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A Numerical Example on Corporate Tax Cuts and Wage Increases

Summary:
In my last post I mentioned that a lot of economists are puzzled that corporations are announcing wage hikes right when the tax cut goes through. I’ve now jotted down some numbers to show exactly what I mean. But before I dive in, let me say what I think the fundamental problem is: The way professional economists (especially in academia) think about firms and production, there is no corporate net income. So it shouldn’t be surprising if they miss what may seem obvious to the layperson. (Let me stress again that I’m not making fun of the economists here. These are all really smart people. I’m pointing out that standard models of perfect competition with “zero profit” don’t typically include the explicit earning of interest as a return to financial capital.

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In my last post I mentioned that a lot of economists are puzzled that corporations are announcing wage hikes right when the tax cut goes through. I’ve now jotted down some numbers to show exactly what I mean.

But before I dive in, let me say what I think the fundamental problem is: The way professional economists (especially in academia) think about firms and production, there is no corporate net income. So it shouldn’t be surprising if they miss what may seem obvious to the layperson.

(Let me stress again that I’m not making fun of the economists here. These are all really smart people. I’m pointing out that standard models of perfect competition with “zero profit” don’t typically include the explicit earning of interest as a return to financial capital. Instead, interest is conceived as a return to the physical productivity of capital equipment. I’ve mentioned this problem before, when I was trying to help some Texas Tech students get ready for their first-year qualifying exams.)

So my “take” here is to ask: Why do corporations need net income in the first place? It’s because the shareholders need a return on their invested equity. If they thought they would get a 0% return, then they’d be better off putting their funds in bonds.

You can either think of it as a very short-term thing, where there is no such thing as pure arbitrage. No matter what the corporation invests in, there’s a chance it will fail. So ex ante, the corporation needs to expect to earn a positive return, even for a timeless transaction. Competition *won’t* drive revenues down to explicit out of pocket costs for factors.

Or, you can think of it with certainty, but then you need to include the time element. That’s what I’ll do here. (And someone tell me if you think I’m botching how accountants in the real world would handle this type of calculation vis-a-vis the tax authorities.)

So, suppose there’s no corporate tax. There’s constant returns to scale. There is just one input, labor. If a corporation pays a wage w, it gets an intermediate product, and then it takes 12 months to market and finally sell it for $110 to the final consumer.

If we suppose that the shareholders require a 10% return on their equity, then in equilibrium it must be that the wage is $100. The corporation would report (right?) net income of $10 for each unit produced. But we economists would say, “That’s not pure profit, that’s just accounting profit. It’s the interest return on invested financial capital.”

OK what if the corporate tax rate is 35%? Then the wage paid is about $95 (rounding down). The product sells for $110, so before-tax net income is $15. But the corporation only keeps 65% of it, i.e. $9.75. And a $9.75 interest earning on the invested $95 works out to a 10.3% rate of return.

Now what if they lower the corporate tax rate to 21%? Then the wage paid jumps to $98 (rounding up). The product sells for $110, so before-tax net income is $12. The corporation keeps 79% of it, i.e. $9.48. That’s a 9.7% rate of return.

So, if you are OK with my rounding to the nearest dollar, we see that cutting the corporate income tax rate from 35% to 21% immediately boosts wages by $3/$95 = 3%. This has nothing to do with investing in physical capital equipment and boosting productivity. This is just the new equilibrium wage needed to keep the rate of return on shareholder equity the same.

What am I missing, friends?

Robert Murphy
Christian, Austrian economist, and libertarian theorist. Research Prof at Texas Tech and author of *Choice*. Paul Krugman's worst nightmare.

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