KUDLOW BLOG - Corporate Tax Cut
Congratulations to Bear Stearns’ Chief Economist David Malpass for his commentary on the recent corporate tax cuts. It is the single best piece I have seen on the recent bill passed by Congress and signed by President Bush. The corporate tax rate drops to 32% from 35%, providing an increase of 4.6% in after-tax income and in the stock price. Mr. Malpass has given all of us a full-throated example of dynamic analysis. Particularly for skeptics, this is a must read:
On October 22, President Bush signed the “American Jobs Creation Act of 2004.” We think the economic benefits are substantial. The bill hasn’t gotten much attention, in part due to the “modest” $145 billion price tag over ten years. Further reducing the bill’s ability to get headlines, it is “budget neutral,” meaning the price tag is offset by extensions of existing taxes and some new taxes. In fact, the bill is scored as causing a net $1 million improvement in the budget for the FY2005-2014 time period.
We think this is a major new tax cut with substantial benefits for the economy and equities:
· The new law lowers the corporate income tax rate on broadly defined manufacturing activity to 32% from 35%. Over time, we expect a shift in U.S. economic activity toward activities which fall within the broad definition of manufacturing, reducing the average effective corporate tax rate beyond the assumptions in the scoring process. The corporate rate cut on manufacturing is phased in, with one-third of the rate cut available for taxable years beginning in 2005 and 2006, two-thirds in 2007, 2008, or 2009, and the whole deduction available for taxable years beginning after 2009.
· The law will cause the Europeans to eliminate on January 1 their 12% tariff on $4 billion of U.S. exports. This is a sizable benefit not covered in the scoring process for the bill.
· The law lowers the tax rate on repatriation of corporate funds held abroad to 5.25% from 35% for one year. Corporations will only do this to the extent that the benefits outweigh the 5.25% tax cost, but the scoring process ignores the benefits.
We emphasize once again (see related pieces below) that Congress’s scoring process for tax changes estimates a portion of the costs, but there is no process to identify or quantify the benefits.
· In this case, the scoring process calculates the assumed reduction in revenues to the government caused by the corporate tax rate cut, but it ignores the improved cash flow to the private sector from the rate cut. The implicit assumption, clearly implausible, is that the improvement in private-sector cash flow won’t be used for new hiring, equipment purchases, dividends, additional tax payments, or any other benefit from increased private-sector activity. (Note: some of the cash flow improvement from the rate cut is canceled out by increased taxation elsewhere in the bill, but a big chunk of the revenue-neutral aspect of the bill is simply the continuation of existing corporate taxes, which would already be in corporate budgets. We think the net effect of the bill is a substantial improvement in corporate cash flow, ignored in the congressional scoring process.)
· Furthermore, the scoring process doesn’t take into account the likely impact of tax changes on asset prices or, in turn, the likely impact of asset price increases on the economy and the government’s budget. The scoring process assumes no difference in the economic or budget outlook from the Dow at 5,000, 10,000, or 15,000. After the 2003 tax cut, equities rallied well over $1 trillion. Partly as a result, in the four quarters through June 2004, the economy grew 4.8%. Tax revenues in fiscal 2004 came in at $1,880 billion, some $55 billion over the August 2003 CBO forecast. Similarly, U.S. house prices surged after the 1997 cut in the capital gains tax rate on homes, yet the benefits from the likely home price appreciation were ignored in the scoring process for that tax cut.
· To make the point with very rough numbers, this bill lowers the corporate tax rate to 32% from 35%. When fully phased in, a corporation taxed at the top marginal rate would keep 68% of its taxable income rather than 65%, an increase of 4.6% in after-tax income and in the stock price. Using hard numbers, the NIPA-based corporate tax liability in the second quarter at an annualized rate was $271 billion. Assuming these are reduced by 10%, this would add $27 billion to the after-tax income of $717 billion, an increase of 3.8% which should pass through to equity prices, economic growth, and future tax payments.
· Scoring Analogy: Say a student is working her way through college. The parents decide to increase their support, so she will stop working for this school year. For the family, the budget impact is negative by the amount of one year’s earnings. Full-cost accounting might recognize that she won’t work in future years, so the negative impact on the family budget is even bigger than initially scored. However, this ignores the immediate benefit to the family in terms of her improved school performance. It also ignores the likely benefit to the family in the event that she takes harder courses, transfers to a better college, goes on to graduate school, or enters a lucrative occupation. |
