Grasping Reality on TypePad, by Brad DeLong

Here on the line with me is Kevin Hassett, Chairman of the CEA, who's going to walk through the report with you and take some of your questions on it. Kevin will be speaking on the record. The information on the call, as well as your copy of the report that you were sent -- if you didn’t get one, just ping me or send me an email, and I'll send you one -- that copy is embargoed until tomorrow morning, Monday, October 16th at 5:00 a.m. Eastern. And that's for the report and for the information on this call.

So, without further ado, I'll hand it over to Kevin to give an overview of the report, and then we'll open it up for questions. Kevin.

MR. HASSETT: Yeah, thanks so much, Natalie. And thanks to all of you for joining us here on a Sunday. And a special apology to football fans who are on the call, presumably, at about the most exciting point, I think, of a lot of the games out there.

We're here to talk about something that I've been working on for many, many years, which is the link between corporate taxes and wages. As I've said in some of my public remarks, there are a lot of parts of the plan that are yet to be determined; they're being worked out up on Capitol Hill. But there's enough detail on the corporate side for us to appeal to a pretty large literature that allows us to estimate the effects of corporate taxes on wages.

I'm going to sketch a little bit of the report that you guys have a copy of and then take questions. And I don’t want you to think that this call was the only time we can ever talk about this. In fact, also on the call is someone who I think most of your know, DJ Nordquist, who has kindly agreed to be the Chief of Staff for CEA. And so feel free to follow up with us if you have more questions after the call.

Economists have been puzzled by the slow economic growth of the American economy in recent years, and many seem to have resigned themselves to accepting that growth rates have to be under 3 percent and that that's the new normal. I think that there are a lot of policy levers that we can move to make it so that we aren’t at a new normal, below 3 percent. And one of them, which I've been working on, all the way back to when I started being an economist, is corporate tax policy.

Now, as our country has endured this weak economic growth for the last eight years, workers have paid a big price. Productivity and wages have both stagnated, while corporate profits have soared. This really has been quite a striking disconnect, which we talk about in the paper, of the sort of normal, former reliable relationship between corporate profits and what we're seeing now. Corporate profits soared at 11 percent per year over the last eight years, while productivity stagnated and real wages of American workers grew only by about 0.6 percent.

This disconnect between wages and profits is really a disconnect from historic norms, and we even have, like, a footnote where we cite statistics about when the trend break occurs. It looks like it's maybe around 1989. But it used to be that you would get about 1 percent of wage increase for 1 percent profit increase, but now the correlation has dropped depending on which (inaudible) you look at -- 0.6 or all the way down to 0.4, if you go to the most recent period.

So the disconnect between profits and wages rose in part, I think -- and I think the literature shows -- because America's broken corporate tax system brings incentives for firms to hold their money (inaudible) our borders. When firms hold their money overseas rather than invest them in America, they're holding down the productivity of the American economy and the wages of American workers. Productivity in America will rise if the firms decide to invest more on American capital assets, like machines. More capital assets that workers produce more -- and when workers can produce more for a business, businesses can afford to pay their workers more, and wages go up.

Our corporate tax rate right now is high, as many of you know, compared to the rest of the world, making our firms extremely uncompetitive on tax grounds. In 1989, the average statutory corporate rate imposed by OECD central and sub-central governments was 43 percent compared to 39 percent for us. And since then, the OECD average corporate rate has decreased to 24 percent while our corporate rate hasn’t budged in almost 20 years. And those firms have reacted to our burdensome taxes by offshoring, and our high rate has also discouraged foreign investment into the U.S.

Now, what has the rest of the world learned from lowering corporate tax rates that we have not? Well, the CEA paper delves into the evidence on this, of those countries, to see how corporate tax reductions have impacted their workers' bottom lines. And again, as I mentioned, we only look at the corporate side in this study and we'll analyze the rest as the details become available.

So you can think of the unified framework as follows: The individual side reforms are how people get taxed, and the business side reforms are how corporations and pass-through businesses get taxed, and the CEA analysis is again only looking at the corporate side.

The corporations make a lot of decisions based on taxes. Whether they decide to invest in new equipment is dependent on whether they can recover their investment with the profits the investment generates. And whether an investment pays for itself depends on a lot of things, but certainly the amount of money you get to keep after tax is a big part of it.

Now, the key CEA findings indicate that lowering the corporate rate from 35 to 20 percent would deliver an average increase in wage and salary income of at least $4,000 to the American household each year. And that's a very conservative estimate, as you can see, if you dig into the numbers of the study.

The main reason that wages increase is that the lower tax rate reduces the total cost of a firm that's investing in a capital asset like a machine here in the U.S., and more assets like machines let workers produce more. And when workers can produce more, businesses can afford to pay their workers more.

CEA calculates these estimates for how much the corporate component of tax reform alone would generate, and that statistical analysis required CEA to input numeric values for things that are hard to measure. The CEA staff based their choices and our choices of numeric values on things that are well established in the economics literature. The CEA chose those numeric values deliberately so that our analysis would be conservative and that we'd be more likely to underestimate, rather than overestimate, the final wage effect.

We also explore a number of different approaches to modeling this question, and compare the answers that you get from the different modeling approaches. And again, the range that is identified makes the $4,000 number a conservative guess -- or conservative estimate, I mean.

And so, with that, I think that you've had a chance to look at the paper. I'd be happy to go into more details about how the calculations are done, or anything else you'd like to talk about. And I'll hand it back to the other Kevin on the call, our operator, to open up for questions.

Q Hi, Kevin. Thanks for doing this call. Really interesting paper as always. Two things. On a clarifying note, can you just say when the $4,000 or the expected increase would kick in? So if the tax cuts are effective in 2018, does that mean that increase happens right away, or does it phase it over time?

And then, secondly, I just wanted to push you a little bit. As you note, so much of this is contingent upon CAPEX going up, more capital spending, more machines. Obviously, that's just been so weak during this recovery, and I just want to hear more about what makes you think it will rise substantially after a tax cut, especially when so many large companies don’t pay anywhere near the 35 percent tax rate right now.

MR. HASSETT: Yeah, thanks so much for that question. First, to the timing, as you can see in the report, that we go towards the estimate in a number of different ways. The first approach that we look at relies on the taxes and wages literature that -- Mathur and I had an early entry and that this developed quite a bit (inaudible). And we picked some of the more conservative estimates in that literature.

Now, when (inaudible) and I wrote our paper, we looked at the timing effects and found that we would tend to get a pretty large, almost fully phased-in timing effect over five years. Some of the other papers that we looked at were relying on cross-section variation, which means that their estimates give you the sort of (inaudible) in the long-run effect as the timing that's less precisely specified than it was in our original paper.

We also look at recent patterns. And if you look at Figure 1, I think that, normally, charts like that, as an economist you're very cautious just showing bar charts. But the point is that that figure shows you that this data happened mostly after the data that was analyzed by other economists. And you can still see this really strong pattern in the data where there's a lot of wage growth for low-tax countries but not so much for high-tax countries. And again, that shows that the correlation is pretty high and that you can probably get a good (inaudible) right away if you believe that that relationship is new.

And so it really depends on which model that you think you believe the most to help you think about the timing. And the fact is that the right thing for economists to do is to show people have to make decisions and people have to think about the effect of policies -- a review of all the different models, and it gives a range of what the results are so that you can form a certain expectation that also, kind of like a probably distribution, knows the different possibilities.

So I would expect to see an immediate jump in wage growth in part because of the large amount of repatriation activity that would happen right after the tax reform is passed, and then that you would probably see the full effect over the time period that we mentioned in the paper.

Was there a second question? After saying that now, Heather, I --

Q No, no, that was quite extensive. (Laughter.) I just wanted -- I was pushing a little bit more on the CAPEX going up, especially since some large corporations aren’t paying that 35 [percent], so they aren’t seeing that big reduction that was catalyzed.

MR. HASSETT: Yes, thanks for the reminder. So, 100 percent you've nailed a key thing to think about. And there's literature that were mostly drawn (inaudible) that looks at how wages affect directly to -- try to respond directly to corporate taxes. That literature, looking at wage effects, is generally in -- directly linking taxes to wages, and not necessarily connecting them through capital spending.

And so the capital spending channel is something that is modeled in a different literature, but an equally important one that I've also participated in for a long time that looks at how user cost of capital affects changes in investment, and how that affects capital spending. And that literature generally finds pretty big capital responses to tax changes. And I think that we could expect to see big capital responses and investment responses to tax changes this time -- because, as you said, capital growth has been so disappointing, and there's so much money on the sidelines to finance these things.

The fact is that, right now, we know that people are locating their capital spending offshore in order to do just what you said, Heather -- avoid paying U.S. tax. And if we cut the rate down to 20, which would be significantly below the OECD average, then there would be strong reason to believe that a lot of that capital spending would come home. The responsiveness should be almost at about (inaudible). And so with the user cost reduction of the scale we're talking about, you can see really quite a bit of capital spending. But exactly where it divides up is something that hasn't been done because those are two separate.

Q Hi, Kevin, thanks for doing this. Fun way to spend a Sunday with you and everybody else on this call. I'm curious about two things. One, what makes us think that these will be -- this is basically a productivity argument that you're making, that cutting taxes is going to improve productivity. Does that reverse-engineer to saying that your belief is that productivity has been slow simply because of tax and no other reasons?

And my second part of that is: I think a lot of American workers see capital spending not as something that gets them more tools to be more productive, but, in fact, might be buying things that can replace their jobs entirely. How would you think about the job dislocation effects of this?

MR. HASSETT: Thanks. So, first, the estimates that we've got (inaudible) based on belief but really on evidence. And so there's a lot of evidence that wages respond to changes in corporate taxes. And I think that there are two reasons why I believe that that's really true. One is that capital spending responds to corporate taxes (inaudible) higher capital investment and higher productivity. And the other is that profits tend to be located in low-tax jurisdictions. And there's a big literature, which we also cite in the study, that suggests that workers tend to share a significant portion of profits when they're located around them.

And so that's, really, I think the channel that makes the most sense. It (inaudible) right where we are -- because in the corporate taxes and wages literature, not every country has as much (inaudible) capital spending at home and cash sitting offshore as we do right now. And so I think that we should expect that those effects would be really quite significant.

And there was a follow-up too, right?

Q Yeah, about whether the technology -- how you think about job displacement from these capital investments.

MR. HASSETT: Yeah, so one thing that someone might think would be -- a critic might worry that it's just going to fund a lot of automation. I think that automation is certainly something that will increase productivity and over time drive higher wages. But at the -- of course, we can imagine robots can replace CEA chairs. And in long run, a study is something that we're focused on.

But in the near term, I think there's every reason to believe that these correlations that are so striking in the data, that you can see it even in something as simple as Figure 1, that those would drive the near-term (inaudible) experience. And that's why we're so optimistic that the wage gains of the scale that we discuss in the paper are extremely doable.

Q Hi, Kevin, let me echo everyone's sentiment, and thank you again for doing this on a Sunday. Two questions. One, President Trump has touted the performance of the stock market in anticipation of his economic plans. Should we have expected a parallel acceleration in wages, given the argument that you've laid out in this? And if so, when would be a reasonable time to expect that wage growth as the market processes that information?

Secondly, a lot of companies earlier in this year, in the administration, said that their primary problem is a skills gap for the workers they're looking to hire. What role do you think the skills gap plays, if any, in whether or not these workers get wage increases?

MR. HASSETT: Oh, sure. Thanks for the questions. So, first, if we think about the economics of the stock market, the stock market values -- basically, the present stock market value of a firm is the present value (inaudible) of the pre-cash flow of that firm. And so if the stock market were to think that there was a chance that the corporate tax rate would drop, say, from 35 to 20, then the stock market could go up, even if the probability of the tax change was somewhere between zero and one.

And I don’t think that when you're trying to think about how big that effect should be, that you should just take the percentage change from 35 to 20 that, and say that (inaudible) to how much the stock market should go up. And the reason that you shouldn’t do that is exactly what Heather was talking about earlier, that right now we have a really high rate but we're not getting a lot of revenue from that because the profits are located in Ireland and other low-tax countries. And so the true burden right now of that tax is not nearly what was (inaudible) given how high the rate is -- that burden is for many countries, because they can transfer so much profit offshore that they don’t even post a profit here in the U.S. -- almost zero.

And so should wages go up when the stock market goes up, I think that we need to deliver and get this tax bill passed to see the wage change. I think that the stock market has factored in right now some expectation of the benefits of deregulation and the probability of tax reform. And I would expect capital spending -- which has been ramping up a little bit -- to really take off if the tax bill passes but would disappoint if it doesn’t.

You mentioned the skills gap. That is something that is very clearly in the data, that there are places where -- parts of the country where labor markets are very tight right now, and then there are parts of the country that we all know have experienced this economic tragedy, really, over the last couple of decades and have lots of able-bodied workers who don’t see a lot of demand for their labor. And one of the things that the President has even talked some about is the fact that there's not a lot of movement from the distressed areas to the areas that are booming, and that that has left distressed areas in distress.

The fact is that a tax cut like this is precisely the kind of thing that you need in order to encourage firms, who will then want to locate plants in the U.S. and foreign firms will also want to locate plants in the U.S. in response to this tax cut, to locate those plants in places where there are people -- available workers with the rights skills. And so I would expect to see that increase in manufacturing employment, for example. And that increase in manufacturing employment, if firms are smart, will be located in places where there are a lot of available manufacturing workers.

Q Hi, thanks so much for doing this. A couple of different clarifying points here. The first you mentioned, but there are, kind of, two different ways of modeling this: one that connects wages and taxes directly, and then one that has a more of a connection between capital spending and wages. Do you get the numbers depending -- the impact on wages depending on which model you use? And then, the other question I had was, does this model or does this result depend on what the rate is for repatriated profits?

MR. HASSETT: Thank you. For the second one, we're modeling just the statutory corporate tax rate, not -- I think you might be referring to (inaudible) -- for those of you who aren’t full-time tax people, there's a lot of (inaudible) firms that have been accumulating offshore, and there's discussion about charging a one-time deemed repatriation fee so that firms could then send it home. And we have not factored that repatriation in, other than at the end of our report mentioning that that's one of the reasons why we expect that these effects could happen even sooner than you see in the tax and wages literature.

You mentioned that we had a couple of different ways of estimating it. Really, we discussed two or three. And in the (inaudible) of time, you could even do it four or five different ways. There are lots of different models. But we cite, for example, there was one academic paper that did a big fancy computer model, and ended up getting an increase above baseline wages of $5,100. We have, within the taxes and wages literature, if we use the low-end estimates, we get $4,000. If we use the, sort of, more optimistic estimates, we get $9,000.

And then there's also a question of whether you care more about the mean household or the median household. And the mean -- the average household income is $83,000 in 2016, but the median is $59,000. And so if you're talking about the $4,000, then you would wonder are we talking about the average person is the median. And we walk everybody through all those calculations in the study.

Q Hi, I just wanted to make sure I'm really clear on something -- which I know is the first question about this timing for this $4,000 annual estimate on the conservative end, increase in household incomes. I understand that over a range of time -- what would be the best way to phrase that for sort of a layman, common reader --

MR. HASSETT: Thanks for the opportunity to clarify. I think that if you look in the study to the part where we talk about what happens if we move our rate to the same as -- or we reduce our rate so that it's about the same reduction, as you see in the difference between those two lines in Figure 1, that then you could get (inaudible) wage growth -- instead of 0.6 up to around 2. We discussed it in detail in the paper.

And I think that if I were making (inaudible) to think about what kind of timing we're talking about, that if you grow off of the base of $59,000, or if you want to talk about the average person in the eighty -- in that higher wage growth rate, then you can watch the money accumulate relatively quickly.

Q So any kind of thing that you might get an initial -- because of the repatriation, you might get an initial surge in wage growth? You were kind of saying beyond this $4,000 annually -- like in 2018, if this bill passes at the end of the year, then people could see their wages increase by $4,000 that year? Or this is still over a long period of time?

MR. HASSETT: It's hard to come up with a model that jumps to $4,000 in the first year. But remember, it's not like a one-time payment of $4,000, but what's happening is that we're growing people to a much a more desirable real wage that (inaudible), and that when you get to $4,000 and say that that happens out a few years, depending on which of the calculations you want to rely on (inaudible), you keep going so that it's an annual number and it's one that would be repeated and continued because it's supported by two things: more profits here in the U.S. and more capital spending here in the U.S.

Q Okay. And then just the last thing to make sure I'm clear on that. And so this calculation is only looking at the effect to the corporate tax rate; it's not calculating other changes like the estate tax? Like, I know an estate tax is mentioned as a tax that could help create jobs, eliminating that. Is it fully looking at just changes to the corporate tax rate?

MR. HASSETT: Sure, that's right. And again, to remind of the conversation at the beginning, that since there's a really big literature that looks specifically at the question of the statutory corporate tax rate -- what happens when it changes, what happens to wages -- right now we have enough details, given the desired target that's been agreed to in the unified framework to model this and say what happens to wages.

But to give you the overall growth effect for the whole U.S. economy, then that would require having the complete plan. And we'll hold off modeling that until we do. But just recall as sort of a final backgrounder on how the CEA works -- that the CEA chairman is the chairman of the troika, which is the Treasury Secretary -- made up of the Treasury Secretary, the CEA Chairman, and the OMB Director. And the troika will go through all of this analysis and set growth assumptions that will be part of the President's budget and the economic report to the President. And that troika process is really going on right now, and so there's a heck of a lot of analysis going on to help us think about what those growth assumptions will look like given these policy developments.

Q So the first one is on base broadening. The report all focuses on statutory rates, but doesn’t the outcome of what happens to things like 199, which is basically statutory rate cut in disguise already, and interest deduction (inaudible) and inbounded changes? And wouldn’t any of that have any effect on wages (inaudible) as opposed to just sort of saying this is just 35 to 20 to all that's going on?

And then, second, a lot of the foreign profits are really just sort of rents shifts abroad with IP, like what makes you think that -- again, these are foreign markets -- what makes you think that any of that would come back, especially if companies are still able to get paid 19 or 12.5 or 2 elsewhere?

MR. HASSETT: Yeah, thanks. So you're absolutely right that the base-broadening things that are under discussion -- like, for example, a change in interest deductibility -- will have economic effects that will lead the model, and we'll definitely model those as they come.

I think that this reduced (inaudible) correlation between corporate taxes and wages is very powerful evidence -- have been very powerful evidence. But you're correct that if there were lots of other changes that we haven’t modeled that worked in the other direction, then these numbers could change. That's what science is all about, is analyzing the stuff that we have before us.

The foreign profits -- I think if you look at -- and now, I'm an economist, not a lawyer, but I studied the law in this place a little bit -- but if you look at transfer pricing practices, it's not just the case that you can (inaudible) only if you have intellectual property. There are transfer-pricing practices that attribute special skills to workers and foreign manufacturing plants and so on. And so the companies really do have a great deal of freedom to move the money around.

And for those who aren't international tax people, I'll just walk through the mechanism for a sec. The way you can think about it is, if I set up a subsidiary in Ireland and I make something that I sell back to the U.S., and their price for that is $5.00 but I pay the Irish $20.00, that what happens is I moved $15.00 to Ireland and increased imports by $15.00, and so increased the trade deficit as well. And those practices do, in part, as you mentioned, sometimes leverage intellectual property, but they also leverage just things that are very, very difficult to litigate. This is an area of tax law where the government almost never wins.

Q On the base-broadening point for a moment, are you saying that if there were a base-broadening equivalent to (inaudible) points on the rate -- so if the net corporate tax went down by trillion, (inaudible) number of decades, that -- that the (inaudible) instead of $1.5 trillion, would the wage growth also be half of what you'd expect -- of what you're saying in the report?

MR. HASSETT: It's a really good question, and the way we would model it is -- so if you look at the corporate tax changes that have been the focus of the study of the literature, so all the countries all around the world that register statutory corporate tax rates, the (inaudible) also then accompanies almost always with base-broadening efforts. So they reduced the rate again, they broadened the base a little bit.

And so really, the correlation that we're picking up underneath it all is definitely some kind of effect of base-broadening as well. And so when we see the final base-broadening, we will be able to adjust these estimates, but it would be not relative to no broadening at all, since we're using this literature, but rather relative to the typical base-broadening that's in there already in the economy.

Thank you, everybody, for showing up on a Sunday. And again, follow up with the press office or with DJ if you have more follow-up questions.