposed to foreign investment but our policy elites have immersed themselves in a colonial mentality that only by attracting foreign investors can jobs be created for Canadians. I disagree with this and would like to point to Crown corporations and public enterprises as alternative vehicles for production, as well as a host of industrial policies used by European and Asian economies to create industries where economists would say they have no comparative advantage. Foreign investors are welcome to join this party, as long as they pay a reasonable share of taxes.