Commentary: I'm a Staunch Democrat, and I Think Corporate Taxes Should be Zero

The very serious people will be aghast to hear it, but today, as in 1946, taxes for revenue are obsolete. The facts speak for themselves.  The US government (as well as national governments in the UK, Japan, Canada and many other nations) has been running a perennial budget deficit for roughly 80 years. Markets happily gobble up new bond issues.  Some have called US Treasurys America's greatest export. 

With the removal of the link between gold and the dollar in various steps between 1933 and 1971, the last vestiges of the old system are gone.  When domestic currency is linked to gold or any other commodity, financing the government with domestic currency issues will inevitably destroy the monetary standard.  In order to run deficits without compromising its own gold standard, the government must issue bonds which are only convertible to gold upon maturity.  

Under the fiat money system which exists in nearly all the advanced economies today, no such constraint exists. A government could theoretically issue no bonds under a free floating fiat money system. Inflation is supposedly the reason why governments must issue bonds.  "Printing money" would caused runaway inflation.  People like to bring up Germany in the 1920s, or Argentina and Zimbabwe today.  However, with modern finance, I contend that deficits financed with money printing are only marginally more inflationary that deficits financed with bond issues. 

Fundamentally, inflation is caused by an increase in nominal spending relative to the economy's capacity to produce.  That spending can come from anywhere.  It can come from the government or private sector. In general, two policy levers exist to affect economy wide spending. The budget balance and interest rates. Government spending directly raises economy wide spending. When the government finances some of its spending via debt rather than taxation, its spending not only increases economy wide spending, but it increases the net worth of the private sector. This leads to higher private sector spending as well.   This has been called many things, the Keynesian multiplier, or a "wealth effect."

Some mistakenly believe that the funds used to purchase government bonds cannot be used to command real resources. Thus, bondholders forgo consumption until the bonds mature. Or in other worlds, the US Treasury cannot sell $10 billion in T-Bills until somebody has saved $10 billion dollars. Thinking along these lines, it is reasonable to conclude that bond financed deficits are not inflationary, because any government borrowing necessarily reduces private sector spending by a corresponding amount. Unfortunately, this is simply not how modern bond markets work. 

Bond markets have come to be dominated by large financial institutions who themselves issue short term liabilities to fund their activities. These firms arose largely because of the desire of some investors to hold ultra-safe short term instruments. In effect, some firms borrow funds on the wholesale funding market, and purchase government securities which are then pledged as collateral. Thus, any increase in the supply of government debt necessarily increases the demand for reserve balances, which the Fed must accommodate or allow short term interest rates to rise.   (Eg, abandon its target for the Fed Funds rate)

Thus, the notion that savings is required for bond issuing is of a bygone era. Because the Fed (or any central bank) takes a fundamentally passive role in supplying reserve balances, the ability of the financial sector to engage in maturity transformation in the bond markets is never reserve constrained. This closely parallels the reality that bank lending is also never reserve constrained either. 

Via a complex chain of intermediaries, government bond issues create reserve balances. The same balances which would have been created if the government had just printed money. So what's the point of bonds anyway? While investment banks are not limited in their capacity to engage in maturity transformation by the quantity of reserves they hold, they are constrained by their ability to take interest rate risk. Because it's inherently risky to borrow short and lend long, investment banks face margin requirements when they pledge their securities. All else being equal, an increase in the supply of longer dated securities increases term premiums. Therefore, government bonds are really instruments of monetary policy, not fiscal policy per se.  

Why did 'money printing' cause runaway inflation in Germany but not the USA or Japan? It all has to do with scale. From 1920-23, the German government was running deficits of close to 60 percent of GDP. The US deficit peak at around 10 percent of GDP in 2009. Japanese deficits have hovered around six percent of GDP in recent years. In both Japan and the US, large deficits came at a time when the economy was running well below peak capacity. By contrast, Germany's industrial base had been ravaged by the war. In other words, German deficits sent spending through the roof at a time when the economy was struggling to produce.

Since the 2008 financial crisis, and even before, a rich literature has developed as to whether its desirable to use the supply of government debt to control longer term interest rates, or if central banks should just be more transparent with their forecasts of the path of short term rates. The very existence of this debate lends credence to the idea that the management of the supply of long term government debt is crucial to the conductance of monetary policy

Finally, this has been known by central bankers for decades, but the cat was finally let out of the bag after the Great Financial Crisis and the implementation of QE.  Ben Bernanke himself stated on numerous occasions that QE operates by changing the mix of assets available to private investors, and ultimately lowers longer term interest rates by making bonds scarcer. There was never the expectation that the reserve balances created would by QE would be 'lent out.' If that were the case, QE would have caused hyper-inflation. Again, bank lending is price constrained, not reserve constrained.

But what are taxes for? If the Federal government finances itself by creating reserve balances, why tax at all?  The answer is to control inflation and to influence economic incentives faced by firms. On the inflation front, the price level is determined by the level of autonomous spending, the government's budget balance, the interest rate/credit policies, and the economy's capacity to produce. Taxes are therefore a key policy lever to target the price level, along with interest rates. This is because any deficit spending, financed with bonds or money printing, adds to the stock of money.  Interest rates influence the rate of private sector credit creation, which also is a key determinant of the price level. Again, the sole purpose of government bonds is to take advantage of capital market frictions which result in the supply of long term debt's ability to influence longer term yields. (Which again is what QE was all about.)

Given the above, we can postulate some first principles for tax design and fiscal policy, namely: 

1. The budget deficit should be set solely with regard to achieving price stability and full employment. Budget outcomes (eg, achieving a 'balanced budget') are never ends into themselves.  Doing so is akin to judging the success or failure of monetary policy on the level of the Fed Funds Rate, rather than the achievement of the objectives of full employment and price stability.    

2.Thus, revenue is never and should never be the primary concern  

3.The distortions should be minimized unless purpose of the tax is penalize a specific activity. (Tobacco Consumption, Carbon Emissions, Puppy Kicking, ect.)

4. Like Beardsley Ruml stated, it may be desirable to use taxes to change the distribution of income within an economy.  However, this should be done sparingly. 

So where does this leave us on the corporate tax?  Fundamentally, corporations are money transfer machines. They take in money from customers, and then transfer it to various stakeholders such as workers, investors, and vendor firms. From the principles above we can conclude that: 

1. We are close to full employment, and there's no evidence of inflation. A neutral fiscal policy is called for. We shouldn't increase or decrease the deficit now. 

2. The revenue raised by corporate taxes is quite small in terms of total receipts. In FY 2015 corporate tax collections were only $344 B, compared to 1.54 T and 1.06 T for indindividual income and payroll taxes respectively.   

3. The corporation is a useful piece of social technology which helps people to organize themselves into productive economic units. There is no reason to penalize corporations specifically. (It would not be desirable for all corporations to become sole proprietorships)  

4. Finally, any corporate tax collection by definition reduces the income of corporate stakeholders, (either shareholders get lower payouts or workers get lower salaries) thereby reducing tax revenues on the individual side of the tax code. 

One fair argument may be that the corporate income tax discourages firms from accruing large amounts of cash on their balance sheets. Both theory and practice discredit this idea. 

First, the existing corporate tax has not stopped US corporations from accruing over 2 trillion dollars of cash, much of it in overseas tax shelters. 

Secondly, if the corporate tax were eliminated and all income derived from corporations (shareholder payouts and wages) were taxed at normal individual rates, the accrual of cash would only defer the tax liability of company stakeholders, but would not increase after tax income. For what its worth, the same is true for 401K accounts.  The tax deferral is only useful because most people are in a lower tax bracket when they draw on their accounts than when they are working. 

Finally, the advantages of allowing firms to accrue cash without tax would:

1. Eliminate tax competition and end the economically wasteful practice of committing real resources to tax avoidance schemes. 

2. Make it easy for firms to finance themselves with retained earnings and build stronger equity cushions. Congress is rightfully concerned that under the current tax system, equity financing is penalized while debt is encouraged. This is not only because dividends are not tax deductible while interest payments are, but also because retained earnings get whacked by a 35 percent tax!

In the end, any corporate tax just reduces shareholder or worker incomes. Revenue is not a primary concern, but it could be easily made up by taxing all corporate payouts at applicable marginal rates. The corporation itself is not an undesirable legal structure, so it makes no sense to tax corporate income before it is paid to stakeholders. The answer is clear. Cut corporate taxes to zero.