The post below is silly. It is based on bending over backwards to take silly arguments for the GOP tax plan seriously. This older post is the one with some relevance to the real world.
The silly argument is that lower taxes on profits imply a lower cost of capital for firms. Investors will demand the same return net of taxes and so demand less from firms if the IRS takes less. The story continues that this lower cost of investing will cause firms to invest more which causes higher labor productivity and wages. This argument makes no sense for the following reasons
1) If you want to change investment, change the tax treatment of investment not something else. The gain (if any) from the GOP proposal should be entirely due to expensing investment. Reinvested profits will not be taxed. This should encourage higher investment in physical capital compared to paying dividends, buying back shares, or accumulating financial assets. I think it is good policy (and have thought so for 37 years at least). But once you have expensed investment, the tax on profits doesn’t affect the cost to the firm of investing. So long as it is constant it shouldn’t affect investment at all. Cutting the rate is a pure gift to owners.
2) Business investment doesn’t seem to be much affected by the cost of capital. This appears in aggregate data. The cost changes a lot with monetary policy as the interest rate changes. These changes have huge effects on aggregate demand, because they have huge effects on investment, in houses. The investment which depends on the interest rate is residential investment. Bigger houses don’t cause higher productivity and wages. For some mysterious reason the housing bubble’s expansion and bursting hasn’t convinced most economists to pay any attention to housing. Krugman says it’s been forgotten since the days of the dinosaurs
Back in the old days, when dinosaurs roamed the earth and students still learned Keynesian economics, we used to hear a lot about the monetary “transmission mechanism” — how the Fed actually got traction on the real economy. Both the phrase and the subject have gone out of fashion — but it’s still an important issue, and arguably now more than ever.
Now, what you learned back then was that the transmission mechanism worked largely through housing.
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