The new price war.
This current trend of countries lowering their corporate tax rates (Trump is proposing reducing US rates from 35% to 15%, the UK from 20% to 17%, Australia from 30% to 25% - maybe lower) is like a price war. And during normal times (I will discuss abnormal times too), this strategy is not wise.
Consider a price war between Coke and Pepsi – both know that they can’t win market share based on price. If one of them lowers the price of a bottle in an attempt to gain market share and profit, the other will just follow suit. Consequently, both will end up with the same market share, but less profit, resulting in both Coke and Pepsi being worse off. So both Coke and Pepsi have an invisible ‘gentlemen’s agreement’ to not engage in a price war because both would end up worse off. To gain market share, they need to win based on non-price competition, specifically advertising/ marketing.
This is similar to attempting to gain international investment by lowering national corporate tax rates – each country would try to gain/ maintain advantage by cheating/ breaking the rules of the ‘game’ (the gentlemen’s agreement), and stealing investment share off others. Philip Lowe, the Governor of the Reserve Bank of Australia, recently made a similar point to the House of Representatives Economics Committee:
“…from a global
perspective … lowering of the corporate tax rate from one country to another
just changes the location of investment and does not increase aggregate
[global] investment.”
But ‘winning’ depends on others not following suit. If all others ‘cheat’ too, everyone ends up with the same shares of global investment but with a lower level of tax revenue, so everyone is actually WORSE off. Income inequality will probably also get worse as governments have less money to support the disadvantaged through redistribution.
Furthermore, corporate tax rates are just one consideration international investors take in their decision making (others include legal, political and broader economic considerations). So even if other countries don’t follow suit, it is possible that only a small amount of additional international investment would actually be enticed by lower corporate tax rates, while lost tax revenue will be more significant.
During normal times, Australia shouldn’t try to win market share by doing something everyone can do – lowering tax rates. They should do it by marketing Australia as the economically and politically most stable and profitable place to do business – something which shouldn’t be hard to do, given our competition is the politically and economically tumultuous Europe and the US.
“… in a perfect
world we would have a common global corporate tax rate, so business could
decide where to locate based on the strategic and comparative advantages and
not on corporate tax. But that is not the world we live in.” (Philip Lowe).
So now for abnormal times…
The only way lowering global corporate tax rates can win is in abnormal times when the global investment pool is smaller than usual (such as following a major global economic crisis when business and industry is undertaking fewer investments out of fear, uncertainty and/ or tight budgets), so lowering global tax rates arguably will cause more TOTAL investment in the world, beyond what monetary policy can do alone, rather than just splitting the global investment pie into different shares. This is basically the fiscal policy stimulus I’ve been supporting. Once monetary policy reaches its limits and the economy is still depressed, fiscal policy becomes an increasingly powerful means of properly bringing the economy back to trend.
But it should only be temporary, otherwise, once the total investment pool returns to normal, countries will be missing out on tax revenue, and inequality will get worse because low tax rates will go back to only being able to steal from your neighbour (not even that if your neighbour follows suit), not being able to expand the total pie.
And it seems that the ‘abnormal’ times of the GFC are not entirely over – at least from an investment perspective. The below graphs illustrate that while World investment rates have returned to their pre-GFC peak, this was driven by investment in Emerging market and developing economies. Advanced economies are still below their pre-GFC peak (or in Australia’s case, its mining and resources boom peak), but these were arguably unsustainable booms. Furthermore, maybe the developed nature of our economies simply doesn’t justify those levels any more anyway (it wouldn’t be surprising if Advanced economies had naturally declining investment rates over time – as occurred in the below graphs even before the GFC struck – as the simplest investment opportunities are exploited[1]). But even if we assume that we don’t want to return to these investment peaks, investment levels in Advanced economies, including the US, the UK, the EU and Australia, are still arguably below long term trend.
It is also true that the protectionist inclinations of countries recently (Brexit, EU nationalists, Trump, Australian minority parties) have the potential to not just disrupt trade flows, but also investment flows, so one may be able to justify lower corporate tax rates in order to compensate for the negative investment-effects of this growing protectionism (but there is an even better alternative for countries – don’t go down the protectionist road in the first place!). Consequently, a boost in investment could still potentially be justified to bring levels back to long term trend and end the legacy of the GFC once and for all.
Consequently, lowering corporate tax rates to spur investment could work – even if such fiscal stimulus should have happened seven or eight years ago. But, on average across the advanced world, it isn’t just private investment that is lacking – public investment is lower than trend also. So governments arguably need to boost investment in public infrastructure, not just outsource such stimulus to the private sector via corporate tax cuts – especially given the potential of the latter to worsen income inequality.
But if everyone is lowering tax rates – even if the advanced world investment pool weren’t unusually low – Australia possibly should still follow suit – not because it will stimulate investment per se, but because it may just stop Australia losing share.
Unfortunately, once one player ‘cheats’, it’s often rational for the other players to cheat too. This is a concept known in Economics – among others – as the prisoner’s dilemma:
Essentially, here is the scenario: two criminals are arrested and held in two separate interrogation rooms. The police don’t have enough evidence to prosecute yet, and are relying on at least one of the criminals ‘ratting out’ the other. Here are the possible outcomes:
· If neither criminal ‘rats’, they are both allowed to go free (both get a ‘payoff’ of 0)
· If both criminals ‘rat’, they both go to jail for 5 years (a payoff of -5 each)
· But if only one criminal ‘rats’, he/ she is given a reward (a payoff of 1) and the other who stayed silent but was ‘ratted out’ goes to prison for 10 years!
Given that the criminals can’t
force each other to cooperate (stay silent) because they are in separate
interrogation rooms, it can be seen that, no matter what Prisoner A does,
Prisoner B always has an incentive to ‘rat’. Similarly, no matter what
Prisoner B does, Prisoner A’s payoff is always larger if he/ she ‘rats’.Ideally, both criminals would remain silent and go free. Consequently, this was a frustrating notion in Economics because it implied that individuals behaving perfectly rationally would actually generate a sub-optimal outcome – something economic theory (but not common sense) had long believed to be impossible. |
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Nobel Prize-winner John Nash observed a similar phenomenon (according to the movie, ‘A Beautiful Mind’, portrayed by Russell Crowe in his Oscar-winning role) in a bar. He and three of his male friends observed five women walk into the bar – a beautiful blonde and four comparably less appealing brunettes. All the men wanted the blonde, and were tempted to act as ‘every man for himself’. But John made an observation that would end up winning him a Nobel Prize:
“If we all go
for the blonde, we block each other. Not a single one of us is gonna get her. So then
we go for her friends. But they will all give us the cold shoulder because
nobody likes to be second choice. But what if
no one goes for the blonde? We don’t get in each other’s way and we don’t insult
the other girls. It’s the only way we win. That's the only way we all get
laid.”
This revolutionary idea reinforces the notion that sometimes, cooperation – and not pure self-interest – actually leads to the optimal outcome in the end. Obvious, right? |
In conclusion, I suppose I do support lowering corporate tax
rates if the rest of the world is doing so. In current circumstances, it does
have the potential to drive global investment and economic activity in Advanced economies back to trend levels, and keep Australia from losing share.
However, it also has the potential to worsen income inequality, especially if
such a policy is pursued for too long. Consequently, I would prefer to see
governments of Advanced economies cooperate by making the first move in terms of
their own public investment. There are certainly investment opportunities
available for a willing government, at least in the US with its ageing
infrastructure needing replacement, and Australia with its vast land resources
that could support expanded public transport networks, broadband, and water and
power infrastructure. Global interest rates are also still historically low for
any credit-worthy advanced economy.
And if governments made the first move on investment, this could drive economic growth and private sector confidence (and eventually, investment) without the need for corporate tax cuts.
Either way, Australia doesn’t need to go as hard as some other countries though, because we’re arguably already in a better place – economically and politically – than much of the advanced world, so we’re already more attractive to foreign and domestic investors and consequently are in less need of stimulus (though still, some more would be good, especially in WA).
But if we do go down the path of corporate tax cuts, we need to understand that this must not be an attempt to steal share from our neighbours, but rather to collectively increase the size of the pie so everyone is better off. And hopefully, once the investment pool in Advanced economies has returned to normal, international cooperation can result in countries bringing their corporate tax rates back up to normal, otherwise inequality will rise as governments will miss out on tax revenue and won’t be able to finance income redistribution efforts.
And we mustn't be afraid to let this result in more debt – that can be dealt with over the longer term via the returns from the investments themselves. We certainly must not cut benefits to the lower end of the socio-economic spectrum (cuts that will hinder economic growth and worsen inequality more than benefits to the top end would stimulate economic growth and reduce inequality) to try to pay for these tax cuts – that would be (more than) self-defeating. Similarly, tax cuts for small and medium businesses may be more stimulatory than cuts to large companies, given the tendency of the latter to just absorb any new windfall and consolidate their existing positions, rather than actually invest further. But again, it will depend on what the rest of the world is doing and what types of investment risk being lost if Australia does not follow suit.
And if governments made the first move on investment, this could drive economic growth and private sector confidence (and eventually, investment) without the need for corporate tax cuts.
Either way, Australia doesn’t need to go as hard as some other countries though, because we’re arguably already in a better place – economically and politically – than much of the advanced world, so we’re already more attractive to foreign and domestic investors and consequently are in less need of stimulus (though still, some more would be good, especially in WA).
But if we do go down the path of corporate tax cuts, we need to understand that this must not be an attempt to steal share from our neighbours, but rather to collectively increase the size of the pie so everyone is better off. And hopefully, once the investment pool in Advanced economies has returned to normal, international cooperation can result in countries bringing their corporate tax rates back up to normal, otherwise inequality will rise as governments will miss out on tax revenue and won’t be able to finance income redistribution efforts.
And we mustn't be afraid to let this result in more debt – that can be dealt with over the longer term via the returns from the investments themselves. We certainly must not cut benefits to the lower end of the socio-economic spectrum (cuts that will hinder economic growth and worsen inequality more than benefits to the top end would stimulate economic growth and reduce inequality) to try to pay for these tax cuts – that would be (more than) self-defeating. Similarly, tax cuts for small and medium businesses may be more stimulatory than cuts to large companies, given the tendency of the latter to just absorb any new windfall and consolidate their existing positions, rather than actually invest further. But again, it will depend on what the rest of the world is doing and what types of investment risk being lost if Australia does not follow suit.
[1]
Interestingly, Australia actually doesn’t exhibit a downward trend, and has a
higher-than-average investment rate versus Advanced economies as a whole. This could be
because Australia, while being a high-income country, is still relatively
young. Not undeveloped – just in possession of more investment opportunities
that older economies like the US and the EU have already exploited – namely,
vast land resources.
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