Yesterday I noted that most discussion of the growth effects of the Cut Cut Cut Act, such as they may be, focuses on the wrong measure. GDP might go up because lower corporate taxes will draw in foreign capital; but this capital will demand and receive returns, which mean that part of the gain in domestic production is offset by investment income received by foreigners. As a result, GNI – income of domestic residents – will rise less than GDP. And surely, as in Ireland with its leprechaun economy based on low corporate taxes, GNI is the measure you want to focus on.
Now, inspired by Greg Leiserson’s post on problems with the Tax Foundation model – the only one that shows significant growth effects from Cut Cut Cut – I think I can give an illustration of how much this might matter. It relies on a stylized version of the TF model, which is a model I don’t believe for a minute, so this isn’t a real estimate. But it’s a sort of proof of concept.
So, as Leiserson says, the TF model assumes that thanks to international capital mobility there’s a fixed after-tax rate of return capital must earn. Cut the corporate tax rate, and capital flows in, driving down the pre-tax rate of return by just enough to offset the tax cut.
The following figure shows the story. Here r* is the required rate of after-tax return, t is the initial tax rate, t’ the post Cut Cut Cut rate. MPK is the marginal product of capital curve. The tax cut leads to a capital inflow that moves the economy down that curve. The rise in GDP is the integral of all successive increments to capital, so it’s the area a+b+c.
But the extra foreign capital, by assumption, receives the rate of return r*. So the area c is an addition to GDP but not to GNI; the true gain to the economy is only a+b.
Now let’s create some stylized numbers. It looks as if 8% is a reasonable number for after-tax required return; with a 35% tax rate, this means a pre-tax rate of 12.3%. Cut the tax rate to 20%, and the pre-tax return should fall to 10%. The increment of capital should have a rate of return roughly halfway between, 11.15%.
Tax Foundation asserts that capital inflows will be enough to raise GDP more than 3%, which is wildly implausible. But let’s go with it for the sake of argument. This means inflows of around 30 percent of pre-CCC GDP.
So how much does this raise foreign investment income? The answer is, 8% times 30%, or 2.4 percent of GDP out of a GDP rise of 3.45 percent in my example. In other words, the true gain to the US is 1.05%, not 3.45%. That’s a big difference, and not in a good way.
The point is that even if you believe the whole “we’re a small open economy so capital will come flooding in” argument, it buys you a lot less economic optimism than its proponents imagine.