Tax Cuts and Economic Growth, Once More – the Corporate Tax Version

The issue of tax cuts and economic growth, which I’ve discussed recently here and here, looks like it’s going to be an important topic for some time now judging by this week’s announcement from Paul Ryan, one of the Republicans in the U.S. House of Representatives.  While all the attention in the media has been focused on the proposed changes to Medicare and Medicaid (I’ll get to those soon), that’s not really where the deficit reduction is supposed to come from in their plan.  When you look at the plan and their projections, it’s really a dramatic improvement in the health of the economy and employment that drives their projected budgetary improvement.  And what do they propose will instantly get this slow-growth economy to dramatically improve immediately?  Why tax cuts of course!  I’ll have more on the specifics of the Republican proposal soon, but for now I want to note the experience of our polite neighbors to the north with regard to this issue of tax rate cuts and economic growth.

In Canada’s case, they bought into the rhetoric of “tax rate cuts” will grow the economy ten years ago.  But the Canadians bought the corporate version.  Specifically, the cut corporate tax rates dramatically over the past decade.  The goal was to growt the economy.  This is the exact same strategy that Rick Snyder, Scott Walker and a host of other Republican governors are now trying to implement in different states in the U.S.  So it should be enlightening to see what happened when somebody else did it.  What happened?  Let’s turn to the Globe and Mail today (emphasis is mine):

Canadian companies have added tens of billions of dollars to their stockpiles of cash at a time when tax cuts are supposed to be encouraging them to plow more money into their businesses.

Corporate tax cuts are becoming a major issue in the federal election campaign. The Conservatives, arguing that they are the best custodians of an economy that remains fragile after the recession, say tax cuts are crucial to stimulate job creation and make Canada more competitive on the global stage.

But an analysis of Statistics Canada figures by The Globe and Mail reveals that the rate of investment in machinery and equipment has declined in lockstep with falling corporate tax rates over the past decade. At the same time, the analysis shows, businesses have added $83-billion to their cash reserves since the onset of the recession in 2008.


In other words, the corporate tax rates did not increase corporate spending on investment.  In fact, the corporate tax rates actually coincided with lower corporate spending on investment.  It’s corporate spending on investment that is what generates and contributes to GDP growth.  So lower corporate tax rates simply functioned to increase profits but those profits are sterile.  They became piles of cash.  Cash that might be used to buy another existing company (and then layoff people) or just allowed to sit idly in the money and bond markets earning more interest.  What lower corporate tax rates do not do is create jobs.

So back to an earlier discussion – does this mean we should stop saying in principles classes that “tax cuts are stimulus”?  No.  It means we have to be more careful in what we say.  A better and more true statement is that:

Tax cuts for middle- and low-income individuals that result in more consumer spending, and tax cuts that are accompanied by deficits (meaning the tax cut isn’t offset by lowered govt spending) will stimulate an economy and grow jobs while tax rate cuts for corporations and high-income individuals won’t.

Unfortunately that’s 50 words long.  That’s way beyond the attention span or understanding of most politicians and media commentators.

Innovation in Monetary Policy in Sweden Works: Negative Interest Rates

The Sveriges  Riksbank (a.k.a.  Riksbanken), the Swedish central bank, tried an innovation in monetary policy two years ago in July 2009 when it set the official deposit rate at a negative interest rate of -.25%.  The objective was to stimulate and motivate banks to lend their “excess” reserves to businesses and households and to therefore stimulate the economy.  The Riksbanken was the first central bank to try a negative interest rate and as far as I know, it’s the only one that has tried it.

The results of the experiment look pretty good.  The Financial Times has reported that Sweden’s economy has come roaring back from the depths of the global recession.  It recorded a 7.3% growth in real GDP for 4th quarter 2010 (year-over-year). Fast enough growth that the bank has long since found it necessary to raise interest rates back into positive territory.

So what happened here? And how does a “negative interest rate” work?  Monetary policy is primarily handled by changes in interest rates. In particular, central banks change interest rates on their dealings with commercial banks in their country.  Remember a central bank is a “banker’s bank” – it’s where your average ordinary bank, be it JP Morgan Chase or Podunk Community Bank, has both deposit accounts and loan accounts.  The average commercial bank keeps a certain amount of money on deposit at the central bank. This is what are called “bank reserves” (technically currency in the vault also counts as “reserves” but it’s minor statistically).  Reserves are used to handle transactions with other banks (customer checks to be cleared) and, sometimes, as a cushion for safety. In normal times when the economy is growing and there are plenty of credit-worthy people to lend money to, a bank wants to hold only minimal reserves.  In fact they want to hold only enough to handle any withdrawals such as clearing checks to other banks.  Historically banks would be required to keep a certain % of their deposits as “reserves”.  However, in many nations that’s no longer true (Canada, Japan, Australia).  It’s partly true in the U.S. where demand deposits (checking accounts) have a minimum reserve requirement, but not true for savings deposits.  The reason banks don’t normally want to hold reserves is because they can make more profit by lending the money out.  But lending is only attractive (read highly profitable) in normal times.  In times of crisis, recession, and panic credit-worthy customers are harder to find.  Banks raise their lending standards and become more focused on security/safety instead of making more loans.  So the amount of reserves tends to rise as the banks are reluctant to lend the money.

So banks have deposit accounts called “reserves” at the central bank.  But banks also can borrow from the central bank when they want or need more reserves.  The central bank can arbitrarily set the interest rate for both of these, the deposit (reserve) accounts and the loan accounts (discount loans).  Historically, the Federal Reserve Bank in the U.S. has only set an interest rate on the loans to banks – this is the “discount rate” and it’s set by the Fed Board.  (it’s closely related to the “fed funds rate”, but that’s a whole other story).  Again, historically the Federal Reserve Bank never paid interest on the reserve accounts.  They required banks to keep them, but wouldn’t pay interest on the deposits.  That changed in October 2008 when The Fed finally did what others have long done and took the new step of paying interest to banks on the reserves they keep on deposit at The Fed.  I believe the current rate is 0.25%.  Not much, but when figured on hundreds of billions of dollars that are just sitting there securely at The Fed, it’s a nice source of profits to banks.

Therein lies a problem.  In the crisis banks accumulated very large reserves. Reserves are now much greater than what the need for transactions suggests.  In effect, banks are simply sitting on the money.  They have the funds to make loans but choose not to. Instead, they choose to let the reserves sit idle rather than loan them out.  It’s a nice deal for the banks.  Nice safe profits with no risk. But it’s a problem for the rest of us.  We need a growing economy. And a growing economy needs consumers and businesses to spend more.  Consumers need to buy more and businesses in particular need to spend more on investment and expansion if we are to create jobs and grow the economy.  Problem is, businesses and consumers aren’t getting the loans they need.  Why?  In part because banks want to sit on the reserves.

The solution?  Obviously we need to lower the interest rate paid on the reserves so that banks would choose to make loans (at least constructive loans, not just loans to buy derivatives) in larger volume again.  Well with an interest rate as low as 0.25%, one-quarter of one percent, it’s hard to go much lower.  Or at least that’s what economists and central bankers have long thought.  We thought there was a “zero lower bound” which fancy talk for “interest rates can’t be negative”.

Now we return to Sweden.  The Swedes at the Riksbanken thought “outside the box”, or at least outside the “lower bound”.   They lowered the interest paid on bank reserves deposited at the Riksbanken to a negative number: -0.25%.  In effect, Swedish banks now had to pay the Riksbanken for the privilege of keeping the reserves at the central bank.  As their chair explained, it was, in effect, like having a penalty tax on holding extra reserves.  The idea was to motivate banks to reduce the level of reserves to what they really needed for transactions and take the rest and lend it.  By lending it, it would lower interest rates charged to business and consumers (‘banks compete, you win!’). Businesses and consumers take their new loans and spend the proceeds.  Spending makes sales at businesses. GDP grows. People get hired.  The economy recovers.

It worked. Dramatically.

And it worked.  Sweden’s growing now at over 7%.  They’re now concerned about how to keep the economy from overheating.  We in the U.S. should be so lucky.  Instead we’re still stuck with anemic growth of around 3% despite unemployment of near 9% or more.  Both the government and Federal Reserve continue to be concerned with the health of the banks – whether they are profitable enough and have enough reserves.  We’re worried about helping banks, but nobody is willing to make the banks help the economy through the right incentives.

The challenge getting an economy to recover and grow again after