Macroeconomics and the New Tax Bill

When I asked my wife if she wanted to write this blog with me, her reply was “I don’t think I can help because all I know about economics is how to spend money.” She didn’t realize it, but her response was dead on the money. To understand how the tax bill that was passed on December 20, 2017, by the republican party (led by Speaker of the House, Paul Ryan) will affect you and me, we need to understand how you and I would spend our extra dollars. We then need to contrast our behavior with the behavior of big corporations. We can use that information to examine the merits of the bill and see if we can figure out why it was passed in the first place.

What the tax bill does

To understand how taxes affect the economy generally, one needs to have a rudimentary understanding of Keynesian economics. There is this theoretical, downward sloping curve that economists say exists in the real world. They call it the IS (investment-saving) curve. When consumers spend more money, invest, and trust the economy, this curve expands outward, leading us all closer to an economic Utopia. When consumers are pessimistic, like in times of economic downturn, this curve retreats inward, leading to less good times and worse economic conditions for everyone.

A disciple of Keynesian economics will tell you that a tax break will always lead this curve to expand outward (which is a good thing), and that this result can be proven. In fact, we can show just how much the curve will expand by using the following formula, (also known as the tax multiplier):

This may look scary if you are the type of person who is scared of math and/or the word “multiplier,” but the intuition behind the formula is basic and there are really only two (easy) pieces one needs to understand. The ΔT symbol is meant to represent a decrease in taxes. If total taxes collected decreases by $1,000, then ΔT equals 1,000. Easy enough. The other piece of the puzzle is MPC, an abbreviation meaning marginal propensity to consume. This is a percentage rate between 0 and 1 that answers the question, if you give me one more dollar, how much of it will I save, and how much will I spend? If you are like my wife and I, you spend most if not all of that dollar, which means you have a high MPC. But, my wife and I are not exactly rich. If a person is rich, she spends less of the dollar and saves more of it, which makes sense, since that person doesn’t have as many basic needs as a poorer person. This observation suggests that the wealthier someone is, the lower her MPC.

Since MPC is different for every person you meet, calculating the national MPC (which is what would be required to predict the full effect of any particular tax break) is nearly impossible. It requires taking pools of different people in different regions with different amounts of money, observing their behavior, and calculating a weighted average. I’m sure some economists have tried to do it; I wouldn’t put too much stock in any of the estimations they come up with. But, the basic principle is what matters—the higher the MPC, the more the economy is boosted by a tax break. And poorer people, when taken as a group, always have higher MPCs than wealthier people.

Once you accept this principle, you can accept that the tax break passed by congress will lead to more economic growth. Granted, the economy would be boosted a lot more if the tax breaks leaned more heavily toward the middle class which is composed of citizens who put a greater percentage of their earned income back into the economy, but at the end of the day, boost the economy this tax overhaul will do. Score one for Paul Ryan.

What the tax bill does not

What we just explored is the tax multiplier, and this is highly regarded by macroeconomists as a real phenomenon. However, the people who pushed this bill, especially politicians like Ted Cruz, say that the cut in taxes goes further than the tax multiplier. They have loaded the bill with corporate tax breaks that go primarily to wealthy people under the premise that these corporations will use the tax break to increase wages and create jobs. The theory says that if large corporations earn more, we will all be better off and this idea is colloquially referred to as “trickle-down economics.”

However, what we observe in real life is that a tax break for the wealthy does not increase wages nor lead to higher employment except in a very roundabout way that is negligible at best. There is an excellent Ted Talk given by Nick Hanauer from 2012 that addresses the market forces that actually increase wages and create jobs. If you have not heard this Ted Talk and you are at all interested in economics, click the link and give it a listen. If you just want the bottom line, it’s this: employers don’t give away jobs as if it were a form of charity. They create jobs when they have to fulfill demand for products and services, but when demand goes away, so do the jobs.

Most CEOs and managers of big companies are shrewd and will do everything they can to produce their services and products while spending as little on labor as they can get away with. So, if you give them more money in the form of tax cuts, what are they going to do? Are they going to create a bunch of jobs for people who were recently laid off from, say, coal mining? No. They are going to reinvest in the business, or take home bigger salaries, or pay transfer-pricing consultants to help the business avoid even more taxes, or invest in technology that eliminates the need for manual labor, or fund political campaigns in exchange for loyalty, or all of the above. So, if you are highly skilled in technology or transfer pricing or if you are a politician, you might get a job as a result of a corporate tax break (or you might at least get more tasks assigned to you), but you were probably going to be fine anyway. If you are an average American, you would be much better off if the tax break went directly to you.

You may think I’m being pessimistic, but this is what all of the empirical evidence suggests. I’ve interacted with a lot of economists from diverse political and cultural backgrounds, and not one of them believes in trickle-down economics. It’s a failed experiment. Not even conservative economist and former George W. Bush advisor Gregory Mankiw, who wrote the macroeconomics book from which I am deriving a lot of my analysis, believes in it.

Jobs are created when demand is created. Demand is created when the IS curve expands outward, as explained above. The IS curve shifts the furthest outward when it’s poor and middle-class people, not big corporations, who receive the break. It doesn’t make sense then, for example, to give the top 0.1% of wealthiest Americans a greater tax break than every other group by orders of magnitude if your goal is to boost the economy. It also doesn’t make sense to put a sunset provision on the tax breaks given to the middle class. And yet, all of the above is true about the tax bill that was passed.

The big question: Why?

All this begs the question: why then, pass this bill? It’s a tough one to answer. Full disclosure, I tend to lean left on most political issues. I may have my differences of opinion with conservative thinkers, but I don’t believe the republican party is full of Machiavellian actors who are passing this bill to screw the average American. I think the republican party is mostly filled with kind, decent people. In fact, their tax bill might actually put a few extra hundred bucks in my pocket in 2018, and they didn’t have to do that. They could have sold this bill on the merits of trickle-down economics alone, leaving the middle class out altogether. But, they didn’t do that. So, thank you, republicans.

I do however think that the republican members of congress, like most of us if we’re honest, care about their own well-being more than the people they work for. And because their party has given tax breaks to corporations in the past, their campaigns have become funded primarily by rich donors who see campaign funding as an investment, and a very lucrative one at that. If the republicans didn’t pass this bill, their funding would have dried up. So, to them, this tax bill is a jobs bill. It gives them a job. Rather, it helps them keep their jobs. You don't need an advanced degree in behavioral economics to realize that this is what they had to do for the sake of their political careers. This may say something about our current political system and the role of big campaign donations by corporations, but I’ll leave it to you to fill in the gaps.

Recap

I'll end the analysis there, although there are some other important pieces worth discussing. For instance, I haven’t talked at all about the deficit, which is expected to balloon anywhere in the range of $1 trillion to $1.5 trillion in the next 10 years from this bill, even after the effects of a growing economy are accounted for. Nor have I talked about the stock market and how that factors into all of this. But, those are issues for a different post.

Economically, it would have made more sense to structure a tax overhaul in such a way as to give the bulk of the tax breaks to the middle class. Middle-class citizens spend more of the money you give back to them and are therefore more of a boon to the economy when they have extra money in their pockets—their tax multiplier is higher. But, the bill doesn’t do that. It gives most of the tax breaks, and virtually all of the permanent tax breaks, to rich business owners who are not going to use the increase in wealth to create charity jobs, but more likely, to further enrich themselves and to fund more campaigns of politicians who will give them more tax breaks in the future, keeping the current form of government alive and well for the foreseeable future.