Wednesday, August 8, 2012

Hassett on Valuation and Tax Policy: Emphasizing Benefits and Ignoring Costs

Let’s pick up on something Brad DeLong noted about Kevin Hassett’s DOW 36,000 claim:
Suppose that you had told me, 15 or 30 years ago, that there was an economist who did not understand the Gordon equation for stock market valuation: somebody who, instead of knowing that the Gordon equation was P=D/(r-g) (where P is the value of the stock index, D is the dividend paid on the index, and r and g are the required rates of return and expected dividend growth rates respectively) thought instead that it was P=E/(r-g) (where E is the account earnings of the index). Suppose you had told me that that somebody would be a respected senior economic adviser to Republican presidential candidates.
Understanding the difference between dividend growth and earnings growth is one of the most basic concepts in the valuation of enterprises. Sure faster dividend growth in a steady state drives up the enterprise’s valuation but for most companies, faster earnings growth has both a benefit and a cost. Growing companies tend to pay out dividends that are less than their earnings because part of their earnings is devoted to the accumulation of capital required to sustain growing sales. If one ignores this cost, one will assuredly overestimate the value of the enterprise. Anyone foolish enough to do so has no business selling himself as an expert in the valuation of enterprises. But let’s apply similar reasoning to the analysis of tax policy and long-term economic growth. The Laffer school of macroeconomics – which Kevin Hassett and his fellow Romney economists – apparently adhere to have an incredibly incomplete view of how tax policy affects economic growth as they have an incredibly incomplete model of the after-tax cost of capital. We should grant that if one can reduce the after-tax cost of capital, then we could enjoy an increase in investment demand. The Laffer school of macroeconomics argument that reducing tax rates will lower this after-tax cost of capital assumes that such changes in tax rates have no effect on real interest rates. Such an argument might have credibility if the overall fiscal policy change were deficit neutral, which would require base broadening so as to be revenue neutral or offsetting reductions in government consumption. We should note, however, that the early Reagan fiscal policy was not deficit neutral and the aftermath of his 1981 tax cuts was a reduction in national savings and a rise in real interest rates. This is a point that Greg Mankiw made many years ago but that was before he joined Team Republican as a policy consultant. The problem many of us have with the Romney fiscal promises is that they seem to be offering us the same free lunch that we got over 30 years ago – reductions in the tax rates on capital income without telling us how they would pay for these reductions. As such, their policy proposal appears to be very similar to the 1981 fiscal fiasco, which of course led to less long-term growth not more. But what would you expect from a team of economists that include Kevin Hassett who has a habit of emphasizing benefits and ignoring costs?


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