The Macroeconomic Effects of Corporate Tax Reforms

“…the time-series of investment and payouts to shareholders reported inFigure 10reveal an interesting pattern. increase in payouts to shareholders outweighs the increase in investment a.er the recent TCJA-17, but not a.er the Kennedy’s tax cuts..is can be observed both at the aggregate and at the c-corporations level. In fact, payouts does not appear to deviate much from the pre-reform trend, unlike investment which exhibits a clear acceleration. The increase in capital formation is gigantic: aggregate business investment is 50% higher in 1966 than in 1963, and c-corporations’ investment is 80% higher….”

Core finding, "... the results are reported in Figure 11. In response to the Kennedy’s tax cuts, the model predicts a large increase in GDP and investment, and a small effect on payouts to shareholders: the opposite of Trump’s Tax Cuts and Jobs Act. Similarly, the corporate tax multiplier for Kennedy’s tax cuts is around 2:5 for GDP, 1:85 for investment, and close to zero for payouts to shareholders. For the TCJA-17, the multiplier is around 0:6 for each variable. For every dollar of lost corporate tax revenues, the Kennedy’s corporate tax cuts stimulated GDP four times more than the TCJA-17. The intuition behind these results is the following. In the early 1960s, the corporate tax rate was high and tax depreciation policy was not accelerated as it was mimicking economic depreciation. As a result, the corporate tax wedge was well below one (around 0:72) before the reform. The Kennedy’s tax cuts increased the wedge significantly (to around 0:84), thus providing strong stimulus to the investment of c-corporations. Moreover, since around 75% of economic activity was taking place in the c-corporate sector, the aggregate effect was less diluted than in 2017….”

Evidence from the Trump vs Kennedy Tax Cuts

Mike Pettis Comment, "In this very interesting paper @Furno_Francesco compares the Kennedy corporate tax cuts in the early 1960s with the recent Trump corporate tax cuts, and finds that the former stimulated output roughly four times more than the latter. Put differently, the Kennedy tax cuts seem to have increased business investment while the Trump tax cuts were mostly passed on to shareholders which, as Atif Mian, Ludwig Straub and Amir Sufi have explained elsewhere, was likely in turn to lead to higher household debt. Furno explains that “A large part of this difference can be attributed to differences in pre-reform tax depreciation policy.” As I argued in my book and elsewhere, I think the reasons the Kennedy tax cuts flowed into investment and Trump tax cuts into savings had to do with the very different relationship between savings and investment at the time of the tax cuts. From a macro point of view corporate tax cuts increase business profits, which raise corporate savings. Whether these are used to fund investment or are passed on to shareholders depends on whether the main constraint on business investment is scarce savings or weak demand. In the former case, higher business profits can lead fairly automatically to higher business investment. If savings are abundant and the cost of capital low, however, the constraint is likely to be weak demand. In that case businesses will have little incentive to increase investment, and a cut in their taxes simply increases the after-tax profits they pass on to shareholders or use to acquire other companies. In the early 1960s, much of the world was still in the process of rebuilding itself after the ravages of two world wars. With high global investment needs and low global savings (the war caused income to plummet and, with it, savings), the main economic constraint was a scarcity of savings needed to fund investment. This was a time when the US was exporting so much of its domestic savings to the rest of the world that capital controls were imposed to restrict the outflow of dollars. Under these conditions it is not surprising that any policy that generated an increase in savings was likely - in classic supply-side fashion - to lead to an increase in business investment. In recent decades, however, conditions were dramatically different. The world has become awash in ex ante savings, and the US has become the dumping ground for nearly half of the world’s excess savings. What is more, US businesses are sitting on huge piles of cash and can only use them to buy back shares or purchase other companies. It is weak demand, in other words, and not scarce savings, that has limited business investment. In that case policies that increase in savings have little to no impact on business investment, and in fact could actually reduce business investment if the increase in business savings were balanced by a reduction in household income (and, with it, consumption). To me this is the key difference between the Kennedy and Trump tax cuts. The former provided more savings at a time when American businesses wanted to invest more, but were unable to do so in part because of the fierce global competition for US savings. The latter provided more savings at a time when the world was awash in excess savings and American businesses wouldn’t invest until they saw a rise in demand. As an aside, I am re-reading Charles Arthur Conant’s 1900 book, and it is amazing how similar the problem of excess savings the global economy faced in the 1880s-90s. At one point he proposes establishing a state pension system to help generate the demand needed to absorb excess global savings. This is because “experience has shown that when saved capital accumulates rapidly, the groping after new uses for it causes waste and disaster”.

Core of paper“…In the model, corporate tax changes affect the economy primarily through the investment decision of c-corporations, which is affected not only by the tax rate but also by tax depreciation policy. Specifically, the possibility to deduct investment from the tax base (partially) counteracts the distortion introduced by the tax rate: the faster investment is deducted from the tax base, the smaller the distortion to the rate of return on investment. As a result, when tax depreciation policy is very accelerated - like it was in 2017 - the rate of return on investment is almost unaffected by corporate tax policy, and a reduction in the corporate tax rate is not particularly expansionary……However, irrespective of how much stimulus is provided to investment, a corporate tax cut always entails a transfer of resources from the government to c-corporations. When pre-reform tax depreciation policy is very accelerated, the tax-savings from a rate cut are not used for investment and are distributed to the shareholders. When pre-reform tax depreciation policy is not very accelerated, instead, the extra cash is used for investment. Moreover, since a change to the corporate tax rate affects only c-corporations, the aggregate effect is diluted by the presence of pass-through businesses. After a rate reduction, pass-through entities are not only excluded from the tax cut, but they are also put at a competitive disadvantage. ‘is happens because they compete with c-corporations in the production of (imperfectly) substitutable goods, which further amplifies the shift of economic activity from pass-through businesses to c-corporations and reduces the aggregate effect even more….”