Friday, January 12, 2018

Right answer, wrong reason

Sometimes it is not good to get to the right answer for the wrong reasons. This thought comes to mind reading to recent WSJ articles, Walmart raises wages and Tax reform releases the bulls.
"Wal-Mart Stores Inc. said it would raise starting hourly pay to $11 for all its U.S. employees and distribute one-time bonuses, doling out some of the windfall it expects from the U.S. tax overhaul as it competes for store workers in a tight labor market." 
"Only 15 market days have passed since the Senate passed the tax bill, ensuring it would become law, and Wall Street analysts have already upgraded their consensus forward earnings for the S&P 500 by an unprecedented 4.6%. Is it any wonder that stocks have rallied?"
Two narratives compete for how corporate tax cuts might spur the economy: cashflows vs. incentives.  Washington and most pundits like to talk about cashflows, "trickle-down" if you will. Corporations (existing, large) don't have to give so much money to the government. So perhaps they will benevolently pass it on to their workers -- or perhaps political pressure is important to force them to this magnanimity.

Economists see the world through incentives. In this narrative, a lower corporate tax rate increases the incentive to invest, broadly construed -- to buy new investment goods, sure, but also to invest in worker skills, organizational improvements, new opportunities, and for new companies to spring up. That investment raises the productivity of labor and hence demand for labor. Competing to hire good workers, companies drive up wages. But companies no more voluntarily give workers bonuses out of extra cash than they voluntarily send money to the electric company on top of the bill.

The Walmart headline falls distinctly into the first category. If so -- if this is how the corporate tax reduction raises wages -- an economist would say it's pretty fragile. Benevolence fades quickly.

Fortunately the rest of the article, if you read it with these views in mind, supports more the economists' view of what's really going on.
"On Thursday, the company also announced plans to cut roughly 10,000 jobs by closing about 10% of its 660 U.S. Sam’s Club warehouse stores.... 
Chief Executive Doug McMillon cited the tax overhaul for the pay increase, which the Trump administration praised at the White House."
In our politicized economy, it is a good time to offer some worker-friendly PR! More deeply "investment" to "productivity" is the same thing as finding ways to do things with fewer, since competition means they must be higher-paid, workers.
"But the wage boost also comes as many U.S. businesses are contending with tight labor markets and rising wages. Retail rival Target Corp. recently lifted its starting pay to $11 an hour and Costco Wholesale Corp. starts hourly staff at $13."
So, Walmart is just catching up to the competition, really.
The labor market is tight and getting tighter,” said Mark Zandi, ...
To combat wage pressures, Wal-Mart has tried to save on labor costs by adjusting the number of workers per store and more recently by automating many rote tasks. It is adding more self-service registers and using robots to scan shelves for items that are out of stock. Last year, Wal-Mart had around 15% fewer workers per square foot of store than a decade ago, according to an analysis by The Wall Street Journal.
I.e. productivity-raising investments. Let us also remember that labor is not a spot market and keeping good workers is a good idea. It does make sense for wages to rise in advance of capital improvements if firms know they want to keep their good workers and know wages must rise in the future from competition.

In the PR battle, it will likely be hard to admit that the kind of productivity raising investments the tax reform is supposed to induce can reduce demand for labor for each unit of output at individual companies. It will read like automation scare. Where overall demand for labor rises is that output rises and new companies come in to being.


We (readers of this blog) all understand that every cent of corporate taxes comes from higher prices, lower wages, or lower payments to shareholders. There is a bit of debate about which, and my previous reviews concluded that lower wages and higher prices were much more important than payments to shareholders.

Opponents of the tax cut claimed it would just be a windfall to profits, which would create a windfall to stock prices, which would benefit wealthy shareholders. This is the prime argument that the corporate tax cut benefited wealthy people. (Note, stockholders get no permanent rise in rate of return. They just get a one time windfall when the tax cut becomes reality.)

Again, cash flows vs. incentives; static vs. dynamic economies. If companies are just money machines, faxing fixed prices, wages, customers, and workers, and shareholders get to keep 80% rather than 65% of the money, then indeed the price should go up. But if companies respond to incentives, they invest, expanding capital, expanding output, and thereby quickly driving wages up, prices down, and profits back to normal. There should be a small bump in stock prices as these investments take time, but competition and entry drive profits back to normal quickly. (I'm describing the Q theory of investment with taxes here.)

As evidence, I pointed to the fact that stock prices seem to have very little historic correlation with corporate tax rates. That's good. It means that tax cuts are not just passed to shareholders, and do result in higher wages and lower prices.   So if indeed this time the tax cut is just a boon to profits driving the stock market up, it will mean its antagonists were right, at least on the first of three links of their dubious chain to inequality.

I've done lots of work on P/E ratios, and I remain of the view that today's PE ratios reflect a low risk premium on top of a very low real interest rate. I also remain of the view that low risk premiums have nothing to do with central banks, QE, and the rest, but are perfectly normal in the eighth year of a very quiet expansion with very low volatility. Like all academics, I am fondly attached to my past papers, but habits does seem to do a pretty good job.


  1. Another possibility is the wages for non-corporates are depressed because of the differential tax effect. We have to hear from main street before judging.

  2. John (and commenting using my real name and you do know who I am),

    Very interesting post. Coming at this from the professional world that I live in and thinking about the contrarians who object, much of the argument from people on the economic left seems to be that yes, some small amounts may go to the rank and file, but the bulk of savings not going to shareholders will be awarded to top executives in incentive payouts are stock awards and grants as after-tax EPS increases.

    I know how I respond to that as a consultant and actuary, but curious as to your response as an economist.

    Thanks in advance

    1. John: Great to hear from you! As an economist, I'd say that in the end management is an input that gets paid its opportunity cost and no more just like inputs, labor, bond and stockholders, and the electric company. In politics and public discussion people tend to think of everything as a bilateral negotiation. Economists tend to think of everything as eventually pushed by competition in markets. If the decline in tax rate makes management more productive, and there isn't a flat supply curve of managers, then we should see management compensation increase.

  3. As a shareholder in Wal-Mart, I expect management to honor its fiduciary obligations and pay as little as possible.

  4. Thank you John (Cochrane),

    I am curuous as to why you put wages before prices in the following sentence: " ... my previous reviews concluded that lower wages and higher prices were much more important than payments to shareholders." Specifically:

    First, what is your best guess as to the percentage breakdown on where the tax-cut goes between decreased prices and higher wages.

    Second, given that high-skilled labor is less supply elastic than low-skilled labor, what is your best guess on the percentage breakdown on where the tax-cut wage-effect goes between high-skilled and low-skilled labor.


    Thomas Tenerelli

  5. I remember the argument advanced by Kenneth Arrow that with zero risk free rate and complete loss offset a decrease in capital income taxes will decrease gross investment as investors use less leverage to remain in their preferred position. I haven't seen this argument advanced recently and wonder why.

  6. This is off topic but I am trying to find the little test an economist gave: Would you rather live on a planet where everybody made $15K or on a planet where half made $15K and the other half made $30K? Or do I have that wrong? HELP!!

  7. As is the case with most things in life, the new tax bill is neither the disaster Democrats think nor the panacea Republicans think. However, I believe that strong economic activity is a desired end and that funding government is not a goal of such activity.


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