Why Business Tax Reform Will Encourage Additional Investment

September 7, 2017

One of the main goals of the Trump administration and Republicans in the Congress is to reform corporate and business taxation in the United States. The idea is to reduce the statutory tax rate on corporate income and speed up cost recovery to encourage business to invest more in the United States. This would boost productivity and worker wages.

Some seem skeptical that a reduction in the corporate tax rate, or other reforms, would produce economic gains. They argue: why would transferring more cash to corporations in the form of tax cuts do anything for investment or hiring if companies already have access to lots of capital? According to the Bureau of Economic Analysis, after-tax corporate profits are near an all-time high. Corporations have nearly $2 trillion in cash that they are not investing. And low interest rates make borrowing cheap.

There is truth to this critique: there really isn’t a strong link between how much money corporations have in the bank and their incentive to hire or invest. We have written before there is little reason that tax changes that transfer money to companies without changing underlying incentives, such as a repatriation holiday or deemed repatriation, would permanently increase economic output in the United States.

However, there is a fundamental error in using this mode of analysis for all corporate tax reforms. The amount of money a corporate tax reform transfers to a company has little to do with whether it encourages or discourages investment. What matters is how tax policy impacts a company’s incentives to invest in new projects.

When companies make investment decisions, they look at whether a new project yields a high enough after-tax return to make it worthwhile. To see whether a new investment, such as a factory, is worthwhile, a company will employ what is called a “discounted cash flow analysis.” They calculate how much that investment will cost, how much revenue it could bring in over its life, and the taxes they will pay on the returns.

If the company does this analysis and finds that under the current tax regime, the factory does not yield a sufficient return, the factory does not get built. If the factory does yield a sufficient return, the company will invest.

Changes in tax policy alter the number of investments that are worthwhile. If the federal government were to reduce the statutory tax rate on corporate income or increase the size of deduction available for new investments, this factory and potentially many more investments may become worthwhile.

This is the way that the Tax Foundation’s model and many other tax models analyze corporate tax policy’s long-run impact on the economy. Notice that this analysis doesn’t consider how much money the corporation has in the bank. In fact, a company could be sitting on billions, but won’t invest if the current tax regime means that potential investment opportunities are not profitable after-tax. Nor does the decision to invest depend on the interest rates on new borrowing. If an investment is deemed worthy on a cash flow basis, the cost of borrowing may affect how a firm decides to pay for the new investment, whether to borrow (if rates are low) or to issue new shares or to use retained cash, but it does not determine whether the investment is done or not done.   

This has a few implications for the current debate over corporate tax reform.

First, the stats on how high after-tax corporate profits are on existing projects, how low borrowing costs are, and how much cash companies have, aren’t as relevant as you may have thought. They tell us very little about how potential corporate investment projects will fair under a different tax regime with lower marginal tax rates. So even though companies may have cash to make investments, those projects may not be worth it under the current tax system.

Second, the size of the tax cut, or how much corporate taxpayers benefit at the expense of the federal treasury, also tells us very little about how a corporate reform would impact the economy. A corporate reform that loses revenue may or may not encourage investment. What matters is how a corporate tax reform impacts the incentives to invest. There is a big difference between cutting the statutory corporate tax rate or enacting expensing, and a repatriation holiday on past earnings. Only the first two would permanently encourage investment.

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