Research shows that corporate tax cuts boosted investment

One way to generate increased per-worker output — which is the essence of economic growth — is to increase the amount of capital per worker. How can policy drive that?

One lever available to policymakers is fiscal policy. For businesses to invest they have to have the funds to invest. There are a number of ways they can access these funds — they can borrow, sell equity, or use profits — but all of these are sensitive to the taxes that will be levied on any profits the company generates. Obviously, a tax on profits will reduce the amount of profits which can be reinvested, but by reducing the net return on investment, these taxes make it less likely that businesses will invest whatever the source of funds. Just as taxes on cigarettes deter smoking, taxes on investment deter investing.

New research shows the impact of taxes on investment. The 2017 Tax Cuts and Jobs Act (TCJA) was the largest corporate tax reduction in the history of the United States, lowering the corporate tax rate from 35% to 21%, temporarily allowing full expensing for short-lived assets (referred to as bonus depreciation), and overhauling the international tax code. In a new paper for the National Bureau of Economic Research titled “Tax Policy and Investment in a Global Economy,” economists Gabriel Chodorow-Reich, Matthew Smith, Owen Zidar, and Eric Zwick use a large sample of 12,000 corporate tax returns covering several years prior to the enactment of the TCJA and two years after to investigate the impact of tax cuts on business investment.

“We have five main findings,” they write:

First, the TCJA caused domestic investment of firms with the mean tax change to increase by roughly 20% relative to firms experiencing no tax change. Second, the TCJA created large incentives for some U.S. multinationals to increase foreign capital, which rose substantially following the law change. Third, domestic investment also increases in response to foreign incentives, indicating complementarity between domestic and foreign capital in production. Fourth, the general equilibrium long-run effects of the TCJA on the domestic and total capital of U.S. firms are around 6% and 9%, respectively. Finally, in our model, the dynamic labor and corporate tax revenue feedback in the first 10 years is less than 2% of baseline corporate revenue, as investment growth causes both higher labor tax revenues from wage growth and offsetting corporate revenue declines from more depreciation deductions. Consequently, the fall in total corporate tax revenue from the tax cut is close to the static effect.

In short, companies that saw larger reductions in tax rates from the TCJA also experienced larger increases in investment in the years that followed.

Based on the responses of corporate taxpayers in the two years following enactment, the authors modeled the long-run effects of the TCJA’s corporate reforms and estimate that the U.S. domestic corporate capital stock will grow by 7.4% over the long run as a result of the law. Most of the growth in investment and the capital stock is predicted to occur within 10 years, and nearly all of it in 15 years. As the capital stock grows, so does worker productivity and wages. The study estimates a 0.9% increase in real wages over the long run.

The Tax Foundation notes that:

About half of the boost in investment and the capital stock is from a reduction in marginal effective tax rates, mainly due to lowering the statutory corporate tax rate. Nearly a quarter of the effect is from bonus depreciation, which boosts the capital stock by 2 percent, assuming firms expect the policy to be extended permanently. If instead businesses expect bonus depreciation to phase out as under current law (reducing bonus depreciation to 80 percent this year and eliminating it completely after 2026), the study predicts the TCJA’s corporate provisions cause an initial surge in investment and capital stock growth that peaks at about 6 percent in year 7 (i.e., around now or next year) followed by a decline in investment, resulting in a long-run capital stock that is about 4 percent higher relative to pre-TCJA law.

These are impressive results and show, once again, that taxes matter.