Lowering the Corporate Income Tax Rate Benefits Old and New Capital
August 14, 2018
Our new analysis on the impact of cutting the corporate income tax rate explains how the reduction helps increase growth in the long run. But one question I’ve been asked repeatedly today is, “What is the impact of the corporate rate cut on old investments?” We have a larger piece of research coming out soon on the topic, but the answer is simple. Cutting corporate income taxes benefits all capital, both new and old.
When Congress passed the Tax Cuts and Jobs Act (TCJA) in December 2017, they lowered the federal corporate income tax rate from 35 percent to 21 percent. This change is generally why economists predict that the TCJA will boost economic growth. For example, we’ve estimated that this provision on its own would increase long-run GDP by 2.6 percent. We’ve also noted that while cutting the corporate tax rate grows the economy, it splits the benefits between new and old capital.
Lowering the corporate tax rate to 21 percent causes two things to happen: a lower tax burden on old capital—leading to higher profits on existing investments—and a lower tax burden on new capital—incentivizing businesses to make new investments.
Boosting after-tax returns on investments that firms made in the past provides a cash infusion to these businesses. Companies have a number of options on how to spend this newfound capital, but they’re likely to share these higher-than-expected profits with their shareholders, whether through increased dividend payments or stock buybacks.
However, the perception that the choice is between stock buybacks or investment is false. Stock buybacks do not preclude increased investment spending and do not deprive firms of cash they would otherwise use for investment. Focusing on the initial action of a stock buyback is short-sighted and ignores the greater context of how the TCJA is expected to grow the economy in the long-run. Stock buybacks also allow for the transfer of capital from old firms to new firms, allowing for a more efficient allocation of capital in the economy.
A lower corporate tax rate also means that new investments face a lower tax burden on future returns, so at the margin, firms are encouraged to pursue more investments. We expect companies to invest more not because they have more cash, but because the TCJA lowered the cost of capital. We’ve explained this process in detail in our new paper. In the first few years after a corporate rate reduction, companies will not have fully put new investments into service. As such, the boost to wages is minor at first. As the economic effect of a corporate rate reduction is more fully phased in and companies have made productivity-enhancing investments, wages are gradually expected to be higher than they otherwise would have been.
Cutting the corporate tax rate has many benefits. These include reducing the incentive to shift profits to lower tax jurisdictions, placing the United States more in line with global competitors, and incentivizing new investment. It also splits its benefits between new and old investments in the process. The criticism of stock buybacks has ignored this inevitable effect and glossed over the fact that it will take years to fully assess the economic impact of the TCJA.
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