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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 (TCJA) significantly reduced corporate income taxes, primarily by permanently lowering the corporate tax rate from 35 to 21 percent and temporarily allowing some investment costs to be immediately expensed. Supporters and opponents of the corporate tax cut continue to disagree about its effects on investment and wages. Unfortunately, much of the discussion has ignored or mischaracterized the tax cut’s economic rationale.
Some supporters suggested that corporations would “use” their tax savings to make more investments, hire more workers, and pay higher wages. They claimed vindication when hundreds of corporations announced employee bonuses and attributed them to the tax cut. Opponents countered that most of the bonuses were one-time payments and that they were only a small portion of corporations’ tax savings. They complained that corporations were “cheapskates” who were repurchasing shares rather than instantly raising wages and that corporations were insufficiently “generous” in the “sharing of wealth.”
This misdirected debate has shed little light on whether the corporate tax cut has worked. Before trying to assess the tax cut’s effectiveness, it is necessary to understand its economic rationale.
Standard economic theory does not rely on corporate generosity. Quite the opposite: It assumes that corporations single-mindedly maximize their after-tax profits.
According to the theory, the effects of a corporate tax cut unfold in four steps.
Because the wage increases are the last step in the process, they are likely to occur over several years. The time frame depends on how quickly corporations can make new investments and reap productivity gains from them and how quickly the labor market responds.
The standard theory is accepted by numerous economists across the ideological spectrum, although there is strong disagreement about the size of the effects. For example, 2008 Nobel Laureate Paul Krugman, who fiercely opposes the corporate tax cut, said, “To be fair, there’s probably something to this theory — something, but not very much.”
Other economists have more optimistic views. Numerous statistical studies have found that investment decisions are responsive to the after-tax profitability of investment, suggesting that the corporate tax cut will provide significant economic gains. Even so, the gains will not be as large as some supporters have claimed.
Under extreme assumptions about the availability of funds to finance additional investment, the corporate tax cut might permanently increase the level of gross domestic product (GDP) and wages by close to 3 percent. There would be no permanent change in the economy’s annual growth rate. Instead, the economy would temporarily grow faster to reach a 3 percent higher level. For example, the economy might grow 0.3 percent per year faster for 10 years, after which growth would revert to its original pace.
The effects would be smaller under more moderate assumptions. GDP and wages might permanently rise by about 1 percent, perhaps through an increase in the growth rate of 0.1 percent per year for 10 years.
Contrary to some supporters’ claims, therefore, the corporate tax cut will not boost the economy’s annual growth rate from its previously projected 1.9 percent to 3 percent, let alone 4 or 6 percent. Instead, the tax cut may temporarily boost the annual growth rate by a fraction of a percentage point.
Nevertheless, according to the theory, workers will enjoy significant permanent gains from higher wage levels.
Of course, the gains are not free, as the corporate tax cut will reduce federal revenue. Because Congress and the president did not adopt offsetting spending cuts or tax increases, the tax cut will add to the federal debt. The increased borrowing may drive up interest rates, counteracting part of the investment boost.
To service the additional debt, Congress will eventually have to raise other taxes or cut spending. Because corporate tax revenue goes into the general treasury, cuts are most likely to be made in general-revenue programs, such as national defense, Medicare Parts B and D, and Medicaid. The tax cut is likely to increase economic inequality.
Understanding the economic theory helps us properly interpret the evidence about the corporate tax cut’s effects. Corporations’ attribution of the employee bonuses to the tax cut was presumably a public relations gimmick, as the bonuses were paid long before the tax cut could have boosted workers’ productivity. The failure of wages to instantly spike upward should have been expected. The wave of share repurchases also should not have been surprising, because another TCJA provision allowed US multinationals to move a vast amount of surplus funds tax-free from their foreign subsidiaries’ bank accounts to their own accounts, enabling them to return the funds to their shareholders through repurchases.
The theory tells us that we should be looking at business investment, the first step in the process. So far, a sharp uptick in investment has not occurred. Is that because the corporate tax cut is not boosting investment? Or because the boost is taking longer than expected? Or has the tax cut boosted investment relative to what it would otherwise have been, even as other factors (perhaps other TCJA provisions or the trade war) have offset the boost? Economic theory does not give us all of the answers, but it helps us ask the right questions.
Alan D. Viard is a resident scholar at the American Enterprise Institute.
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Much of the discussion around the TCJA’s slashing of the corporate tax rate has ignored or mischaracterized its economic rationale.
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