Mar 9, 2018

Answering Your Questions About Federal Tax Reform

Q&A With Veronique de Rugy, Jason Fichtner, and Michael Farren
Chad Reese Managing Editor

The federal tax reform bill signed into law in December included a lot of promises about economic growth, including higher wages, more jobs, and more investment in the American economy.

While some companies have already announced wage hikes, bonuses, new hiring, and additional investment in response to tax reform, many economists claim the true economic growth from corporate tax reform, including its effects on workers and families, have yet to be seen.  

Below, Mercatus Center Scholars Veronique de Rugy, Jason Fichtner, and Michael Farren answer pressing questions about tax reform, including why it matters, and how we’ll know if it’s working.

What are the real benefits of the kinds of reforms we saw in December, particularly changes to corporate tax rates? 

Veronique De Rugy: The number one benefit of the reduction in corporate income tax rate is that it will make American companies more competitive. By all accounts, our system was extremely punishing. Our rate was the highest of all Organization for Economic Co-Operation and Development (OECD) countries and we doubled down with a worldwide tax system. The result was a system that forced companies to engage in massive avoidance behaviors and made it more profitable to keep one’s profits shored abroad. Under the new regime there will be fewer distortions and less avoidance behavior. The penalty for bringing money back to the United States and for competing abroad has been significantly reduced.

The second important benefit is that the reduction of the marginal rate will lead to more capital expenditures (investment), which in turn increase productivity and wage growth.

Michael Farren: One benefit of lowering the corporate tax rate, as well as changes to repatriation tax policy, will be a return of some of the $2.8 trillion indefinitely reinvested foreign earnings (IRFEs) that have been sitting overseas. This is a substantial amount of money—more than the 2017 GDP of California, or nearly 15% of annual national GDP. Furthermore, the lowering of the corporate tax rate will reduce the incentive for American firms to hold profits overseas in anticipation of the next tax repatriation holiday.

The return of these funds, as well as the lower taxes in general, will enable new investments in productivity leading to new job creation, increased wages, and general economic expansion.

Jason Fichtner: Though it will be years before we start to see the effects work their way through the economy, the lower corporate tax rate now makes the United States a better place for investment. We’ll start to see companies repatriate profits that were held overseas, wages will increase, investment will increase, and fewer firms will move headquarters operations overseas. We should also see an increase in foreign investment as the United States becomes an even better place to do business.

How can we measure the success of lowering the corporate tax rate? What specific indicators should we look for? 

De Rugy: Looking at nonresidential investment will give us a good idea of whether or not the tax reform has had some positive effects. We should also look at wage growth—and by that I don’t mean bonuses—and repatriated income down the road. I would also look at foreign direct investment in the US. In theory, lowering marginal rates should make our country for attractive to domestic and foreign companies.

Farren:  Specific indicators of the success of a policy change designed to support increased long-run growth are hard to come by, in part because they’re designed to change the growth rate rather than create a once-off GDP bump (which is easier to measure), and in part because there isn’t a good control group to compare what would have happened in the absence of policy change.

That said, measuring the value of IRFEs returning to the United States will give us an initial estimate of the short-run impact of tax reform, while the value of IRFEs that US firms declare in the future can help estimate the long-run effect. Comparing the previous trend of IRFEs in the US, as well as in other countries, with near-term repatriation and future IRFEs will offer some insight into how tax reform has changed corporate investment behavior (and therefore influenced economic growth).

Fichtner: Decisions are based on the margin. Meaning, if a major company has already started with a costly and burdensome headquarters move, a new tax code will likely not change that decision already made.  However, as the company continues to plan for their next decision, next investment, or next new branch, the tax rate will be a factor in their decision process.   Again, it will years before we start to see the effects work their way through the economy, the lower corporate tax rate now makes the United States a better place for investment.

Should we expect that the results of tax reform will only help wealthy CEOs and the ‘top one percent?’

De Rugy: Absolutely not. The academic literature shows that workers have been shouldering a large burden of the corporate income tax in the form of lower wages. Overtime, they will see their wages go up. Investors will also benefit as they shouldered some of the burden of the tax in the form of lower dividends.

Farren: The current low unemployment rate means that companies are fighting amongst themselves to attract and keep the best workers. One of the most direct ways to do this is to raise wages over that of other potential employers. Companies may use the soon-to-be repatriated IRFEs (and future funds that because of tax reform are brought to the US rather than be declared as IRFEs) to raise wages or otherwise improve their working environment, meaning that it’s entirely possible that the average worker will share in the benefits of corporate tax reform.

Fichtner: Of course not. Economic growth benefits the country and its citizens as a whole. Critics will point out that the “bulk” of any economic growth will go to the already well-off. But that is somewhat misleading. A person with $1 million in their 401k that returns 10 percent will gain $100,000. While a person with $10,000 in their 401k also receiving a 10 percent return will get $1,000. Obviously, the “bulk” of the returns went to the person with the larger beginning balance, but both received a 10 percent return and both are better off. That’s what we’ll see happen with tax reform.

What are some examples of ways that the lower corporate tax rate could help an average family in the middle of America?

De Rugy: Barring any counter-productive decision to dramatically reduce immigration or to withdraw from the North American Free Trade Agreement (NAFTA), we should see corporations invest in and expand their business. That will improve job prospects. Also, a growing economy increases the demand for labor and puts upward pressure on wages.

Fichtner: We should expect unemployment to remain low and economic growth will further the demand for workers, allowing for an increase in wages. Further, if the economy does well, then the stock market should also do well. This doesn’t mean there won’t be dips and volatility in the stock market, but over the long run, returns to equities will be higher with improved economic growth. Today, workers are also stock owners. Almost everyone that invests in a 401k or defined contribution retirement account owns stocks.

Farren: Tax reform, by incentivizing companies to bring back IRFE funds from overseas, may end up working as substantial economic stimulus in the short run, and enable greater long run growth by decreasing the reason for storing money in IRFEs in the first place.

The economic stimulus package signed by President Bush in 2008 cost $168 billion, while President Obama’s economic stimulus package cost $831 billion. If all of the estimated $2.8 trillion IRFE funds were repatriated, the corresponding infusion of cash into the US economy would be around two-and-a-half times larger than both economic stimulus packages combined.

If IRFE funds are indeed repatriated in substantial amounts, the surge in corporate cash flow would likely increase near-term economic growth, while the reduced likelihood of US corporations holding money overseas in IRFEs would act like smaller stimulus package each future year.

Both the short-term and resulting long-term economic growth will benefit all Americans to some degree, whether it is through new jobs and wage growth or through increased access to higher quality goods and services arising from corporate investments. Because economic growth is “the most powerful instrument for reducing poverty,” the poor will benefit more than most people would expect as they gain access to goods and services which heretofore had only been enjoyed by the wealthy.

What if companies bring money back from overseas, and then just use it for paying dividends to wealthy shareholders and stock buybacks? 

Fichtner: Even if this were the case, stock buybacks increase the price/return to equities. Again, workers are also stock owners. We’re already seeing companies announce that they are increasing their investment in the US due to the recent changes in the tax law.

Farren: Stock buybacks end up putting money back into the company by increasing the amount of profit it keeps, rather than paying it to shareholders.  This can be used in investing in equipment, facilities, or workers (by increasing wages, offering better benefits, or improving training).  Doing this can help insulate firms from the worst effects of future economic downturns as well as give them a means to enable future expansion when the time is right.  

What if companies bring back this money and then just use it for mergers and acquisitions? In this case, don't people often get laid off and actually lose their job?

Farren: Mergers and acquisitions may result in short term layoffs as companies re-engineer their internal systems to increase efficiency. Layoffs can be terribly disruptive to families and workers’ careers, but the low unemployment rate suggests that even if layoffs increase, the workers who are affected are unlikely to spend a long time out of a job.   Instead of looking at layoffs, we should keep an eye on the length of unemployment, which has been steadily decreasing for the average worker—in fact, the proportion of long-term (more than 6 months) unemployed workers has already been steadily declining.

Mergers and acquisitions can result in more productive and efficient companies.  This means that if tax reform does motivate corporate consolidation, one indirect effect could be cheaper products for consumers and higher profits that can result in higher wages and better benefits, as well as better returns for investors—which include workers contributing to 401k and 403b retirement plans.

Is it true that companies may not come back anyway because of cheap labor and lower levels of regulation overseas?

De Rugy: The decision to locate outside of the United States isn’t just a product of the level of taxes. The cost of labor and the regulatory regime are some of the other factors a company takes under consideration when deciding where to operate. This is particularly important for low profit margins industries like generic drugs.

Fichtner: Companies make decisions on where to locate business activity for many reasons, labor costs and taxes just being two of the reasons. Companies also want to be closer to their customers. A less-burdensome regulatory environment is also important and the current administration has focused on reducing the regulatory burden as well.

Farren: Regardless of the many factors that influence a company’s decision of where to locate, it’s certain that lower tax rates will push companies who are on the fence to locate in the U.S. The lower cost of doing business will also help U.S.-locating companies compete with other companies who chose to locate in countries with less regulations or more favorable labor markets.

One criticism of the tax reform package was that it made corporate tax cuts permanent, but didn’t do so for income taxes. What does that trade-off mean, particularly for lower or middle income Americans?

De Rugy: There is no question that reducing the corporate income tax rate was a pro-growth policy. The same cannot be said about cuts to the personal side of the tax code, in particular when these reductions take the form of larger tax credits and a doubling of the standard deduction.

Fichtner: Solely from the perspective of economic growth and competitiveness, the corporate tax structure was more in need of reform. This isn’t to say the individual income tax didn’t need reform, it did and still does need further reforms. But businesses need certainty when making business decisions and allowing corporate tax reform to be temporary would have reduced the economic benefit of the reforms. Making the corporate tax reforms permanent was the right decision.

Farren: Milton Friedman sagely observed that “nothing is so permanent as a temporary government program.” Given the public pressure that legislators would face to extend the individual income tax cuts before they expire, I wouldn’t be surprised if this temporary change is surprisingly permanent.

One major selling point of the tax reform plan was a simplification of the tax code (and the filing process, specifically). Does the reform plan deliver on that promise, and why is simplification an important goal?

De Rugy: This was a significant and important goal of the tax reform. I don’t think lawmakers have delivered enough on that front. They have abolished some tax privileges in the tax code but for the most part they have simply reduced the number of tax loopholes. Reducing the distortion isn’t the same as getting rid of it. Also, they have added some complexity by making some of the tax provisions expire in 2025. I consider this to be a real missed opportunity.

Fichtner: The complexity of the tax system makes compliance difficult and costly. Complexity also encourages tax avoidance. A simpler and more transparent tax code promotes compliance and increased revenues. The recent tax changes improved simplicity in some areas, such as increasing the standard deduction for individual filers and lowering the corporate tax rate, but also increased complexity in other areas, such as the treatment of income for pass-through businesses.

What are the likely effects of tax reform on the deficit?

De Rugy: It is hard to tell since we don’t know exactly what the overall growth rate will be. That being said, taken in isolation, the reduction of the corporate tax would have had a positive impact on the deficit while the individual income tax cuts would increase the deficit. Congress was ultimately irresponsible to reduce taxes without cutting spending to offset the potential revenue losses.

Fichtner: I wouldn’t phrase the question that way. We have a spending problem in this country, not a revenue problem. But we also can’t reduce revenues without reducing spending or else deficits will increase and continue to add to our already large national debt. Unfortunately, Congress has shown no willingness to control spending. Deficits and debt will reduce, at some point and to some extent, the economic benefits from tax reform.

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