With the enactment of the Tax Cuts and Jobs Act (TCJA), I have revised my December 2017 Commentary to cover the specifics of the new legislation. Notably, the conclusions have not changed; if anything, they are reinforced.
To reiterate, the most significant and powerful growth engine in this legislation is the benefit that will accrue to almost 32 million pass-through businesses and 1.6 million corporations, the overwhelming majority of which are small (see The Business of America is Business). Active owners of these businesses and their families could easily constitute 100 million Americans who will benefit from lower business tax rates and other advantages that will encourage businesses to grow.
The second important growth driver is the effect of the low corporate tax rate (as distinct from the business pass-through tax rate) and the shift to a quasi-territorial tax system on large publicly traded corporations. These provisions will dramatically reduce the role that tax considerations play in large global business decision-making and, thus, render the United States a globally competitive platform for investment and expansion.
This legislation is revolutionary in that it operates through the long-term incentive structure in the tax code. The new incentives increase the returns from business activity relative to labor. They also tend to equalize returns from investing in the United States with returns from investing abroad.
Changes in incentives have more or less permanent effects on economic behavior, as opposed to more traditional Keynesian approaches which depend on the size of the absolute dollar transfer from the public to the private sector. Keynesian benefits influence short-term spending decisions but have little long-term effect on investment or business behavior.
The legislation especially benefits domestic U.S. companies. Unlike multinational companies, they do not have to pay any of the new taxes imposed on multinationals associated with operations outside of the United States.
The shift in relative taxation in favor of business will also encourage new business creation which will help reverse the decline that has been ongoing for more than a generation. The United States provides unique opportunities to transform labor income into capital which is one of the reasons it is such a powerful magnet for immigration. This legislation enhances those opportunities.
Tax rates are reduced for individuals as well but these benefits total only a few percentage points of tax liability for most taxpayers, with relatively larger net benefits in the middle- and lower-income levels. Much of the benefit at the highest incomes is offset by the elimination of deductions and preferences.
As indicated in my previous Commentary, this legislation is no superficial “giveaway” to the rich. On the contrary, the limitations on state and local deductions will raise the taxes for many high-income taxpayers in high-income states.
Not only are incomes and housing prices much higher than the national average in these states, but some, like California, have imposed high-income surtaxes that make the effective state income tax rate still higher. Moreover, many high-income taxpayers shift their primary residences to low-tax states but have business activities and residences in other states; they will be hit by this provision.
Lowering the corporate rate to 21 percent will have an immediate, positive impact on domestic corporations now paying the 35 percent rate and higher. Not only is the rate much lower than what most corporations have paid – remember most corporations are small – but the previous corporate tax rate was more progressive than individual tax rates, discouraging enterprises from forming corporations in the first place (Chart 1).
After-tax profits are the primary source of cash and it is cash that drives a business. High tax rates on businesses siphon off cash resources and hamper companies’ ability to fund operations. Conversely, lower taxes add cash and increase business demand for a wide range of goods and services, as well as investing in capital and workers, particularly in the manufacturing sector.
The economic effect of cutting the corporate tax rate to 21 percent on multinational corporations is considerably more complicated. The United States is among the most cost-competitive countries in the world. Yet, under the previous law, the 35 percent tax rate acted as a surtax on U.S. investment.
Were corporations to use foreign profits for U.S. investment, they would have to pay the difference between the 35 percent U.S. rate and the tax rates paid to foreign jurisdictions. Those are significantly lower, adding to the cost of capital for U.S. investment (Chart 2).
That said, several provisions offset the apparent benefits of the lower corporate tax rate for multinationals. These include:
Foreign companies also face this surtax on U.S. activities. Although the United States remains a top choice for foreign companies investing abroad, its share of foreign direct investment has dropped from 39 percent in 2000 to 21 percent in 2014 as global competition for foreign investment has intensified. Reducing the effective surtax on U.S. investment will increase the U.S. foreign investment share.
High corporate tax rates together with the high progressivity of the corporate rate structure have prompted many businesses to shift away from corporate structures to sole proprietorships and other pass-through entities. Under the new law, the pass-through rate is capped at 25 percent, which roughly equalizes the gap between the individual tax rate and the pass-through rate.
Do pass-through businesses stay small because they don’t have any big profitable ideas? Or are they small because under the previous system, the marginal rate on success above $150,000 was 8 to almost 15 percentage points?
Under the new law, the individual rate comes down to a level that is almost equal to the new corporate tax rate through about $315,000. In addition, qualified pass-through businesses will be able to deduct 20 percent of their business income. This deduction phases out between $315,000 and $424,000 and then is eliminated above $424,000 (Chart 3). Pass-throughs are disadvantaged relative to corporations at income levels above $315,000 and may be encouraged to shift to a corporate form.
Despite its considerable long-term impact, the short-run benefits of this tax reform are limited. For businesses, many of the revenue raisers are front-loaded. Individuals and pass-through businesses are likely to wait until the end of 2018 to understand their tax liability under the new law.
For multinationals, the immediate benefit from the lower tax rate will be offset by deemed repatriation, limitations on interest deductions, new permanent taxes on foreign income, and possible excise taxes on foreign transactions.
Rather than a rush of cash into stock buybacks next year, as the market expects, the very early years of tax reform for many multinationals are likely to be a wash. Moreover, foreign profits are often held in working capital that supports business operations and expansion overseas rather than in cash and cash equivalents. The taxes owed on these historic profits and other foreign entity provisions will dig into the cash benefits from tax reform. The U.S. stock market is overly eager to capitalize these long-term gains into current stock price valuations.
As with businesses, any stimulus from the individual tax cuts will also likely be delayed. Most individuals and pass-through entities will not fully understand the impact of tax reform on their tax obligations until the end of 2018, delaying any stimulus to demand.
In sum, the Tax Cuts and Jobs Act is intended to spur business activity and job creation. Its long-term effects depend on just how businesses, particularly small businesses, respond to the new incentive structure.
Given that the effects of tax reform won’t be felt until late 2018, Republicans will have to go into the 2018 midterm elections with promises but little to show in the way of tangible impact.
This legislation is transformational for the U.S. economy. The political question will be how voters view these benefits. A shift in congressional control from Republicans to Democrats in 2018 could undo what is a very promising deal for the future.
 “Entrepreneurship Is on the Rise but Long-Term Startup Decline Leaves Millions of Americans Behind.” Kauffman.org, Kauffman Foundation, February 16, 2017.
 “Foreign Direct Investment in the United States 2016 Report.” ofii.org, Organization for International Investment, February 19, 2016.
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