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Corporate taxes and the federal deficit.

In the business press, the federal deficit is issue number one. Warnings by Wall Street economists, president advisers, and other economic experts are everywhere. Most agree that the $180-billion deficit this year is holding interest rates up and that the even larger projected future deficits contain the danger of a rapid run-up in rates. They argue that in a debt-logged system, such an increase in interest rates would threaten to "crowd out" new capital expenditures directly through a reduction in profits and indirectly by slowing up new purchases of houses and consumer durables. Their concern is understandable, given the already high level of bankruptcies, foreclosures, third-world debt reschedulings, and trade deficits that could only get worse if rates were to increase. While rapidly increasing the money stock might ward off such a scenario, the economists warn of the specter of renewed inflation and question whether such a counteracting measure would be worth the price.

So the deficits are a big problem. Why are they so big? How are they to be cut? Among business and government spokespeople there is a general tendency to avoid answering the first question and move on to the next. The consensus view first emphasizes the full complexities of federal budgetary expenditures--from agricultural subsidies, to medicare, to social insurance, to Pentagon extravagance, to federal retirement programs, to grants and aid to state and local government. The message impresses on the reader that modern society is big and has a lot of things in it. After supporting this truism with facts and figures, the approach then leans toward further cutbacks in social insurance, medicare, and other programs designed for the aged, disabled, unemployed, and dependent, all the while insisting on the necessity for a strong "defense." Then, taking up the taxation side of the deficit question, the economic advocates line up to suggest a myriad of regressive solutions that include: (1) a flat-rate tax that is supposed to provide incentives for growth; (2) implementation of the Value Added Tax (VAT), a European scheme that taxes "value added" at each stage of production and so hides the regressive nature of the tax within the final price; (3) elimination of the middle-class tax break of interest deductibility; (4) taxation of social insurance benefits when the recipient receives an income above a certain low leve.

In this article I argue that this consensus masks another reality: the long-term tendency of corporate taxes to decline. This decline has now reached a new bottom and is, in good part, responsible not only for a slowing in the rate of growth of the economy but for present deficit levels. I argue that in capitulating to corporate demands for new tax incentives for business, Congress has undercut the efficacy of government spending as a mans of enlarging markets. Consequently, the system now requires more and more high-powered stimulants that are provided by the large and growing deficits.

The argument rests on modern stagnation theory. Accordingly, it is necessary to review the basis of this theory to put the present tax question in perspective.


The Keynesian revolution of the 1930s was based on the proposition that in a mature capitalist economy savings tend to outpace investment as income grows. Keynes put forth his "fundamental psychological law" that when income increases, consumption also increases but not as fast. Consequently, the ratio of savings to income rises. For Keynes (and even more for some of his followers), this could be fatal. For if all of these savings were plowed back into investment, this would mean a rise in ratio of investment to consumption--a situation that would soon run its course as businesspeople perceived that capital goods were growing at a faster pace than final consumption demand. And here lies the rub. A cutback of investmen would reduce employment and the final demand for products, but the capacity of the system to produce would still remain intact. Excess capacity would develop which would stifle further investment, and the system would then spiral downward.

Keynes' theory provided the rationale for increasing state spending. If savings tend to expand relative to investment, then purchasing power can be kept up by taxing away the unspent increment and spending it, or by altering income distribution to enable the middle and poorer classes to spend more on consumption. Keynes' theory thus provides the basis for the conclusion that high taxes on the wealthy can keep the capital accumulation process moving ahead.

Keynes understood savings as the difference between individuals' income and consumption, and did not inquire into the workings of the coporate system through which nowadays the bulk of savings and investment are generated. Keynes' residual view of savings was rooted in an earlier period when an expansion of the income of the lower and middle classes could be safely assumed to be spent and when business enterprise was controlled within "interest groups" and family circles that were so rich that any expansion of their income would pass immediately into savings.

Becuase savings today are generated, for the most part, by large management-controlled corporations, Keynes' residual view of savings is wrong-headed. Still, the Keynesian proposition that taxation of the wealthy (and their corporate institutions) tends to expand markets retains its validity. In order to understand why this is so, we must probe into the economic behavior of the large corporation. Fortunately, we do not have to start from scratch. Modern stagnation theory--as represented, in particular, by the writings of Baran and Sweezy--provides us with a good approximation of the corporate investment process.

Stagnation theory begins by recognizing the power of modern corporations to avoid price competition. Oligopolistic firms are constantly struggling--through the "sales effort" (product differentiation, advertising, extension of trade credit, back-up service arrangements, etc.)--to steal markets away from rival firms. But the most obvious form of competition--price competition--is generally taboo. The reason for this apparent anomaly is the structure of oligopolistic markets. If one fir lowers its price, others will follow and the joint profit that they share is likely to decline without any improvement in the profit for any firm. Once this is understood, the problem becomes one of setting the price of the product to maximize the profit for the industry as a whole. But this means that in setting prices oligopolies act as if they were monopolies.

This limit on price competition means higher prices than would otherwise obtain. In turn, these high prices limit the amount of output, employment, and investment that corporations deem to be in their profit-maximizing interest. So the Keynesian picture reappears in corporate garb: corporations' ability to dominate markets tends to expand revenue potentially available for investment (corporate savings from profits plus depresciation charges) at a faster clip than investment. And with technological progress the situation becomes worse. True, innovation propels the oligops to invest in new equipment. But this new equipment enlarges the capacity of the economic system which tends to swell excess capacity unless the final demand for products rises accordingly. And in the absence of external and conteracting forces this is not likely to happen.

Moreover, by reducing labor and capital requirements, the very efficiency of new capital equipment can accentuate the stagnation problem. During the post-Second World War period, corporations have been able to reduce the amount of both labor and fixed capital required to produce a given amount of output. Less capital needed means fewer investment dollars, less employment, and reduced final demand.

Viewed through the lens of stagnation theory, the earlier Keynesian understanding that high taxes on the upper classes promote growth corresponds not just to the requirements of "depression" economics but to the requirements of a modern corporate system that tends to sink by reason of its very foundations. By raising ervenues through taxation of corporations, the state diverts a stream of purchasing power that would otherwise have gone into nonproductive spending (advertising and the like, mergers, land acquisition, financial assets) rather than new investment. By spending these funds directly, or redistributing them to the lower and middle classes, the state can prop up the final-demand markets that entice new investment.

Success in this effort, however, could only be short term. For as the economy grows, the monopoly problem is reproduced at a higher level. So government taxation of the corporations would have to keep pace. Moreover, as investment becomes more efficient, the tax bite would have to rise as a proportion of production to offset the productivity gains that would otherwise translate into excess capacity.

The monopoly-stagnation viewpoint offers a good vantage point to assess post-Second World War tax history. It offers a guide to inquiry, suggesting that high and growing corporate taxes--by absorbing the system's otherwise wasted savings--might make for a smoother and more sustained accumulation process than would otherwise occur. To be clear: I am not implying that high corporate taxation is some kind of panacea tht could somehow eliminate the many contradictions inherent in modern capitalism. Still less am I suggesting that raising corporate taxes would not entail other problems. Quite apart from the obvious political problem of how a ruling class could effectively police itself on the tax question, two other difficulties remain: one that I explore at the end of this essay is the difficulty of raising taxes under condiitions of high corporate indebtedness; the other difficulty is that capital today is multi-national capital: an increase in corporate taxes in one nation entices capital away to other nations.

Stagnation theory tells us that a decline in corporate taxes makes stimulation of the economy by the state ever more difficult. This implication is important to understand, for post-Korean war taxation policy has been consistent in reducing the corporations' tax burden. And--paradoxically--this policy has been carried out in the name of promoting capital growth.

The high level of corporate taxation at the time of the Korean war can be traced back to the need to raise money to support the New Deal programs of the 1930s. Under the "balanced budget" concept of finance then in vogue, these programs could be financed only by taxing the wealthy; there was no one else to tax. And when the Second World War came along, tax policy continued to tap the upper stratum. Along with planned massive deficit spending (a shift that indicated that the new foreign crisis was perceived to be of a different order of magnitude compared to the domestic crisis of the 1930s), an excess profits tax was levied on corporations. This levy reflected not only congressional recognition that such taxes could pull in large amounts of revenue but also that tapping a newly employed working class had political limits. Congress allowed this tax to lapse in 1945 but refurbished it when the Korean war hit. At the end of the Korean war, corporate income taxes contributed a post-Second World War high of approximately one third of federal receipts.

The high levels of production associated with the two wars show that rapid economic expansion is not incompatible with high taxes on corporations. Indeed the experience corroborates the basic Keynesian understanding of state finance. But when the Korean war ended and another recession took hold, the Congress embraced a new understanding of proper tax policy, one that reflected the common sense of the business classes. This new understanding (today called "trickle-down") maintains that the corporate system works best when corporations receive tax incentives for investment. At a time when the Cold War had become a permanent fixture in American politics (expressed as a percentage of the federal budget, military expenditures receded only gradually after Korea) and domestic markets could be expanded through large-scale extensions of debt, concern about the long-run ability of American capitalism to survive. As depression economics faded into memory, the ruling class shifted to a tax policy geared to reducing its own burden while increasing that of a now relatively prosperous working class. In a move that prefigured tax history to come (including Reagan's 1981 tax cut), Congress passed an accelerated depreciation act that lowered taxes on corporations and at the same time raised social security (payroll) taxes.

Theoretically, of course, depreciation is that part of the costs of production that results from the wearing out of capital equipment over its useful life. To take a simple example, assume that a corporation spends a million dollars for a new machine that will last 10 years. In calculating profits it must deduct from its revenues not only the costs of labor and materials but also an annual depreciation charge of $100,000 if it is to maintain the value of its capital. Assume revenues of $1,000,000 a year and labor and materials costs of $600,000. Profit will then be: $1,000,000-600,000-100,000=$300,000.

If the tax rate on corporate profits is, say, 50 percent, the company pays the government $150,000 and retains $150,000 in after-tax profit plus the $100,000 in depreciation. Its cash flow available for investment is thus $250,000. (While this sum is available for investment, this doesn't means it has to be used for investment: it can be used for any legitiamte corporate purpose such as dividends, advertising, research and development, buying out another company, etc.)

Now assume that the tax law is changed to allow the machine to be depreciated in five years instead of the 10 years of its actual useful life, in other words, at the rate $200,000 a year Profit will now be: $1,000,000-600,000-200,000=$200,000.

The new tax will be $100,000 (instead of $150,000), and cash flow will be $200,000 (depreciation) plus $100,000 (after-tax profit) = $300,000 (instead of $250,000).

In practice of course things are always more complicated, but this simple example serves to highlight the principles involved. More rapid write-offs enable corporations to disguise what are really profits under the heading of depreciation, while at the same time reducing the corporate tax liability. The net result is lower taxes and more cash flow. No wonder corporate managements are always clamoring for more!

As far as the government is concerned, the argument in favor of faster depreciation is couched in terms of its alleged stimulating effect on investment, which in turn is supposed to create more jobs and more consumer spending. While situations are possible in which this would be the effect, for the general run of big corporations it is not likely to be an important consideration. Most of them have--or have easy access to--more capital than they can profitably invest, and adding to their cash flow by way of more rapid depreciation in no way opens up new investment opportunities. What it does do, however, (as the above arithmetical example illustrates), is to reduce the amount of revenue the government takes in from the corporate income tax.

Expansion of depreciation, then, lowers the corporate tax bill. If depreciation were but a minor component of cash flow, this factor could be ignored. But the exact reverse is true. Depreciation is an important element in any advanced capitalist society, and it tends to grow larger relative to current profits the more developed (capitalized) the economy becomes. Thus, as Table 1 shows, depreciation grew from 50 percent of corporate profits in the late 1950s to over 100 percent in the early 1980s.

Liberalization of tax is not the only reason for the relative growth of depreciation. In addition to the expansion of the economy's stock of capital goods, already mentioned, there is another factor which has been much in evidence in the post-Second World War period affecting the increase in depreciation, namely, a shift in investment in favor of equipment as compared to structures. Since the lifespan of equipment is shorter--often much shorter--than that of structures, such a shift boosts the rate of depreciation. (In the 1955-60 period the average equipment-to-structures ratio of U.S. investment was 0.57. This rose to 0.89 in the 1960s, 1.68 in the 1970s, and declined only moderately to 1.41 in the depressed years of the early 1980s.) But neither the growth of the capital stock nor the shift from structures to equipment is important enough to explain the change from the late 1950s, when depreciation was only about half on profits, to recent years, when depreciation has equaled or exceeded profits. This was primarily due to the liberalization of the tax laws.

The long-term slowdown of investment shown in column 2 of Table 2 clearly evidences a movement into stagnation. As the capital stock slows its rates of growth, depreciation charges should show a similar trend. But it present political arrangements continue, such declines will be followed by new rounds of tax breaks. Reagan's 1981 Tax Act, with its new liberalized acceleration rules for depreciation, is the latest example.

Accelerating depreciation, as noted above, lowers corporate taxes as a percentage of cash flow and should, if one were to believe the "trickle-downers," encourage more capital expenditures. But Congress and the executive branch have not been content with just accelerating depreciation. The other main incentive mechanism for state-sponsored investment has been the investment tax credit. First implemented by the Kennedy administration, the credit is designed to lower the costs of new capital. For a company that invests heavily, the gains can be impressive. For example, a firm that has depreciation charges equal to its profits and invests the whole of its cash flow can, with a 10 percent credit, almost halves its tax bill. Originally intended as a tool that would be employed only in times of investment slowdown, it has become--despite an earlier on-and-off again history--a permanent part of the tax code. Originally set at 7 percent, the tax credit now contains a 10 percent subsidy.

Table 3 showsd the net result of state-sponsored tax breaks and the associated increase in depreciation charges. The rapid decline in taxes paid out of cash flow (Column 1) is reflected in a rapid decline in the contribution of corporate taxes to federal receipts (column 2). Some part of this relative decline has been due to the icrease in receipts--largely increases in social security taxes. But the larger portion has been due to the decline in the effective rate of taxes paid on cash flow. Column 3 of Table 3 hypothetically maintains the 32 percent rate of 1957 and shows that if corporations now paid that rate, they would be paying over 350 percent of what they now pay. Although Table 3 does not show it, this hypothetical increase would mean that corporations would be contributing not 6 percent of federal receipts (as they do now) but 23 percent--a figure comparable to what they were paying in the late 1950s and early 1960s.


The logic of stagnation theory holds that high and rising taxes on corporations facilitate the capital accumulation process; the logic of post-Korean tax policy is based on the opposite view. Which logic is correct?

The logic of post-Korean tax policy is a short-term logic. It suggests that--other things being equal--investment incentives will encourage more investment than would otherwise occur. For stagnation theory, the question must be: What will be the eventual result of successive applications of stimulants to a system bridled by monopoly power? And the answer is an increasing inability of state-sponsored stimulants to further the investment process.

This answer holds true for two reasons: First, by reducing corporate taxes, the government shifts the burden to workers and others in society who would have spent the money anyway in final consumption markets. So while an enlargement of tax-financed government spending changes the composition of output--mainly from consumption to military procurement on the federal level--the total volume of output remains basically unchanged. Every reduction in corporate taxation is therefore two-sided. Even if it encourages investment in the short run, the potency of state spending in enlarging markets (and long-term investment spending) is undercut. Second, an encouragement of investment today increases productive capacity and requires larger and larger final markets in the future to justify a sustained tempo of investment. But with corporate monopoly power, there is a premium on the restriction of output. Consequently, investment growth translates either into the rapid retirement of outdated equipment (as firms add to the capital stock at a faster rate than the profit-maximizing level of output would warrant) or into a buildup of investment-stifling excess capacity. This, such incentives cannot work without the right kind of technological advance and thus may not work at all. Moreover, such technological advance would induce new investment without tax incentives. But even to the extent that tax incentives do "lubricate" the introduction of technology, the economic situation becomes more and more precarious. By reducing the amount of capital necessary to produce a given amount of output, technological advances today mean that future technological gains must be even larger to keep the capital accumulation process moving ahead.


The well-publicized slowdown in the U.S. economy since the mid-1970s is fully compatible with what stagnation theory implies. Numerous factors of course are involved--one might mention, for example, increased foreign competition in world markets, the growing debt burdens of the public and private sectors, and a slowing of urban growth associated with increased congestion and rising land prices--still it would be wrong to underestimate the important part played by mounting difficulties of stimulating effective demand through state spending. And this in turns is in large measure caused by the continuing success of the political-corporate nexus in securing legislation ostenisbly aimed at encouraging investment through supposedly "growth-producing" tax incentives. It is at this point that we can understand the recent explosion in deficit spending. For all the problems that the deficits hold for financial markets, these borrowings represent billions upon billions of high-powered spending. With unemployment and excess capacity rates oscillating around trends that have been rising ever since the Second World War, and with new and more efficient capital equipment reducing the amount of investment needed to maintain profit-maximizing levels of output, these deficits are best understood as necessary props to a faltering system.

For reasons explained earlier, raising taxes on the lower and middle levels of the income spectrum would not help, and in any case it has become increasingly difficult to do. In a major section of the recently released Economic Report of the President, entitled "Reducing the Budget Deficit," there is only one mention of the need for future tax increases, and this is followed by total silence about where these taxes are to come from. The reason for this silence is not far to seek. It would be difficult to state, as the Report does, that the "real earnings per week of the average employee were actually lower in 1980 than they had been a decade earlier," and then suggest higher taxes on the American working class. But if corporations (and upper-income individuals) are to have their tax rates lowered (as in the Reagan administration's tax policies) to "encourage growth" and if--as stagnation theory argues--more and more stimulants are required to keep the whole economy up, then there is simply no alternative to borrowing and spending the money.

That large deficits are now a permanent part of the economic system is well recognized. Orthodox economists have even coined a new term to reflect this new situation--"structural deficits." The distinction is made between that portion of the deficit that is due to a fall in tax receipts caused by low economic growth (or recession) and that portion that remains as a result of alleged structural overspending. This structural designation allows attacks on those components of government expenditures not directly linked to defense, namely, expenditures on social services. In the official view--as contained, for example, in the above-cited Economic Report--present deficits are the result of over-zealous congressional spending on social programs beyond available means. We learn that "in such [entitlement] programs, the basic legislation does not appropriate a fixed amount of money for a particular purpose, but establishes rules that define who is eligible for benefits and the nature and amount of the benefits for which each person is eligible. Funds must then be made available for these benefits." According to the Report, the Congress' fiscal excesses have resulted from an over-optimistic assessment of the future:

In the mid-1960s, when the Great Society programs were launched, and even in the late 60s and early 70s, there was a comforting but mistaken assumption that continued rapid growth would make it easy to finance an ever increasing level of government spending. Unfortunately, the real rate of growth fell from the 4.7 percent experienced in the first half of the 1960s to 2.8 percent since then. If that earlier rate of growth had continued, real GNP would now be nearly 40 percent higher, and with current tax and expenditure rules, the federal budget would now be in substantial surplus.

Why has the growth rate slowed up? The Report does not say. What is the relationship between the recent stagnation and the need for more social services? The Report does not ask.

Accepting the Keynesian view of state finance is tantamount to suggesting that long-term investment (and profits) would probably have increased if corporate taxes had remained high. Since we cannot history as social experiment, the case can of course not be proved. But the theory gives us a solid rationale for comparing the size of recent deficits to the revenue losses associated with the lowering of corporate taxes. Table 4 makes this comparison by applying the 1957 effective tax rate on cash flow (32 percent) to recent levels of cash flow. In this way we get an estimate (column 1) of what the government might now be taking in from corporate taxes. If we then juxtapose these hypothetical tax increases to the federal deficits of the last four years, we find that they would account for almost three quarters of the total of $424 billion.

How would the increased hypothetical corporate tax total stack up against the so-called structural deficit? Here we have to recognize that estimating the structural part of the deficit involves a kind of numbers game. The Council of Economic Advisers (CEA), which writes the President's Economic Report, plays the game by estimating the amount of the deficit that would be associated with "the minimum level of unemployment that can be used sustained without raising the rate of inflation." This rate they put at 6.5 percent, a full 2.5 percent above a recently forgotten criterion of "full employment." The deficits thus estimated are considered "structural." For the four years covered in Table 4, they add up to $243 billion. We can conclude that if the 1957 rate of corporate taxation had remaind in force, the federal government would have taken in revenues in excess of $50 billion over the CEA's identified structural borrowings.


Modern tax politics add up to a virtual burial of earlier Keynesian views on state finance. If, on rare occasions, a Democrat calls for a possible hike in corporate taxes, it is on the basis of equity, not function. That high corporate taxes might actually boost the economy is not considered. This is understandable. The largest part of this inability to rethink is undoubtedly due to the blinding of political imagination under the corporate spot-light.

But there are financial problems as well. Unlike the situation of the Great Depression and the post-Second World War aftermath, corporations today are multinational on an unprecedented scale and deeply in hock. Could an American president raise corporate tax rates and keep capital on these shores? Apart from such hypothetical questions, any substantial increase in corporate tax rates would have an uncertain outcome on large debt-ridden corporations and on financial markets generally. Recent economic history is replete in examples of large firms going broke. A rapid run-up in corporate taxes would intensify fears that further bankruptcies would not be far behind.

If corporate debts now block reconsideration of raising corporate taxes, they also provide the main reason for the corporate outcry against present and project deficit levels. Corporations heavily in debt consider deficits primarily as obstacles to lower interest rates rather than as market-enlarging props. Expanding the money supply is no cure. Recent experience shows that even a rapid growth in the money supply does not ease the interest-rate burden. Since capital losses rooted in inflation can best be guarded against by compensatory interest-rate increases, monetary expansion translates into higher "floors" under interest-rate levels.

It is in light of these financial difficults that we can best understand the corporate-political response to the present fiscal crisis. Perched at the top of the social system, political and corporate spokespeople cannot contemplate any basic alteration in the private property system they rule over. Since the social system (and its mega-problems) appear as given, the job then becomes one of devising solutions that protect the interests of large corporations. So corporate taxes not the issue; VAT and a flatter-rate tax system are. So federal deficits are caused not by massive increases in arms spending but by unanticipated increases in social security costs. Even more remarkable: the deficits are understood not as necessary high-powered spending and reflective of a near abolition of the corporate income tax but simply as stumbling blocks hampering the rate of investment growth.

This myopia is understandable. For to comprehend the deficits as high-powered spending is to raise the question of why a modern corporate economy needs it. And an answer to this question leads to the conclusion that recent deficits are rooted in the structure of modern industry with its fusion of technological advance and monopoly power. Solutions being but corollaries to the way problems are presented, there is a natural reluctance on the part of corporate and political persons to pursue a line of inquiry that could only terminate in solutions that would rein in, if not eliminate, the private profit-seeking nature of investment decisions.
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Author:Medlen, Craig
Publication:Monthly Review
Date:Nov 1, 1984
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