Corporate Taxes and Jobs: Myers Discovers the Business Cycle

I have reviewed Jayson Myers’ recent Canadian Manufacturers and Exporters report on corporate tax cuts, which I made public yesterday.

Proponents of lower corporate taxes usually argue that these will help Canada compete with other countries in attracting internationally-mobile investment. However, as Myers admits, “over the past decade, reductions in Canada’s effective and average combined statutory corporate tax rates have had little observable impact on net flows of foreign direct investment into the country” (page 13).

Significantly, Myers does not claim to find any positive relationship between lower corporate tax rates and investment, employment, innovation, growth or incomes. All of his numbers are based on positive correlations between after-tax corporate profits (or cash flows) and these variables.

It is certainly possible to measure corporate tax cuts as increases in after-tax profits. However, as Myers’ own graph shows (page 15), changes in tax rates are not the main driver of changes in Canadian after-tax profits. A correlation with profits is not the same as a correlation with corporate taxes.

Profits and Jobs

Myers actually does not find a very close correlation between after-tax profits and employment (page 16), so he instead focuses on the unemployment rate (page 17). His summary mistakenly states, “Close positive relationships exist between: Canada’s unemployment rate and after-tax business profits” (page 3), implying that higher unemployment corresponds to higher profits. As noted later, “it is a negative relationship” (page 17).

This negative correlation is hardly surprising. During booms, profits go up and unemployment goes down. In recessions, profits fall and unemployment rises. Indeed, Myers’ graph of profits and unemployment looks like a graph of Canadian business cycles (top of page 17).

However, correlation is not the same as a causal relationship. It is always possible that a third factor – such as the business cycle – is driving both variables.

Even if there is a causal relationship, it is unclear which way the causation runs. Myers’ story is that higher business profits cause more hiring, which causes lower unemployment. But an equally plausible story is that lower unemployment causes more consumer spending, which causes higher business profits.

To manufacture his conclusion, Myers works back from profits to tax cuts and from the unemployment rate to numbers of jobs: “planned federal and provincial corporate tax rate reductions in 2011 and 2012 can be expected to: Lower Canada’s unemployment rate by 0.52 percentage points and boost employment by 98,800 net jobs” (page 4).

Cash Flow and Investment

Myers proceeds to apply the same “methodology” to investment as well as research and development, but changes the explanatory variable from after-tax profits to after-tax cash flows. Profits exclude capital consumption allowances, the amounts that business must invest just to cover the depreciation of existing assets. Cash flow is profit plus these allowances.

There is obviously a pretty strong connection between capital cost allowances and actual investment to cover depreciation. This connection is on top of the business-cycle relationship between profits and new investment. Hence there is an undeniable correlation between cash flow and total investment, but it has nothing to do with corporate tax rates.

Myers makes another notable admission in this area: “Canadian businesses have invested a declining share of after-tax cash flow in both new facilities and machinery and equipment over the past thirty years” (page 21). So, cash given to corporate Canada with no strings attached will not necessarily be invested here. Indeed, corporate taxes could be increased without cutting into the cash used to finance investment.

Magic Tax Cuts

Myers goes back to straight after-tax profits in examining overall economic growth, personal income and government revenue. Of course, all of these variables are subject to the same business cycle as unemployment and investment.

Based on the correlation among after-tax profits, growth and incomes, Myers argues, “The one percentage point reduction in the federal corporate income tax rate implemented in 2010 added 0.5% to Canada’s GDP last year and as a result can be expected to boost the personal income of Canadians by 0.4% or $4.7 billion” (page 28).

Since government revenues are based on GDP and personal income, he concludes that “Lower corporate income tax rates increase overall government revenues” (page 29). By comparison, the typical supply-side contention is that tax cuts increase government revenue until it reaches the Laffer Curve’s peak.

Myers’ claim is subject to no such limit. Anytime the public sector needs money, it can just give $1 to the corporate sector and watch it turn into more than $4 of additional GDP, which yields about $1.60 of tax revenue.

Unfortunately, most of that money would go to other levels of government. But I am sure a federal-provincial accord can be negotiated to put this perpetual revenue-generating machine into action!

Again, Myers’ report is not about corporate tax rates or their possible incentive effects. In his model, corporate tax cuts matter only insofar as they increase after-tax profits. Rather than implementing planned corporate tax cuts at an annual cost of $6.2 billion, Ottawa might as well just write corporate Canada a series of postdated cheques for $6.2 billion each.

Misleading Premises

Before the report starts making Voodoo economics look cautious, its opening section compares statutory corporate tax rates in Canada and other countries. Myers argues, in bold text, that “Canada’s combined corporate tax rate needs to fall to 25% simply to allow Canada to catch up with the rest of the world” (page 11).

However, his benchmarks are unweighted averages of the OECD and the whole world, which are artificially dragged down by small tax havens. As I noted years ago, these averages are appreciably higher when countries are weighted according to GDP. Canada was already in line with appropriately weighted OECD and global averages before the current round of corporate tax cuts.

Of course, the United States has a relatively high statutory corporate tax rate and the world’s largest GDP. But Myers contends that it has a lower effective corporate tax rate and, in bold text, that “Canada’s combined corporate tax rate needs to fall to 25% simply to allow Canada to remain competitive with the United States in terms of the percentage of profits that are actually left in the hands of business” (page 12).

However, his graph actually shows that effective corporate tax rates (i.e. revenues/profits) have been almost identical in the two countries, at least since 2000 (page 12). Canada’s effective rate jumped up in 2010, when the Department of Finance attributed “higher-than-expected corporate income tax revenues” to “exceptional one-time factors.” A one-year blip in revenue hardly makes the case for ongoing corporate tax cuts.