Arnold Kling  

The Case for Stimulating Profits

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The Oil Cycle... Talking Points on Stimulus...

I am going to endorse the idea that Bryan Caplan called smart stimulus.


if you cut employers' share of the payroll tax, this puts money in employers' hands, not workers'. But the indirect effect is to reduce the labor surplus; employers want to hire more workers (or lay-off fewer) when labor costs are lower.

Standard economic analysis says that the employer's share of the payroll tax is borne by workers. With flexible wages and prices, one would expect a cut in the employer's share of payroll taxes to result in higher wages, not higher profits.

However, as Bryan points out, we are in a recession, in which wages are probably too high to begin with and there is unemployment. Under these circumstances, workers are unlikely to press for still higher wages.

Given that we are in a recession, Bryan's smart stimulus really would, as he says, put more money in employers' hands. That is, it would create profits and stimulate investment.

If you are a folk Marxist, then profits are bad. Your instinct is to oppose any policy that raises profits and instead always support redistribution toward labor.

However, if we ever needed higher profits, the time is now. Profits are much more cyclical than wage income. We will not have data for another month, but my guess is that the decline in profits over the four quarters of last year will turn out to be more then ten times the decline in labor income.

We especially need profits because the financial sector is contracting. I have referred a number of times to Hyman Minsky, who pointed out that investment is particularly sensitive to profits when the availability of credit is low. From that perspective, now indeed is a "Minsky moment."

Another unhelpful framework is what I have called folk Keynesianism. I wrote,


Regardless of the state of scholarly belief about Keynes, folk Keynesianism is dominant. For example, most people believe that we should worry about whether "the consumer" will spend freely. Everyone fears that if consumers tighten their belts then this will "weaken" the economy...Instead, Keynes himself focused more on business investment as a determinant of economic fluctuations.

Tax cuts that go to consumers will be saved. Government spending, including infrastructure projects will take years to have an effect. Right now, the biggest multiplier for any fiscal stimulus would come from stimulating profits.

UPDATE: Alberto Alesina and Luis Zingales have two other stimulus proposals geared toward investment. One is to eliminate capital gains taxes for investments made in 2009 (I think that would cause much more trading than actual new investment). The other is to allow firms in 2009 to expense investment rather than have to use depreciation. However, if companies continue to lose money, the value of tax deductions is not going to matter.


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COMMENTS (28 to date)
dearieme writes:

You have perhaps omitted the strongest argument in support of your proposal - to wit, that I have advocated the same policy for the UK. Since I saw the calamity coming, my amateur opinion is surely worth more than that of the economics profession. Surely?

Randy writes:

I was thinking the other day... that most of the proposals I've seen floated would not have made any sense prior to the recession, and therefore don't make any sense now. That is, a government spending program doesn't magically turn into a true investment opportunity just because we're in a recession. But here we have a proposal that would have made sense even prior to the recession. There has never been any good reason (in my opinion of course) to mandate an increase in the cost of labor.

8 writes:

What about a future tax holiday? Eliminate capital gains from 2010 to 2012, or cut business taxes.

Government could cut spending today to pay for the future cuts and signal their commitment. The government would be "saving" by shifting deficit spending forward.

hutch writes:

what are the advantages of a cut to the payroll tax to a cut in the corp income tax as a means of spurring investment? i can see in the short run how cutting payroll taxes might be better in an environment right now of lower employment, since corporate taxes are lower due to lower profits. but what about over the long term? the point of investment isn't current profits but profits in the future? if we cut the cost of investment, shouldn't we see more investment?

ryan yin writes:

The Alesina/Zingales proposal seems similar to Judd's JPE 1987 result that temporary investment tax credits are almost always self-financing and more efficient than permanent ones. Over at Marginal Revolution, I read Bruce Bartlett say Judd had changed his mind, saying that permanent investment credits are preferred to temporary, but I've never seen him explain why. Anyone know what brought about Judd's change of position?

El Presidente writes:

However, if we ever needed higher profits, the time is now.

Here's an old fashioned idea: EARN THEM.

We especially need profits because the financial sector is contracting.

So what? Did you shed a tear when domestic manufacturing contracted? Why does this industry merit protectionist policy?

Tax cuts that go to consumers will be saved.

Indeed. Then they will be deposited. Then they will be lent out. Then they will be used for investment. All provided there is some sort of demand to make investment worthwhile.

Standard economic analysis says that the employer's share of the payroll tax is borne by workers. With flexible wages and prices, one would expect a cut in the employer's share of payroll taxes to result in higher wages, not higher profits.

First, if the tax is borne by workers, then why should we favor reducing the employer's contribution over the employee's contribution? That makes absolutely no sense to me. Why not split it in half or give it all to the employee if that's where it ends up anyhow? (I can't wait to see your answer, though I bet it won't be forthcoming)

Second, flexible prices assumes something other than short-run analysis. I thought you were targeting short-term stimulus.

Third, employers, or proprietors, are consumers too. Their MPC is lower, as a group, than the MPC of their employees, as a group, because their incomes are higher. If you are concerned about people saving instead of spending, you're giving the money to the wrong people. Furthermore, many "employers" are shareholders and many of them are foreign. If we are trying to stimulate our domestic economy, doesn't it make sense to give tax breaks to people we know will use that money in our economy in the first instance?

Fourth, I think we are not talking about a one-time change in income like the stimulus checks mailed out last year. We are talking about a change in tax rates, which changes the flow of income and has a greater effect on demand than a single infusion. If we are talking about a change in rates, what manner of sophistry disproves this?

It's cute to call people folk Marxists or folk Keynesians and hope they will be cowed, but where is the evidence that reducing the employer's contribution will have the greatest magnitude, the most immediate, or the most eduring stimulative effect? Where is the evidence that such a stimulus would increase the median real income of Americans, over what period of time, and how much?

floccina writes:

hutch,
One difference is that in this environment few companies will make a profit, the copr take cut would only help the comonies that do.

IMO the great thing about cutting the payrol tax is that starts to break the idea that SS is a retirement plan that you pay into and so are able to get so much out, more for those who earned more and paid in more. I think that the sensible thing is to welfareize SS, everyone gets the same pay out even if they put more in.

Greg Ransom writes:

What dominated in academia and in the press is essentially the crank economics of Foster and Catchings -- a view which gained massive currency in the 1920s, and deep influence among economists. And the ideas of Foster and Catching on using "public works" and monetary policy to cure the problem became mainstream thinking with Hoover and Roosevelt and Sen. Wagner, among other politicians.

Economists in America and around the world focused great attention an the "underconsumption" model of Foster and Catchings, which no economist being able to refute their argument. Essentially, through Robinson and then Keynes in Britain, and through Alvin Hanson in America, the fallacy of Foster and Catching entered the economics of most all economists throughout the world.

The only economist who challenged the fallacy? Hayek. Read Hayek vs the underconsumption fallacy here:

http://mises.org/story/2804


Cyberike writes:

It is not just folk marxists who think profits are bad. With their actions, everyone who shops at WalMart (or drives a little further down the street to find cheaper gas prices) basically is saying that profit is bad. I think that over that last 20 years or so we have created an environment where the consumer is just plain cheap.

I think we are getting close to the fundamental source of problems in our economy: most of the economy does not create enough profits to be a desirable investment, and those that do get so much investment it creates a bubble.

My opinion is our economy may recover, but our problems will linger until the American consumer changes their demand for ever lower prices (I am not going to hold my breath).

By the way, this attitude manifests itself toward taxes and government. As I have said before (many times) the American people want as much government as they can get (re: the deafening outcry againt the stimulus plan), they just don't want to pay for it.

Greg Ransom writes:

Sorry. Comment rewritten:

What dominates is essentially the crank economics of Foster and Catchings -- a view which gained massive currency in the 1920s. The ideas of Foster and Catching on using "public works" and monetary policy to cure the problem became mainstream thinking with Hoover, Roosevelt and Sen. Wagner, among other politicians -- and with economists everywhere.

Economists around the world focused great attention thesis of Foster and Catchings that under consumption and lack of demand creates the trade cycle -- and that consumption determined profits and investment. Economists everywhere grappled with the Foster and Catching thesis -- and none were able to refute it.

Through Robinson, Hansen and Keynes the core fallacy of Foster and Catching entered the mainstream of economic thinking.

The only economist who challenged the fallacy? Friedtich Hayek. Read about Hayek and the under consumption and lack of demand fallacy here:

http://mises.org/story/2804

FXKLM writes:

El Presidente: Arnold addressed many of your concerns in this paragraph:

However, as Bryan points out, we are in a recession, in which wages are probably too high to begin with and there is unemployment. Under these circumstances, workers are unlikely to press for still higher wages.

Cutting the employer share of payroll taxes is equivalent to cutting the employee share of payroll taxes only to the extent that wages are flexible. Arnold was very clear that he didn't think that was a reasonable assumption in this environment.

dearieme writes:

The other advantage of cutting the employer's share of the tax rather than the employee's is that it would be a bloody sight easier to reverse if needs be (in Britain, at least).

As an amateur, I prefer policies that can be reversed if they don't work - I lack the infallibility of the professional.

Lord writes:

This may increase profits, but profits won't do much good without increased demand. It may temper layoffs since it will reduce costs, but it is unlikely to increase investment that is already unneeded. More likely employers will continue to cut unneeded staff and simply pocket the difference, not a very stimulative effect.

Stimulus is hard. Public investment may be costly and unneeded. Steve Randy Waldman's idea of flat checks to everyone may not produce anything longlasting of value, but it could support more people more efficiently. Expanding unemployment to everyone without work, including those who don't qualify for it under existing programs may be the best targeted.

Steve Roth writes:

"Bryan's smart stimulus really would, as he says, put more money in employers' hands. That is, it would create profits and stimulate investment."

The unstated assumption of this post is that investment will spur the economy, and/or that it is what's lacking at this time. As evidence you cite--your own post.

There are a number of items that make that assumption questionable.

1. Among privately held businesses asked what items they consider to be "constraints" on their growth, only 10% cite a lack of investment capital--it's last on their list. (A shortage of skilled workers is #1.)

http://trueconservative.typepad.com/trueconservative/2008/11/do-wealthy-investors-create-growth-and-prosperity-not-so-much.html

2. S&P corps have pumped out more in dividends and stock buybacks in recent years than they earned in profits. (The rest came from cheap borrowing, easily available.) If they were so short on investment capital--if that shortage was an important constraint on growth--why were they spending it down?

http://trueconservative.typepad.com/trueconservative/2009/01/we-need-to-spur-business-investment-yeah-right.html

3. As someone who actually created, built, ran, and sold more than one multimillion-dollar business (so a guy who's all for profits), I can tell you in no uncertain terms that a savvy entrepreneur in this environment is looking for one thing--the same thing he's always looking for--more people who want to buy his products. Investment is a very second best (or worse).

Do you really think businesses are just dying to invest in expansion right now? (Think: liquidity preference.) That all they're lacking is investment? That's silly. What they're lacking is business. Read: demand.

El Presidente writes:

FXKLM,

El Presidente: Arnold addressed many of your concerns in this paragraph . . . Cutting the employer share of payroll taxes is equivalent to cutting the employee share of payroll taxes only to the extent that wages are flexible. Arnold was very clear that he didn't think that was a reasonable assumption in this environment.

With respect, I don't believe he addressed them adequately. I draw this conclusion from his willingness to advocate the reduction in the employer's contribution instead of the employee's contribution for the expressed reason that he believies it will stimulate investment and thus employment, as Bryan proposes. The dispute is over the engine of investment. Do we invest because we have a bunch of money lying around, or do we invest because we see a reward for doing so? TARP put a lot of money in banks, but not a lot of loans on paper. Why is that? It would seem that wealth is a necessary and insufficient condition for investment. Giving employers money for nothing won't stimulate investment unless there is sufficient demand to make the investment profitable.

In a post that advocates government profit support, he identifies two conflicting scenarios: one in which the tax incidence of the employer's contribution falls fully on the wage of the employee, and one in which it falls considerably on the profits of the employer. Tax incidence is a tidy thing. We divide the whole tax into percentages, thus the total tax incidence cannot exceed 100%. If the whole of the employer's contribution is borne by the employee as Arnold states here:

Standard economic analysis says that the employer's share of the payroll tax is borne by workers.,

regardless of the fact it is paid by the employer, then the incidence to the employee is 100%.

Then, as you point out, he remarks:

[W]orkers are unlikely to press for still higher wages.

So, the employee would see an increase in their wage equal to 100% of any reduction in the employer's contribution, except that the tax incidence at this moment is not what we would expect. Instead, this is the opportune time to stuff money into rich pockets.

He is arguing that in the short run we will see the quantity of employment increase as wages remains static. So, he needs some reason to believe that demand would prompt employers to hire more (unless investment is not a function of demand). Where is this demand? In short, Arnold is saying that we need more investment, and that those with higher incomes (i.e. employers) are more prone to invest (higher MPS), which requires the hiring of workers for the purpose of production. He takes this approach in opposition to the notion that it is DEMAND which drives investment. While he is correct for the moment because demand is faltering, he is advocating going further down a dead-end street, an unsustainable pattern of redistribution.

This is trickle-down 101: give rich people your money and they'll make your problems go away . . . magically. There is no reason in his argument to think that this will work better than giving poor people money, is there? If so, how and for whom? At best, it seems this approach will provide employer security as opposed to employment security. It will protect the established interests of present employers rather than allowing the so often worshipped free market to weed out the bad from the good, the profitable from the unprofitable. And I'm the Marxist?

If I was a merchant and received a reduction in my taxes while my customer traffic was stagnant, I would not hire more workers. If I was a manufacturer and capital was uncharacteristically cheap (as it is now), I would use the tax reduction to purchase capital, thus altering my MRTS in favor of capital, and I would not feel compelled to raise wages for the gains in productivity since there is no upward pressure on wages generally. How is this supposed to work, exactly? We are depending on a weaker multiplier that will decline rapidly the more money we throw at it, and we are running out of money to throw.

A 'folk Keynesian' might call it "pushing on a string", because a 'folk Keynesian' wouldn't understand the difference between his comments on monetary policy and his comments on fiscal policy. They'd still be correct, in spite of our pompous disdain for them. They would be more in tune with Keynes' notion that economic vitality in these circumstances requires more emphasis on giving unemployed people jobs than giving private employers money, and that government should see to it when private employers are insufficiently inclined to do so. This it what Arnold REALLY objects to, and he doesn't defensibly articulate why.

We need _reasonable_ profit expectations. We don't get to that point by continuing to raid the public coffers in order to sustain unreasonable expectations. Investor expectations are adaptive more than rational. They need time to adjust and they need responsible regulation of markets in order to be sustainable. This is gonna hurt for a while. Maybe we'll think twice next time some nimrod suggests that a second capital gains tax cut is the right thing to do with a surplus when we have a national debt we could be paying off and investments in worker health and productivity we could be making. Maybe.

FXKLM writes:

El Presidente: In a tight labor market, a cut in the employer's share of employment taxes would ultimately go to employees. In a very weak labor market (with possible deflation), wages would be going down if not for the fact that wages tend to be very sticky and it is difficult for nominal wages to decline. So in this environment, the incidence of employer-side employment taxes falls on the employer. And I don't agree that incidence always adds to 100%, by the way. Deadweight losses lead to effective total incidences of over 100%.

If we cut the employer's share of employment taxes, the cost to an employer of keeping an employee or hiring a new employee goes down. Obviously, that's going to lead to higher employment at the margin.

fundamentalist writes:

"Given that we are in a recession, Bryan's smart stimulus really would, as he says, put more money in employers' hands. That is, it would create profits and stimulate investment."

Not necessarily. Business owners aren't soda machines. Business owners invest in new production and higher new employees when they see a good opportunity. Greater profits from reduced taxes may simply go into savings in the same way banks have taken the Feds money and built up reserves. Business owners will probably sit on the new profits until uncertainty passes and new opportunties appear.

In addition, you have to disaggregate employment. Not all jobs are the same. As Hayek points out, low levels of profit will spur economic growth because it encourages companies to purchase new and better labor-saving equipment. It's ironic, but labor-saving equipment drives employment because someone has to make the labor-saving equipment. As companies demand labor-saving equipment in order to boost profits and reduce labor costs, investment and employment in the industries that produce the labor-saving equipment grows. That's how sustainable growth takes place. Tax cuts to employers would do nothing but cut off the head of the recovery just as it's started to poke above water.

fundamentalist writes:

El Presidente: "Giving employers money for nothing won't stimulate investment unless there is sufficient demand to make the investment profitable."

As I wrote above, the demand may come from employers trying to save money on labor by purchasing labor-saving equipment. But that will happen only if profits remain low.

El Presidente writes:

FXKLM,

If we cut the employer's share of employment taxes, the cost to an employer of keeping an employee or hiring a new employee goes down. Obviously, that's going to lead to higher employment at the margin.

Of course it will, but how much, and how much more than the alternatives? It's not completely feckless, but it's not our best alternative. Why choose this way when this pattern of redistribution got us into the mess in the first place?

Arguing for this particular action is really disappointing when economists know full well we can do better by doing it a different way. Are we so ideologically biased that we would knowingly advocate suboptimal policy to protect our sacred cows?

If changing our pattern of redistribution in favor of the more wealthy would bring about a sustainable increase in the median real wage and a reduction of relative poverty (below 50% of median), I would support it. It won't, so I don't. My goal is clear.

Arnold has said he wants to cut taxes because he says government is too big, but he can't or won't say how big he thinks government ought to be (I've asked more than a few times and he hasn't responded). That ambiguity leads to this sort of a suggestion, and I don't think it's going to leave us in a better place if people adopt this sort of policy. I can have no objection to people setting their own goals on the basis of ideology, even though I may disagree with both the goals and the ideology. Goals are normative constructs that embody our preferences. However, if we conflate goals and prospective technical solutions and rule out technical solutions on the basis of ideology, we may frequently be right but we will almost certainly eventually be wrong. When we do so, we fail to identify what matters to us, then we claim that the policy will help us achieve it. How can a policy achieve a nonexistent goal, and why would we advocate policy for policy's sake?

El Presidente writes:

fundamentalist,

As I wrote above, the demand may come from employers trying to save money on labor by purchasing labor-saving equipment. But that will happen only if profits remain low.

Fair enough. Will they remain low?

blink writes:

Regarding Alesina and Zingales proposal, you say, "I think that would cause much more trading than actual new investment." What is the mechanism? It seems that it must be that I expect to make money by swaping stocks, but the capital gains tax reduces my expected profit so I am not able to cover the transaction costs.

In this case, reducing the capital gains tax can improve the allocation of current investment, even if the total amount increases little or at all. That sounds like a recipe for speeding the adjustment process. If you are correct, you are indirectly arguing in favor of the proposal.

fundamentalist writes:

FXKLM: “If we cut the employer's share of employment taxes, the cost to an employer of keeping an employee or hiring a new employee goes down.”

Obviously. Then what happens? As they teach in intro to micro the employer switches to using more labor and less capital. Hayek called it the Ricardo Effect. That does two things: 1) it reduces the marginal productivity of labor and 2) reduces the demand for labor-saving capital equipment. So jobs increase in consumer goods producing industries and decrease in capital goods producing industries. And jobs will increase in low-pay labor-intensive industries such as restaurants and hotels.

El Presidente: “Arnold has said he wants to cut taxes because he says government is too big, but he can't or won't say how big he thinks government ought to be…”

25% of GDP. Some guy did an econometric study years ago of the optimum level of government. I’ll try to find the article, but it has been a while. And that 25% includes fed, state and local. In other words, the total tax take for all levels of government should be 25% of income.

El Presidente: “Fair enough. Will they remain low?”

Depends on what the state does. The stimuli proposed will raise profits because consumer spending on limited goods causes price increases and increases in profits. Tax reductions on businesses will raise profits. Rebates that citizens mostly save will help, but not if it goes into government notes and bonds.

El Presidente writes:

fundamentalist,

25% of GDP . . . I’ll try to find the article[.]

I'd truly love to read it. Thank you.

El Presidente writes:

Depends on what the state does. The stimuli proposed will raise profits because consumer spending on limited goods causes price increases and increases in profits. Tax reductions on businesses will raise profits. Rebates that citizens mostly save will help, but not if it goes into government notes and bonds.

Alright. If consumption is driving profits, consider the alternative of giving the tax break on the employee's contribution instead. Given that this is a rate reduction, a reduction in their per-period withholding leading to a larger check with each pay period and not a single stimulus rebate, wouldn't they have a higher MPC than the employers? If they would, then it seems that reducing the employer's contribution is a less efficient way to stimulate consumption. It may be a more efficient way to stimulate investment, but that presumes profits, which are dependent upon consumption (demand), right?

If our goal is to have fuel flow through a hose and into our gas tank, we need to place the fuel in the gas can and siphon it through. That's how we establish a vacuum and a flow. There are other ways to accumulate fuel in the tank like putting it directly in and bypassing the can and the hose altogether. But, if we want it to go through the hose, that's how we'll have to do it. The volatility in profits in unfortunate, and undoubtedly destructive and wasteful, but it was no less so when they were rising to unsustainable levels. We do not combat volatility in a healthy way when run around putting out fires. Let's fill the gas can and reestablish the vacuum. Then we can tune the flow to make it work well.

fundamentalist writes:

If you stimulate demand for consumer goods through tax relief to workers, you still get higher profits in the consumer goods industries, which causes the Ricardo Effect to kick in. The tax relief to workers might work if they save most of it, but not if those savings go into gov bonds.

El Presidente: "Let's fill the gas can and reestablish the vacuum. Then we can tune the flow to make it work well."

That might work if the economy were a machine. Unfortunately it ain't. It's made up of living human beings. They don't respond well to gasoline or sucking. Most economists assume that the patient is ill. It's not. Austrians don't assume that. The patient became drunk and he now has a hangover, which is the body's way of cleansing the alcohol from the system. The best thing to do is let the body heal itself, which it will and always has.

El Presidente writes:

fundamentalist,

Most economists assume that the patient is ill. It's not.

Well, I would certainly curious about an economic hippocratic oath. :-)

That said, whether or not we are ill depends on our definition of wellness. With respect to economics, I think the health of an economic system cannot be measured absent consideration of the health (mental, physical, emotional) of the people who constitute it. An average won't suffice and a median is still a crude measure. That places me at odds with economists who disavow the normative as irrelevant or inscrutable in matters of economics. I'm perfectly comfortable with that and I would encourage others to join me. It's not so bad.

In my analogy, the flow of gasoline is like aggregate demand and the rate of flow is like the velocity of money. Have we or have we not had an abrupt change in the velocity of money? Even if we take an Austrian approach, there is no correction if there is no overreach, and there is no overcorrection if there is no correction. Creative destruction is destruction all the same. Neither laissez faire nor incrementalism suit my temperament in their extremes. Maybe that's my problem, but I doubt it's mine alone.

fundamentalist writes:

El Presidente: “In my analogy, the flow of gasoline is like aggregate demand and the rate of flow is like the velocity of money.”

I got your analogy and it really wasn’t bad. I was just being obnoxious. But to paraphrase Hayek in his Nobel speech, mainstream economists focus on aggregate demand because that’s the data they have. It’s sort of like the drunk looking for his keys under the street lamp. The policeman asked him if that was where he lost them and the drunk replied no, but that’s where the light is.

Austrian econ doesn’t think aggregate demand is even useful, let alone important. In its most simple form, Austrians think that relative demand is important, that is, demand for consumer goods relative to producer or capital goods. The economy is healthy and growth sustainable when the two are in balance. Booms happen when credit expansion causes too much capital goods production. That’s unhealthy, but mainstream econ doesn’t know it. Mainstream thinks it’s good.

Because too many capital goods are being produced, the output of consumer goods must slow because there are limited resources. (This only takes place after idle resources are used up.) But consumers demand their goods. Several things happen to restore the balance, but the end result is business failures and higher unemployment in the capital goods industries. That’s the beginning of the bust. A secondary effect is that people default on loans, pay off loans, and don’t take out new loans and the credit structure shrinks. One result of that is falling prices. Mainstream econ thinks this phase is bad, but Austrians see it as the necessary healing process to restore the natural balance to the economy.

El Presidente: “Have we or have we not had an abrupt change in the velocity of money?”

Yes we have. But it’s a symptom, not the illness; an effect rather than a cause. Increasing velocity or any other kind of monetary stimulus will not restore balance to the economy. I’m sounding like Jedi now. Time to go home.

El Presidente writes:

fundamentalist,

Increasing velocity or any other kind of monetary stimulus will not restore balance to the economy.

I couldn't agree more. It's a distributional problem.

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