Cato @ Liberty
Lower the Corporate Tax Rate As Much As We Can, While We Can
Thu, 14 Dec 2017 13:38 EST

The recently concluded tax reform conference report draft includes a one-percentage-point increase in the corporate tax rate above what both the House and the Senate passed, with some of the revenue savings being used to keep a portion of the deduction for state and local taxes as well as forego delaying its implementation until 2019, as the previous bills proposed. There remains a chance the rate may tick up yet again before negotiations are concluded, especially if other targeted tax breaks get some traction in the Congress over the next few days.

However, even this small diminution in the rate reduction is a mistake: while a one point increase may seem to be a trifle, each uptick in the corporate tax rate represents a large opportunity cost that Congress won’t be able to easily rectify in the future.

My former colleague Gordon Gray and I examined the tax code that emerged from the 1986 tax reform, as well as the various changes Congress made to the code in the subsequent thirty years, in a study published in Tax Notes, to see if we could discern some broad patterns regarding what sorts of changes proved ephemeral and which ended up being permanent.

As to the former, the list stretches a mile wide: Congress has changed the top personal tax rates four times since 1986 and seems poised to change it again. It has also tinkered with tax rates on dividends and capital gains numerous times. It has also inserted a litany of tax credits, subsidies and the like over that period as well, in order to encourage us to conserve energy, pollute less, or save more for retirement, or health care, education, or a funeral. A few years ago Rep. Thaddeus McCotter even proposed a tax break for pet expenses.

On the corporate side, Congress has done nearly as much tweaking. For instance, it tends to change the tax treatment of capital investment every business cycle, and a few years ago it created a special tax rate for manufacturers (and other industries with enough juice to be labeled as such). Congress has also modified how overseas income is taxed several times, and altered the code repeatedly to encourage environmentally sound behavior.

What hasn’t changed over the last thirty years? The corporate tax rate. A mere one point increase in 1993 marks its only alteration since the 1986 reform. In the context of our government’s predilection to conduct a wide manner of economic policy through taxes, its stickiness is remarkable.

We suspect the durability of the corporate tax rate owes to the fact that the benefits to reducing the rate can be difficult for voters to comprehend. Opponents of tax reform can simply shout that it is nothing but a giveaway to big business and that has often proven to be enough to get congressmen to back away.

Of course, it is anything but a giveaway. During the three decades of U.S. corporate tax rate stasis, literally every country in the OECD has reduced its tax rate numerous times. In 1987 we had one of the lowest corporate tax rates amongst the group, but today we have the highest by far, which has made it more difficult for U.S. companies to compete against their foreign competitors. From 2000-2012, there were 85 different corporate rate tax reductions in the OECD, I found.

The high U.S. corporate tax rate is especially pernicious, because it is a lousy way to collect tax revenue. Since a good fraction of it is borne by the workers in the form of lower wages, it’s not nearly as progressive as most people assume, and it achieves that progressivity at an extremely high opportunity cost in terms of foregone economic growth. Nobel Laureate Robert Lucas once said that eliminating the corporate tax was the closest thing to a free lunch that he has ever observed in economics.

History has shown that many other changes in the tax reform plan may be unwound in the near future, no matter what the final legislation contains. For better or worse, Congress cannot tie the hands of a future congress. But whatever happens with the corporate tax rate in the final bill will likely remain the law for the foreseeable future, so above all else we should strive to get it right.

And the right rate is the lowest rate possible. 

All I Want for Christmas Is...Civilian Leadership of U.S. Foreign Policy
Thu, 14 Dec 2017 12:35 EST

In their infinite wisdom, the Founding Fathers warned against the dangers of standing armies and determined that it should be civilians, not military leaders, who had final authority over the size, shape, and use of America’s armed forces. Their reasoning was simple. Without civilian control of the military there would be no bulwark against military coup or dictatorship. 

But civilian control should not stop at simple control over the armed forces. Civilian officials must provide active leadership and management of the full spectrum of American foreign policy efforts, from intelligence gathering and alliance building to arms sales and crisis diplomacy and, most importantly, the decision to make war. The old chestnut that “War is too important to be left to the generals” is an old chestnut for a reason: It’s true.

Civilian leaders have institutional incentives to be responsive to the full range of considerations that must inform foreign policy. Military leaders, as well informed and dedicated as they may be, operate with too much occupational bias to be the only source of input to the foreign policy making process. Their input on military matters is critical – but not sufficient. Socialized to look at every mission in black and white military terms, military leaders are in fact poorly suited to exercise the kind of political judgment required in a liberal democracy.

And this is where we have a problem. Since taking office, Donald Trump has made it achingly clear that he has little or no respect for the concept of civilian control, and little interest in exercising the sort of political judgment necessary from the White House.

As a candidate Trump exhibited signs of militarism, but it was his appointment of several current and former generals that signaled the coming erosion of civilian leadership. McMaster, Kelly, and Mattis are all clever and competent people, but  putting military leaders in charge of the Pentagon and the National Security Council began the tilting of the playing field, ensuring that Trump would get a larger dose of the military worldview in every conversation about world affairs.

The real proof of the loss of civilian control over foreign policy, however, has been Trump’s abandonment of diplomacy. First, Trump appointed Rex Tillerson, a man he had never met and whom he clearly did not really trust, as the Secretary of State. Then, he made sure that Tillerson’s main job would not be to act as the nation’s top diplomat and top foreign policy advisor to the president, but instead to perform radical surgery on the State Department. Tillerson’s plans to shrink and reorganize the State Department have already led a large percentage of the department’s most talented people to resign or retire. The failure to appoint new leaders for a vast number of top State Department jobs not only echoes Trump’s disinterest in diplomacy, but also undermines the broader concept of civilian control in foreign policy.

Of course, it’s not clear that Trump even thinks he needs a State Department. When Tillerson was trying to encourage North Korea to sit down for talks with the United States in late September, Trump hamstrung his efforts by issuing a contradictory pair of tweets: “I told Rex Tillerson, our wonderful Secretary of State, that he is wasting his time trying to negotiate with Little Rocket Man…” and then, “…Save your energy Rex, we’ll do what has to be done!”

The implication is clear: not only aren’t Rex Tillerson and the State Department part of the solution, Trump doesn’t even think of Tillerson as being part of his national security leadership team in the first place. It’s hard to imagine any previous president saying “we” with respect to a foreign policy issue and the Secretary of State not being part of that “we.”

Beyond the loss of diplomatic influence and engagement it portends, Trump’s breathless militarism and the loss of civilian control also puts the nation at grave risk. Less than two weeks ago one of Trump’s generals, National Security Adviser Henry McMaster, warned that the potential for war with North Korea was increasing by the day and that there “isn’t much time left” to prevent it. Rather than working with a wide range of civilian and military leaders to figure out how to make diplomacy work in North Korea, it looks like Trump has already decided that the military option is the only one that matters.

When Trump took office, many people hoped that “responsible adults” might be able to moderate his foreign policies. Without greater civilian leadership, however, the prospects for sound foreign policy look grim.

Explaining Commerce to the Commerce Secretary
Thu, 14 Dec 2017 12:33 EST

As college students across the country begin their final exams, we are reminded of the unfortunate reality that much of what we learn in school or other parts of life will eventually be forgotten. Usually, this is more of a nuisance than a problem. A failure to recall the finer points of Shakespearean literature is unlikely to trouble most accountants, nor is a marketing specialist apt to lose sleep over the lost ability to define the Pythagorean Theorem. It’s a bigger problem, however, when the Secretary of Commerce forgets some basic lessons of international trade.

Appearing at an Atlantic Council event earlier this week, Commerce Secretary Wilbur Ross argued that the Korea-U.S. Free Trade Agreement (KORUS) should address the U.S. trade in goods deficit with South Korea. Despite the fact that economists generally agree that the trade deficit is not a good indicator of a country’s economic performance—or as our colleague Dan Ikenson argues, is not a problem to solve—Secretary Ross thinks otherwise. In the context of president Trump’s recent visit to Asia, he stated the following:

President Trump…underscored the need to rebalance the KORUS free trade agreement to reduce the substantial trade deficit that we have with Korea. That deficit has nearly tripled to $27.7 billion since KORUS went into effect. Among the most important reasons for the increased deficit has been the imbalance between automotive imports and exports. Our automotive imports from Korea are almost nine times our exports of autos to them. And remarkable as it may sound, we export to Korea more dollars’ worth of corn and beef combined, than we do cars—seems strange for an industrialized economy.

The solution he offered to this “problem” was for South Korea to agree to purchase more liquefied natural gas, petroleum, food products, machinery and industrial equipment from the United States instead of other countries.

There are two basic things Secretary Ross gets wrong with this line of reasoning. First, he misunderstands the one true and nontrivial principle in the social sciences, which is Ricardo’s theory of comparative advantage. Second, by focusing only on goods—and cars in particular—he ignores the diversity of the U.S. economy, and some of its greatest strengths, such as the services industry. We address both in turn.

David Ricardo clearly explained the theory of comparative advantage in On the Principles of Political Economy and Taxation 200 years ago. He stated:

If Portugal had no commercial connexion with other countries, instead of employing a great part of her capital and industry in the production of wines, with which she purchases for her own use the cloth and hardware of other countries, she would be obliged to devote a part of that capital to the manufacture of those commodities, which she would thus obtain probably inferior in quality as well as quantity.

The quantity of wine which she shall give in exchange for the cloth of England, is not determined by the respective quantities of labour devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal.

England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.

To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth (para. 7.13-7.16).

This example highlights an important element of comparative advantage. First, even if one country is the best at everything (in other words, has an absolute advantage), it is still better served by focusing on what it produces best, and importing the remaining items. Why? Because an absolute advantage does not necessarily equal a comparative advantage, as the latter is based on the opportunity cost of making one thing over another. For instance, if planning a birthday party with a friend, and you’re better at both baking cakes and writing nice invitations but only slightly better at the invitations, it makes more sense for you to bake the cake and for your friend to send out the invites than for you to do both. It not only is more efficient, but it also spares up the time you would have spent writing those invitations to focus on making an even better cake. Essentially, comparative advantage allows for greater investment in the thing you are good at, and in turn, makes you better at it over time.

This logic is easily applied to the bilateral trade relationship between the United States and South Korea. Endowed with vast amounts of land ideally suited both for cattle grazing and growing of corn, the United States enjoys a considerable comparative advantage in such products and is the world’s largest producer of both. Lacking such geographic advantages but possessing a highly-skilled workforce and some of the world’s leading manufacturing firms, South Koreans instead specialize in the production of cars. By focusing on what each country does best, and then engaging in trade, the citizens of both countries are made better off. Rather than building cars, Iowa corn farmers raise crops, harvest them, and then send them to foreign lands where in exchange they receive cars and other needed goods. To force South Korean autoworkers to grow their own corn or Iowa farmers to build their own cars would be to live in a less prosperous world.

Also overlooked by Secretary Ross is that a country as vast and economically developed as the United States is able to enjoy comparative advantages across multiple sectors and industries. In addition to being an agricultural juggernaut, the United States is—perhaps contra the popular narrative—a manufacturing powerhouse with output near record highs. While the United States does indeed send large amounts of beef, corn, and other agricultural products to South Korea—$6.2 billion worth in 2016—these are dwarfed by its manufacturing exports.  Indeed, one category of manufacturing exports alone, machinery, saw exports ($6.1 billion) nearly equal to agricultural products in their entirety. The United States exported another $5.3 billion worth of electrical machinery, $5.2 billion in aircraft, and $2.9 billion worth of optical and medical instruments, in addition to vehicle sales of $2.2 billion.

Beyond its massive agricultural and manufacturing sectors, the United States—like most advanced economies—is also increasingly oriented towards the production of services where it possesses considerable expertise. Not mentioned by the Commerce Secretary is that the United States exported $21.6 billion in services to South Korea in 2016 and was left with a trade surplus in this sector of $10.7 billion.

Unlike the goods trade deficit, Secretary Ross has made no indication that he believes this particular trade surplus to be a problem or that he intends to pressure Americans into purchasing additional South Korean services to achieve balance. Nor should he. Rather, the citizens of both the United States and South Korea should be left to their own devices to purchase the products and services they desire and trade as they see fit with minimal interference. Instead of bemoaning a goods trade deficit that is more statistical quirk than indicator of economic vitality, or puzzling over why the United States does not export more of a particular good, Ross would do better to spend his time removing the remaining barriers to trade between the United States and South Korea and allowing the miracle of comparative advantage to work its magic. 


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