The basis of the market mechanism is efficient allocation of scarce resources. This allocation happens primarily through price signals to market participants. In the financial markets, the price of capital is expected to enable efficient allocation.
But we live in times when both assumptions about price signalling and efficient allocation are deeply questionable. The extraordinary monetary accommodation and the commitment by central banks to keep rates down for the foreseeable future has rendered the price signal blunt. As to efficient allocation, the loss of disciplining powers of the price signal has resulted in several signatures to the contrary.
Consider a few prevailing trends (all documented in great detail in The Rise of Finance).
1. Buoyed by the ultra-low rates, business leverage has grown at a rapid pace to reach clearly unsustainable levels. Zombie companies, kept alive by low rates, are estimated to form nearly a fifth of US corporates. So much so that the fear of bringing the whole house down alone is enough incentive for policy makers and central bankers to keep rates low going forward.
2. Even as debt and cash surpluses too, atleast among the largest companies, have ballooned, business investment has been declining. As Larry Summers and others have argued in the context of secular stagnation, this may also be dictated by the declines in the prices of capital goods.
3. Instead of investments, businesses have preferred to payout higher dividends and undertake large-scale share buybacks. The latter has now consistently outpaced investments across the top strata of US companies.
4. Such share buybacks have been an important contributor to a deeply worrisome bubble in the equity markets, which are now clearly decoupled from the real economy.
5. Then there have been the growing practice of tax avoidance by way of borrowing cheap even while sitting on large cash surpluses, off-shore and on-shore tax havens, inter-corporate loans, transfer pricing, and so on.
In the circumstances, some historic policy choices on tax treatment of capital may need to be revised. I have blogged earlier on the issue of tax deduction of interest expenses. Another one is the issue of low corporate taxes and it being lower than income tax rates.
The argument in favour of low corporate tax rates are two-fold. The main reason is to encourage entrepreneurship. Since businesses create wealth and jobs through its investments, the need for policy to incentivise them accordingly. A low tax rate maximises the profits available to be ploughed back as investments.
The second reason is competition across countries. In a globalised world, businesses, being far more mobile than individuals, have the choice of moving to jurisdictions with the lowest tax rates. Besides there is intense competition among countries to attract businesses.
Let's examine each in turn. The entrepreneurship argument is questionable on at least two counts. As we have pointed out with several examples and research in The Rise of Finance, neither is a lower tax rate likely to incentivise more investment, nor is a higher tax rate likely to deter market competition and effort which is today largely oligopolistic across markets. All things being equal (for any given tax rate), oligopolists are primarily interested in maximising their market share.
The point about competition is trickier. It is indeed a challenge that even well-meaning officials across countries interested in upending the order grapple with. But as Gabriel Zucman and Co have argued here, it is possible to tackle the issue.
So, if higher cash surpluses do not translate to higher investments and higher taxes do not deter innovation and entrepreneurship, then the case for a lower corporate tax rates start to look weak.
Take another example. The income tax schedules have traditionally been designed around a handful of slabs, with the highest slab being in the range of $150,000-200,000. While mainstream debates on tax rate rationalisation talks about tinkering with the lower slab (in the name of expanding the tax base), very few discuss any radical revisions to the highest income slab.
But we now know the high degree of variance and stratification at the top end of the income ladder. There is a compelling case for revising the tax schedule to treat the top 0.1%, 0.1-1% and 1-10% differentially, with very high marginal rates at the top. Again, apart from other considerations, the case for higher rates are also dictated by many of the aforementioned trends.
Clearly, several assumptions that underpinned the post-war consensus on the economy and the functioning of markets no longer appear to hold. It is therefore natural that the rules of the game which were designed based on these assumptions be revised. The challenge however is to mobilise the consensus or majority required to push through the required revisions. This becomes even more so since some of the revisions may have to involve radical departures from the present.
If any country can pursue a transformative agenda, it is the United States, even in the present circumstances. A unilateral decision by the US government in these directions coupled with its moral suasion and influence could tip over the vast majority of European countries. In fact, a US move is also likely to strengthen progressives in many countries, within their respective ruling establishments, who have been grappling with the same line of thinking but have been unable to take any action given the collective action problem associated with such reforms.
The point about competition is trickier. It is indeed a challenge that even well-meaning officials across countries interested in upending the order grapple with. But as Gabriel Zucman and Co have argued here, it is possible to tackle the issue.
So, if higher cash surpluses do not translate to higher investments and higher taxes do not deter innovation and entrepreneurship, then the case for a lower corporate tax rates start to look weak.
Take another example. The income tax schedules have traditionally been designed around a handful of slabs, with the highest slab being in the range of $150,000-200,000. While mainstream debates on tax rate rationalisation talks about tinkering with the lower slab (in the name of expanding the tax base), very few discuss any radical revisions to the highest income slab.
But we now know the high degree of variance and stratification at the top end of the income ladder. There is a compelling case for revising the tax schedule to treat the top 0.1%, 0.1-1% and 1-10% differentially, with very high marginal rates at the top. Again, apart from other considerations, the case for higher rates are also dictated by many of the aforementioned trends.
Clearly, several assumptions that underpinned the post-war consensus on the economy and the functioning of markets no longer appear to hold. It is therefore natural that the rules of the game which were designed based on these assumptions be revised. The challenge however is to mobilise the consensus or majority required to push through the required revisions. This becomes even more so since some of the revisions may have to involve radical departures from the present.
If any country can pursue a transformative agenda, it is the United States, even in the present circumstances. A unilateral decision by the US government in these directions coupled with its moral suasion and influence could tip over the vast majority of European countries. In fact, a US move is also likely to strengthen progressives in many countries, within their respective ruling establishments, who have been grappling with the same line of thinking but have been unable to take any action given the collective action problem associated with such reforms.
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