Zeev's Turnips Patch-No Politics (ZEEV)

[TJ Parker]

wsj article [Re TJ (Roach on China)]

http://online.wsj.com/article/0,,macro_investor,00.html

Washington Needs to Decide
If It Favors Capital or Labor

With strong rhetoric, Democratic presidential candidates have linked President Bush's tax cuts to job losses. But they've failed to provide the intellectual connection, explaining just how the president's changes to the tax code have eliminated a job.

Now there is help for the Democrats from an unlikely source: a supply-side economist who has consulted with the White House on economic issues and was even mentioned as a potential adviser to President Bush. In a recent report, David Malpass, chief global economist at Bear Stearns, said recent changes to the tax laws may actually have reduced hiring. His comments raise an issue that gets at the heart of the debate over the correct economic policies to forge economic growth and create jobs. Specifically, what are the appropriate incentives government should provide business? Should it favor capital or labor?

"… the differential cost between labor and capital has probably widened in recent years due to the improvement in the tax treatment of business investment and the increase in the employer portion of health insurance costs, encouraging business equipment purchases rather than new hiring," he wrote earlier this week.

For the market, the question of capital or labor is especially important. The lack of hiring in the economy looks good for stocks… now. Productivity and profits have been rising along with overall economic growth, and companies have been doing better without adding new workers. But the market wants to know how sustainable the recovery will be, and job growth is critical to keep the engine humming. As mortgage refinancings wane, it will take earning and job growth to keep consumer income and spending high. That's why the August employment report, showing a loss of 93,000 jobs has been so troubling.

(A big fan of the tax cuts, Mr. Malpass believes hiring should revive in 2004 as a result of the president's policies.)

Mr. Bush has been successful at implementing several changes to the tax code that have been beneficial to capital, including a reduction in the capital-gains and dividend tax rates. But among the most important and least discussed is the change in depreciation rules under the Bush administration. Previously, business equipment was depreciated by a schedule that conformed roughly to an estimate of the life of the asset. In the first round of the Bush tax cuts, business was allowed to write off 30% of the asset's value in the first year (plus the first year of the depreciation). That was bumped up to 50% (plus the first year) in the latest round.

By one estimate, this ended up reducing the cost of capital by about 6% compared to before Mr. Bush took office. (There is an argument that the reductions in income-tax rates are beneficial to labor, reducing the after-tax dollars required to hire a worker, but Mr. Malpass's comments make clear that capital has done better under this president.)

The president is fond of noting the tried-and-true economic idea that if you want more of something, tax it less. And he was responding to a consensus in the economic community that what we needed more of was business investment. Beginning with the last quarter of the Clinton administration, investment in equipment and software fell for six straight quarters. The president's economics were sound in that he was banking on another ostensibly tried-and-true relationship: the one between growth in business investment and payroll growth.

I ran some numbers, and over the past 50 years, employment and spending on business equipment and software dance in tandem about 70% of the time. That is, when one goes up the other almost always does too.

But Mr. Bush may have made a classic mistake in believing that correlation proves causation. To wit, while the two series may move together, there is no actual proof, only theory, that one causes the other to rise or fall.

And so Mr. Bush got half of what he wanted. Business investment has risen in five of the past six quarters. But payrolls have grown in only one of those quarters.

This represents what may well be the greatest anomaly in the relationship between these two series of the past half century. If the correlation has been 70% over that time, it has been less than 20% during the Bush presidency. Put it this way: In the post World War II era there has never been so much growth in equipment and software spending by business with such a decline in employment.

Are the tax changes to blame?

I contacted about half a dozen economists across the political spectrum, including professors and business economists, and nearly all agreed that the depreciation change could indeed have led to reduced hiring. (There were arguments over whether it caused a lot or a little, but the dynamic wasn't disputed.)

The process by which this could happen is called substitution, in which employers choose equipment over labor because of a reduction in the tax on capital. Read that as a reduction in the relative price of capital, that is, machines become cheaper than workers because of reduced taxation (among other reasons, including technological ones). As Mr. Malpass pointed out, these taxes have been going down while the cost of labor has been rising, especially health-care costs.

Now, an opposing force that should create jobs is called "the income effect.'' This dictates that as the price of producing something falls, more of it should be produced. As more of it is produced, and produced more profitably, employers should have incentive to hire more workers. Also, if machines do more of the work, then we have raised the economy's growth potential, that is, the ability of the economy to grow without creating inflation. By freeing up workers, we essentially create more resources.

The problem for workers arises, however, when the price of machines drop but growth is sluggish. Labor suffers inevitably. (In economic terms, the substitution effect overwhelms the income effect.) What could have caused this? How about the 9/11 terrorist attack, corporate-governance scandals and the war in Iraq? All combined to make companies more risk averse, choosing to substitute capital for labor but not boost output or hiring.

It is virtually impossible to know what the optimal difference should be between the taxation of labor and capital. Ultimately, the best tax system is the one that produces the least distortions from what the market would create on its own. So there should be no preferential treatment for capital or labor in the tax code --- ideally. Still, societies can make choices, opting to advantage labor over capital or vice versa because of cultural preferences. It can also do so for economic reasons, or social ones at a specific time in history.

This remains a time of technological revolution, when the market should have a greater preference for machines. Labor, especially unskilled labor, suffers from such a bias. This is made worse by the sluggish growth created by the series of shocks that have hit the economy. Moreso, low inflation and low interest rates also tend to reduce the cost of capital. Given all of that, there's a legitimate question as to whether it made sense to accelerate depreciation and favor capital.

But that's in the past. The question now is whether there's a case to be made for helping labor through reduced payroll taxes or additional assistance in retraining. Mr. Bush can wait to see if the income effect takes hold later this year and into 2004, resulting in job growth. That's Mr. Malpass's bet, but the consensus of economists sees the unemployment rate falling only to 5.9% by the end of 2004, from the current level of 6.1%.

Or Mr. Bush can start to consider incentives to help firms hire and retrain unskilled workers. He has already proposed personal re-employment accounts to help retraining, but it appears to be moving slowly through Congress. He could use some additional presidential clout to push it through. And how about a cut in the payroll tax?

After all, if you want more of something, as the president has said, it makes sense to tax it less.

If you'd like to reach Steve Liesman, write to him at [e-mail], and place "Attn: Macro Investor" in the subject line, or write to [e-mail] to have a comment published about the Macro Investor.

Updated September 12, 2003 11:14 a.m.