When the Tweeter of the Free World, Donald Trump, recently announced his administration would be proceeding with large corporate tax cuts, he accompanied it with a 140-character announcement that suggested it was the ‘right tax cut at the the right time’.
Moreover, the tweet said, the US would ‘all succeed and grow together’.
(If that tweet looks slightly unusual, it’s because I removed the capitalisation and symbols to make it easier to read.)
In doing so, President Trump invoked one of the most used — and most discredited — economic approaches of the last generation: so-called ‘trickle down’ economics.
Apparently, the theory holds, when a company or individual pays less tax, they’ll spend more in the economy — either employing more people, or buying things from others, who will, in turn, hire more workers.
And at the extremes, it must — by definition — be right. If tax rates are 100%, there’s no money for anything else. At 0% there’s only money for everything else.
For those who would like to pay less tax — or have their companies pay less tax — this is an easy idea to get behind. It makes sense on the first pass, too. After all, if you’re paying less to the government, isn’t it likely that you’ll be spending at least a little more elsewhere?
But here’s the problem: when you think a little more deeply about it, the idea breaks down. First, if governments have less money, they spend less on public service employees, who now don’t have jobs or income. They spend less on healthcare and education — spending which goes to buying equipment and employing doctors, nurses and teachers. And they spend less on infrastructure: the very thing business tells government it needs more than anything.
Not convinced? Let’s turn to the taxpayers themselves. Let’s compare two people. One is a low-wage worker, who already spends everything they earn. The other is wealthy, with a high income, who saves 25% of what she makes. If you reduce taxes on the lower-paid person, there’s a very, very high chance that each dollar goes straight back into the economy, in the form of increased spending. But the more highly-paid are far more likely to save or invest any incremental income — the tax cut didn’t only reduce government spending, but total economic activity.
Ah, but won’t a company paying less tax employ more people? No, that doesn’t pass the sniff test, either. You only pay tax on your profits. And if an extra employee doesn’t boost your profit, you’re not going to employ them, no matter what the tax rate. Conversely, as Warren Buffett has pithily said:
“… maybe you’ll run into someone with a terrific investment idea, who won’t go forward with it because of the tax he would owe when it succeeds. Send him my way. Let me unburden him.”
No sensible business person wants to make less before-tax profit, just so they pay less tax. Tax is levied at a percentage of profits — the more tax you pay, the more you’ll have, after-tax. It’s a mathematical certainty.
Now, there is one area in which it might — maybe — be sensible to consider company tax rates, and that’s the competition argument. That is, when all else is equal, investments are likely to flow to the lower-taxing jurisdiction, rather than a higher-taxing one. (It’s just a coincidence that BHP’s ‘marketing hub’ ended up in low-taxing Singapore, right?)
If there was evidence — or a strong likelihood — that the amount of tax revenue lost to that sort of practice was larger than any potential tax cut, then it’d make sense to review our rates. I don’t think that’s the case, and other policy can be brought to bear — but it’s something to be aware of.
Indeed, the US state of Kansas has already tried it. It went badly. Very badly.
And remember, company tax is credited against individual taxation — thanks to the imputation (franking) arrangements, meaning dividends aren’t taxed twice. So you can cut company tax, but some of the difference will be made back by individual tax payments rising (because fewer franking credits mean shareholders will have to make up the difference).
See what’s missing in that scenario, though? Companies with foreign owners would pay less tax here, but their overseas owners pay no n tax, either. So, in effect, the tax break would be larger for foreign companies than our own. I’m a huge fan of foreign investment, but a system that levies higher effective taxes on our own companies makes no sense. Foolish takeaway
Don’t get me wrong: the tax system desperately needs an overhaul. It’s ridiculously complex, with silly distortions — for both ideological and political reasons — that need to be removed.
But when it comes to reforming the tax system, changes to company tax should be one of our last priorities. Yes, the idea that ‘less tax means more growth’ is alluring, because it makes instinctive sense on the surface. But any open-minded independent thinker soon realises that it’s a mirage that would hurt revenue without an offsetting economic gain.
The ideologues, on both sides of politics, should agree that the best driver of economic growth is the program that costs the least, but has the largest impact. That’s likely to boost the income of the lowest-paid in the country. And for some, that’s an uncomfortable truth.
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Scott Phillips is the Motley Fool’s director of research. You can follow Scott on Twitter @TMFScottP. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).