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This blog post is part of a series dedicated to analyzing the impact of the Tax Cuts and Jobs Act. Click here to see all of the blogs in the #TCJANowWhat series.
The Tax Cuts and Jobs Act’s (TCJA) centerpiece was reforming the taxation of business investment returns, as this process addressed the largest domestic economic weakness. Entering 2017, the trend growth rate was the Achilles’ heel of the US economy. Powered by steady rises in productivity, income grew so rapidly from the end of World War II to 2007 that standard of living doubled roughly every 35 years. In contrast, forecasts for the US economy anticipated anemic productivity growth and top-line growth so slow that standard of living was projected to take over seven decades to double. As such, access to the American dream was disappearing over the horizon.
Overall, productivity growth is a mysterious process, but there is a reliable link between higher productivity and improvements in the quantity and quality of capital per worker. Hence the TCJA’s key provisions were those that incentivized the accumulation of physical and intangible assets, the location of that capital in the United States, and the efficient allocation of that capital across businesses, sectors, and asset types.
The starting point is reforming corporation income taxation. Before TCJA, the United States clung to an outmoded “worldwide” income tax system in which firms were taxed based on their global earnings at a statutory rate of 35 percent — easily the highest rate among developed countries. In contrast, competitor developed countries taxed firms only on income earned within their jurisdictions (a “territorial” approach) and at much lower rates.
These features had a few implications. To begin with, US multinationals were at an immediate disadvantage when competing with, say, a German firm in an overseas market. The German firm would pay the local tax rate and be done. A US firm would owe the local tax plus a second layer up to the total US corporate rate of 35 percent.
The second layer of tax could be deferred if the earnings were not repatriated (brought back to the US). Thus, firms could produce a level tax playing field as long as they held ever-larger amounts of earnings overseas — thereby distorting their capital structures and investment plans.
Finally, if a cross-border merger or acquisition arose, it was inevitable that the headquarters would be located outside the United States. It made no financial sense to expose the merged company to a worldwide system with the highest tax rate when lower-tax territorial options were available.
The TCJA addressed these flaws. It moved the United States toward a more (if not pure) territorial system. Even more important, it cut the top rate to 21 percent, which puts the United States in the middle of the pack of developed countries. Some observers think the rate ended up lower than necessary, but given the dynamics of international tax competition that have played out recently, this rate is likely to be at the upper end before long.
In addition to a lower rate, the TCJA introduced expensing of equipment and intellectual property investments while limiting the deductibility of interest. Those are good steps toward lowering the effective marginal tax rate on capital income and equalizing the treatment across debt, equity, and asset classes. Unfortunately, expensing is temporary; it should be made permanent and extended to structures and the interest deductibility eliminated entirely. (In expensing, interest deductibility creates a negative effective marginal tax rate. I’m all for low taxes on the return to investment and innovation, but zero should be the limit.)
All these reforms are good as far as they go. Yet more than half of business income is still taxed on individual returns as income of pass-through entities such as partnerships and S-corporations. To get capital allocation right, the effective tax rates on that return to capital should match the effective rates on corporate-source income.
On this front, the TCJA gets a gentleman’s C at best. Rather than attempting to equate the effective rates, the TCJA introduces a 20 percent deduction for business income, thereby ensuring that the statutory (and thus effective) tax rates will differ across individuals and the assets in their investment portfolios. It is a long way from neutrality.
Still, on the whole, the TCJA improved incentives to invest and to invest in the United States. The real question is: Did it work?
The figure below shows the quarterly annual growth rates (from the same quarter one year previous) for investment in structures, equipment, and intellectual-property products from the beginning of 2016 to the second quarter of 2019. The TCJA passed in December 2017.
There is a discernible ramping up of the growth rate of investment following the fourth quarter of 2017 — although it has tailed off in early 2019. Indeed, the averages for the latter period are 3.4 (structures), 3.3 (equipment), and 4.3 (intellectual property) percentage points faster than in the first part of the window.
Even more important, the rate of labor-productivity growth in the following figure follows the same pattern.
Do these trends mean the TCJA is an unqualified success? Of course not. Many other changes in the economic environment may have contributed to this pattern. For example, one of the less appreciated aspects of the Donald Trump administration has been its success in reducing regulatory burdens. American Action Forum’s regrodeo.com has documented that over the Barack Obama administration, a costly regulation was finalized at the rate of 1.1 per day. The total self-reported cumulative cost — that is, the cost reported by the agencies themselves issuing the regulations — of those regulations was $890 billion.
Since President Trump’s inauguration through the end of fiscal 2018, the burden fell by $1 billion. a remarkable U-turn that has contributed to better investment and productivity growth. More recently, the TCJA’s impact has been intermixed with the negative fallout from misguided trade tactics and the administration’s ad hominem attacks on the Federal Reserve. It is going to take a minimum of five years before the data will allow a statistical decomposition that teases out the TCJA component.
So, it is not yet clear how the United States will end up on balance, and whether the improved, albeit still imperfect, tax-based investment incentives have changed the long-run trends in investment, productivity, and growth.
Douglas Holtz-Eakin is the founder and President of the American Action Forum.
Return to the series
Douglas Holtz-Eakin explains how the TCJA reformed the taxation of business investment returns. He argues that, although still imperfect, it addressed the largest domestic economic weakness of the United States.
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