The Tax Cuts and Jobs Act in Year One

The Tax Cuts and Jobs Act in Year One

With Tax Day just behind us, it’s a good time to reflect on our first full year under the Tax Cut and Jobs Act (TCJA), which President Trump signed in December 2017. In many ways, 2018 was a banner year. The economy grew by 2.9 percent, unemployment fell to 3.7 percent and wages grew by 3.4 percent. Some of the good economic news seems to be associated with the TCJA, and particularly the law’s reduction of the corporate income tax rate and changes to depreciation allowances.

 

Up to this point, the evidence on the impact of the TCJA on investment, labor productivity, employment and economic growth is only suggestive. Each had been rising due to the economic recovery. But there are good reasons, based on economic theory, to suggest that part of the growth during 2018 is related.

 

Proponents of the tax reforms projected they would increase investment, which would result in raising household income. The reforms lowered the percentage of each corporate dollar earned that will be taxed, giving firms an incentive to invest in a wider array of projects, including some with slightly lower pre-tax rates of return. In other words, lower taxes make more projects worth investing in.

 

As firms increase their investment in capital, workers have more capital to work with. Workers become more productive, firm output and revenues rise, and firms can afford to pay their workers more. And sure enough, due to lower taxes on corporate profits and expected increases in capital investment, workers were able to bargain for wage increases.

 

Critics emphasize that corporations used much of their tax savings for stock buybacks, where firms purchase existing stock from their shareholders, which primarily benefits those wealthy shareholders. However, the most important and long-lasting benefit of last year’s corporate tax changes are the incentives they give firms to invest more money in domestic operations. In addition to the benefits of investment for workers, shareholders expect to gain more after-tax income.

 

The results of the TCJA were consistent with proponents’ expectations based on economic models. During 2018, investment rose by 0.5 percent of GDP — with business investment rising faster than residential investment—while consumption spending fell by 0.3 percent of GDP. People consume less and save and invest more when the rewards for investing — higher after-tax profits — increase.

 

The uptick in investment may not last forever due to the temporary nature of one provision that allows for 100 percent “bonus depreciation.” It permits businesses to deduct the full costs of certain short-term investments, such as machinery, equipment and computer software, in the year they are incurred. However, it is only scheduled to be in full effect for five years, and will gradually be phased out until expiring at the end of 2026.

 

This matters because firms and investors often prefer to keep more of their profits sooner in exchange for lower profits later. That means more investment over time, because investors, like everyone else, value a dollar today more than a dollar one year from now.

 

According to the Tax Foundation, making the bonus depreciation provision permanent for short-lived assets would ultimately result in a 0.9 percent-larger economy with a 2.2 percent larger private capital stock in the long run. Instead of eliminating it for short-term assets, why not extend it to long-lived business assets, such as structures? That could lead to a similar boost for long-term investments that could pay off for years to come.

 

Bonus depreciation can actually have a bigger effect on investment and economic growth than lowering the corporate tax rate. That may seem odd, because bonus depreciation only benefits new investment while lower corporate tax rates benefit both new and existing investment. But the tax cuts did not change the incentives to invest in existing capital goods — those decisions were made before the TCJA was enacted. It only changes the calculus for future decision making.

 

By increasing incentives for American businesses to invest, the TCJA has already had a positive effect on economic growth, which in turn has benefited many workers in the short run. The logical next step is to lock in these gains and make sure we can enjoy them in the long run.

 

Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University.

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