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In this article, Viard examines the economic effects of the recent reduction of the corporate income tax rate from 35 percent to 21 percent. He explains the economic case for corporate tax rate reduction and analyzes some of the factors that will shape the size of the investment, employment, and wage effects. He also discusses the employee bonuses that some corporations have recently announced.
On December 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act (P.L. 115-97), which slashes the corporate tax rate from 35 percent to 21 percent. The rate reduction is a sharp break from three decades of relatively constant rates; the corporate income tax rate was reduced from 46 to 34 percent by the Tax Reform Act of 1986 and increased to 35 percent by the Omnibus Budget Reconciliation Act of 1993. Such a sweeping corporate income tax rate reduction seemed unlikely only a few years ago.
Contrary to some commentators’ perceptions, the economic case for corporate tax rate reduction does not involve the hope that corporations will “use” their tax savings to make additional investments, pay higher wages, or hire additional employees. Profit-maximizing corporations look at the anticipated tax savings from their decisions, not the tax savings they have already reaped from previous actions. The economic theory also does not assume any altruism or social responsibility by corporations.
Instead, the economic case for corporate tax rate reduction relies on corporations’ response to incentives. The rate reduction will prompt self-interested corporations to make additional investments to obtain larger tax savings from the rate reduction. The additional investment will make workers more productive and therefore more valuable to employers. Competition by employers to hire additional workers will force employers to pay higher wages. The additional investment and the increases in productivity and wages will occur over several years.
In an economy with fixed interest rates, such as a small economy perfectly open to capital inflows, a corporate tax rate reduction is clearly beneficial. Workers receive all the benefits of the rate reduction. Because workers’ wage gains are larger than the revenue loss from the rate reduction, workers benefit from the rate reduction even if the revenue loss is covered through increased wage taxation. Moreover, using deficit finance to delay the fiscal burdens would not drive up interest rates and would not crowd out investment.
The actual impact of the corporate tax rate reduction will fall short of the rosy picture painted by the small-perfectly-open-economy model. Because the United States is a large economy and is not perfectly open to international capital inflows, corporations’ increased demand for capital will push up interest rates, which will blunt the increase in investment and workers’ wage gains.
A deficit-financed corporate tax rate reduction has further implications in a large imperfectly open economy. The additional government debt will further push up interest rates, offsetting or maybe even reversing the gains in investment, output, and wages. Also, a complete accounting of the effects of the corporate tax rate reduction must include the future tax increases and spending cuts that will be adopted to service the debt. Dynamic estimates of the TCJA that allow interest rates to change generally find small gains in output and wages, which may be reversed in future decades because of the deficits.
Several corporations announced one-time employee bonuses after the TCJA was enacted, citing the corporate tax rate reduction as part of the reason for the bonuses. The timing of the bonuses indicates, however, that they do not reflect the gradual rise in productivity that economic theory predicts from a corporate tax rate reduction. The bonuses may be a public relations response to the rate reduction or they may be responses to the ongoing economic expansion that corporations are attributing to the rate reduction for public relations reasons.
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