Jefferies

Economics and Strategy

Fiscal Stimulus: Another Force for Disinflation

In standard Macro 101 textbooks a deficit-financed tax cut generally causes both output and inflation to rise. This analysis, however, only considers tax cuts for individuals, not for corporates. When one begins to consider corporate tax cuts, a simple shift outward in the “aggregate demand” curve does not produce the correct storyline.

The main difficulty in analyzing a corporate tax change centers on distribution. And to be sure, the economics profession is having some pretty heated open-air debates on the distributional issues surrounding the current corporate tax cut proposal. On one side you have the Krugman/Summers Keynesian camp arguing that the benefits will all go to “fat cat” business owners through share price increases. Then on the other side you have the Cochrane/Mankiw/Hassett neoclassical camp arguing that workers will see the bulk of the benefit through higher wage payments.

I do not want to get into the debate on the allocation of benefits between workers and shareholders. What I want do want to discuss is a third possible outcome from the proposed corporate tax cut: disinflation. And in order to tee this idea up, I want you to first read John Cochrane’s description of who actually pays corporate taxes. The following excerpt is from a recent post on his “Grumpy Economist” blog:

“I think every economist in this debate admits, if some reluctantly, that ‘corporations’ pay no taxes. As an accounting matter, every cent corporations pay comes from higher prices, lower wages, or lower payments to shareholders. The only question is which one. And indirect general equilibrium effects are central. The question is not just, how do corporations respond immediately, but how do wages, prices, and capital in the whole economy adjust. ‘Make corporations pay their fair share’ is just nonsense.”

That paragraph is honestly a work of economic art. And what it highlights is that the costs of a tax increase, or benefits of a tax cut, can only go to three distinct entities: shareholders, workers, and consumers. It’s just accounting. So a tax cut can pass to shareholders through buybacks and/or capital deepening; it can go to workers through higher wage payments; or it can accrue to consumers through lower product prices.

The key here is the last part, “lower product prices.” No one in this debate seems to be discussing the idea that a firm with some newfound change in its pocket might decide to grab a bit of market share by CUTTING prices. Now, my best guess is that as the unwind of “Secular Stagulation” continues, competitive pressures will force businesses to think much more strategically. In the post-crisis era of large increases in regulation, incumbent businesses were able to enjoy the increased barriers to entry by reaping the benefits of monopoly/oligopoly power. I have argued many times in these notes that this has been one of the primary drivers of record-high corporate profit growth as a percentage of GDP over the last 8 years.

The idea I have in mind here is pretty simple - as our deregulation-induced positive supply shock continues to take hold, businesses will need to work harder to hold onto market share. In that setting a corporate tax cut may very well be “spent” on lower product prices. So today I want to put yet another disinflation risk on the table for the U.S. economy. I wrote a piece in July titled “The Fourth Turning of Disinflation” (reprinted below). In the piece I outlined two secular forces and two cyclical forces that are pushing inflation lower. The two secular forces are technological advance and demographics, and the two cyclical forces are monetary-policy tightening and the unwind of “Secular Stagulation.” We now have a fifth turning: corporate tax reform. It too creates a positive supply shock, which pushes inflation lower and growth higher.

As for the magnitude, I would be lying if I told you I had a model to forecast the size of this effect. I don’t think anyone can do that, even if the economics profession likes to pretend it is possible. I do however feel comfortable with the direction and with the additive nature of this corporate tax reform plan to the already heavy forces that have been pushing inflation lower.

Finally, let me just make a few quick observations on the proposed changes to individual tax rates. There are so many moving parts here that it is almost impossible to tell if this part of the proposal is actually stimulative. But I did find it fascinating (and somewhat ominous) that the WSJ op-ed page came out against the overall tax plan because they did not see stimulus for the individual. Now to be sure, there may be some stimulus for individuals in my home state of Florida at the expense of those in New York and California, but in the aggregate it is not easy to determine the overall effect. I am therefore going to run for now with the idea that this individual side of the tax reform plan, as crafted, will have minimal effect on the “aggregate demand” side of the equation. The only real story with the combined corporate and individual reform plan, if it passes, is on the supply side. And as such it is just another disinflationary positive supply shock which should be welcome news for our nicely performing “Spoos and Blues” trade. Good luck trading.