The Macro Report | February 2017

The timing of fiscal change

Corporate tax cuts may provide a boost to the U.S. economy, but not as big a boost as other types of stimulus.

Since the election, markets have eagerly anticipated business- and consumer-friendly fiscal policies from the Trump administration. But, from the perspective of an economist, this eagerness is generally tempered by two things: the controversy over the fiscal multipliers on household spending cuts and infrastructure spending, and the differential impact of stimulus based on when it is delivered.

Late-cycle stimulus is weak

Of course, we know very little about the size and composition of Trump’s stimulus package, and we are still in the dark on its timing. But cross-country studies suggest that stimulus on the order of 1% of GDP raises GDP by about 0.45 percentage points when output is below potential. And yet, when output is running at or above potential, that same magnitude of stimulus raises GDP by only about 0.1%. Moreover, the multiplier is greater when fiscal stimulus takes the form of tax cuts to low- and middle-income households, and of government spending on employment and infrastructure. The multiplier is lower for corporate tax cuts and high-income household tax cuts.

How much greater or lower? According to a 2009 Congressional Budget Office study, tax cuts for low-income households, for example, could be four or five times more effective than corporate tax cuts. What’s more, the impact of stimulus on interest rates is far greater when the economy is running above potential. Given the cyclical position of the United States today, it seems likely that the direct real growth effects of fiscal stimulus will be small.

Corporate tax reform: Modest potential

Will lower corporate taxes be likely to ignite a corporate capital spending boom, pushing up both demand in the short run and productive capacity in the medium term? In our estimation, it is surprisingly difficult to be confident about an answer.

The dominant academic model of corporate investments strongly suggests that corporate sales matter much more for investment than the costs of capital. In other words, firms respond to demand prospects much more than to changes in the cost of making investments. The evidence from the Reagan-era corporate tax cuts is that they had no independent, longer-term impact on the investment-to-GDP ratio.

Given the cyclical position of the United States today, it seems likely that the direct real growth effects of fiscal stimulus will be small.

The corporate-tax kick start

On the other hand, a detailed OECD study of corporate tax changes across a range of OECD countries over more than 30 years suggests the effects are bigger than we may have thought.* Using the results of this study as a guide, we think that a U.S. corporate tax cut from 35% to 15% would have an impact on the investment/GDP ratio over five years that would be enough to raise annual GDP growth by between 0.14% and 0.34% per year over this period.

However, the impact of a large corporate tax cut may appear to dwindle when we also consider the cost of dropping tax rates by 20 percentage points. Also, we note that the 0.14%–0.34% impact range does not also contemplate loopholes in the U.S. tax code, which serve to lower the effective tax rate. If lower corporate taxes come with border adjustability and the closing of loopholes, then the growth benefits of lower taxes may take longer to materialize. Some firms, disadvantaged by the changes, would probably cut their investment faster than the firms that benefit could increase theirs. Nonetheless, we should not rule out the idea that corporate tax cuts will produce some beneficial growth effects.

* Laura Vartia, “How do Taxes Affect Investment and Productivity?” OECD Economics Department Working Papers No. 656, 2008.

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