Understanding Corporate Tax Cuts: embracing conventional wisdom and coming to radical conclusions

Warning this post contains scenes of graphic illustration, it is not intended for short attention spans or people who can not locate coordinates in two dimensional space.  Viewer patience is therefore highly advised.

The debate on corporate income taxes brings out a really nice teachable moment in that it provides an occasion to clarify the terrain of past present and likely future debates on macroeconomic policy.  In what follows I will hew closely to the standard story, but what I intend to show is that even within the terms of the conventional collective memory there is an important contradiction that helps clarify what the real debate over corporate cuts ought to be about.  Let me see if I can deliver.

The conventional account of history runs something like this.  By the 1970s and early 80s unions had become too strong, unemployment insurance and welfare programs too generous and together they produced highly distorting macroeconomic outcomes: high unemployment, high inflation and low output (referred to at the time as stagflation).  Let me just accept this account for argument sake because I think it represents the story in the back of the head of most policy makers and economists over forty.  Let us represent this conventional story by line A in the diagram below.  Notice the oscillating line around A.  That represents the economic cycle.  From the vantage point of policy makers and economists over forty  the problem with the Keynesians is that they were preoccupied with stabilizing those oscillations when they should have been preoccupied with moving the economy towards line B.  Line B represents an equilibrium in which both employment creation and output proceed in a balanced manner.

Point Y represents the bad equilibrium that Keynesians were unwittingly fixated.  In their drive to stabilize the macro economy via employment they gave short thrift to output and thus created an inflationary environment which produced increasing high levels of unemployment, low levels of output and high levels of inflation. In time policy makers and economists shifted their attention away from cyclical stabilisation to structural change .  That is, from attempting to smooth the oscillations around line A to moving the macroeconomic trajectory from line A to B.

Notice that point Y does not entail a lower level of employment but rather a higher level of output.  And this was what was so seductive about the supply side arguments of that time.  What they in fact said was that it was possible to maintain employment and increase output provided the appropriate structural reforms were undertaken.  Everybody and I mean everybody wanted lower inflation and higher employment.  And in the face of stagflation the punters got onside and away we went.

My argument is simply this.  After the largely successful attack on trade unions was accomplished, after the reform of both welfare and unemployment insurance programs were completed and within the context of free trade and capital mobility the real impact of he structural changes was to move the economy to line C point Z.  That is to say, even granting neoliberalism was not some radical attempt to reconfigure income and wealth distribution between economic classes the structural reforms were more successful than its antagonists imagined and thus instead of landing on trajectory B point Y we landed on trajectory C, point Z.

When therefore there is the call to cut corporate income taxes it explicitly assumes that the Canadian economy is still stuck on trajectory A point X.  But if in fact we are on trajectory C, point Z; we are thus in fact stuck at a bad equilibrium.  The move to further juice up output without a commitment to juice up employment is like the Keynesians of yore trying to smooth the oscillations around a bad equilibrium. But this time around it is employment which is lacking not output capacity.

What does this have to do with corporate tax cuts?  Corporate income tax cuts are suppose to be a stimulus to increase the output capacity of the Canadian economy over the medium to long term.  But if as is widely recognized output is not the problem but employment why are we even talking about supply side measures (i,e. corporate tax cuts)?

I think economists are still fighting the last war and not the war we are in.  And as any historian of war will tell you an army that does so will loose.

Update: this is not as radical an idea as it may appear: see this article in the business section of the Globe online.  The difference with Canada is that I think are debt growth is papering over the underlying bad equilibrium.