May 21, 2018

How Recent Tax Cuts Will Affect Financial Markets and the Economy

Tracy C. Miller Senior Policy Research Editor

The  fear of poor timing of The Tax Cut and Jobs Act  - that the  tax cuts will stimulate the economy when it is already booming but then have the opposite effect when tax rates increase in the future – should not be policymakers’ primary concern. What matters is how those tax cuts will influence incentives to invest, and the composition of spending in the economy.

The tax cuts have two distinct effects on the economy and on financial markets. The first comes through the incentive effects of lower corporate tax rates, and the second through the effect of lower tax revenue on government borrowing. The net effect of the tax cuts should be greater investment but also higher interest rates.

The cuts in corporate tax rates raise the after-tax return on investment and lower the cost of corporate investment. They should lead to more capital investment, which leads to productivity and wage growth.  The beneficial effects of the increased investment, however, take time. Investment projects take time to complete and will be spread out over time. Only when those investments are completed, and workers adjust to them, will productivity and wages increase. 

To the extent that cutting taxes reduces government revenue while government spending remains the same or even increases, government deficits will increase, which will likely lead to an increase in government borrowing.  The more the government borrows the smaller the percentage of savings that can go to fund private investment.

When government spends more, fewer resources are available to households to spend or save. When that spending is paid for by taxes, taxpayers tend to notice. When spending is high, but taxes are much lower, the public may underestimate the cost of government spending. The resulting deficits will be paid for with a combination of government borrowing and money creation

More government borrowing means less investment. To the extent that deficits are funded by money creation the result is inflation, which works like a tax.

The net effect of the tax cuts on the total amount of investment in the economy depends on the size of each effect. Lower corporate tax rates encourage investment while higher deficits discourage it. The Congressional Budget Office estimates that the net effect will be greater investment and faster economic growth.

Corporations are also likely to fund more of their investment with equity (reinvesting profits or issuing new shares of stock) rather than debt.  Because corporations could deduct their interest payments from their taxable income, high corporate tax rates encourage using debt to finance investment. The tax bill also placed limits on how much interest can be deducted from taxable income, further reducing the benefits of using large amounts of debt to finance investment.

It is important to put the Trump tax cuts into perspective. The reduction in revenue is small in comparison to the expected growth in government spending in the future, which is largely driven by expected increases in Social Security and Medicare spending.

30 Year Deficit Projections With and Without Permanent Tax CutsShare this

Government borrowing is already trending up, which is likely to contribute to higher interest rates and reduced investment. Even without tax cuts, it is likely that the federal government will have to restructure its obligations in a way to lower payments, particularly those promised to Social Security and Medicare recipients at some point in the future.

Critics of the tax cuts also emphasize the fact that income tax rates are slated to rise back to their 2017 levels in 2025. The reductions were made temporary to limit the increase in the debt. Whether or not individual income taxes do increase again in the future, the difference will have a much smaller effect on the economy than the growth of entitlement spending and the cost of financing the debt.

By themselves, tax cuts or tax increases have almost no impact on the total amount of spending in the economy.  Most of their effect is likely to be on the composition of spending.

The tax cuts will affect financial markets.

Although reductions in corporate tax rates will lead to more capital investment, the reduction in revenue will contribute to higher interest rates and reduced capital investment.  Reducing taxes in order to reduce the size of government would be beneficial to the economy in the long run; but reducing taxes without a reduction in government spending, as actually happened, is less so. The failure of Congress to reduce spending, therefore, will offset much of the beneficial effect of the tax cuts.

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