Recent empirical evidence surrounding the 2017 US Tax Cuts and Jobs Act can shed some light on the short run effects of similar tax policy here in the UK, as proposed by Tory leadership candidate Boris Johnson. Although many commonly claim that tax cuts can have a profound effect on stimulus and growth, short-run analysis from the US points that the recent large tax cuts have so far had a tepid effect on economic growth, if any. However, they have had distinctly large effects on corporate repatriation of earnings and dividend income.
What do the charts show?
The first chart plots quarterly US Real GDP Growth and Consumption Growth from Q1 2014-2019 Q1. Real GDP Growth is plotted in green (distinguished from nominal growth in that it is adjusted for inflation) and consumption growth in quarter on quarter percentage change is plotted in yellow. The second chart plots quarterly percentage change in components of private nonresidential investment from 2014-2019. The solid blue line plots investment in intellectual property, mostly comprising of Research and Development. The dashed blue line plots firm investment in equipment and machinery. Finally, the dotted blue line plots firm investment in structures such as new buildings or factories.
Why are they interesting?
Following announcement of Theresa May’s resignation, many potential candidates for Prime Minister have begun to discuss their respective agendas and priorities. Such topics include Brexit, the environment, and tax reform. Prominent candidate Boris Johnson recently laid out his leadership bid by proposing a rise in the threshold of 40% tax bracket from £50,000 to £80,000. Given that yearly incomes ranging from £30,000 to £40,000 are considered to be median figures, most individuals who earn yearly incomes at this level are well within the top quintile of income earners. In support of his proposed policy, Johnson stated that the cuts will provide economic stimulus and help ‘the huge numbers that have been captured in the higher rate’ while and following the UK exit from the European Union. ‘We can go for much greater economic growth – and still be the cleanest, greenest society on earth,’ he asserted in his Daily Telegraph column. Johnson also added that the UK ‘should be cutting business taxes’ from the current corporate tax rate of 19%. Regardless of any distributional concerns around affording society’s highest-income earners and firms tax cuts, it is worth examining whether such policies serve to stimulate the economy.
Recent empirical evidence from the US following the 2017 Tax Cuts and Jobs Act (TCA) sheds some light on the short term effects of similar policy. Similar to Johnson’s proposed income tax policy, this legislation extended several lower rate tax brackets. Additionally, the Act lowered many of the rates in their respective brackets, with most substantial rate cuts benefitting top and middle earners. However, as the income tax cuts were accompanied by additional cuts in estate taxes, dividend income taxes and taxes on income earned by S corporations (commonly used as a legal means of tax avoidance/reduction through income shifting), the benefits reaped by top income earners were compounded. The TCA also lowered the corporate tax rate from 35% to 20%. In a similar manner to Johnson, the proponents of the US tax reform touted the measures as leading to GDP growth, wage growth as well as increased investment.
The non-partisan Congressional Research Service (CRS) recently released its assessment of the effects of the TCA through 2018, in order to test the validity of the claims. The findings of this report must be qualified, however. This is a short-run analysis and many economic reforms take several years to make more profound impact. Despite this, it is helpful in shedding light on whether the claims that these reforms would have an immediate effect on economic growth, wages, and investment are valid. In US, advocates of the TCA took figures modelling the long run impacts of the reform and advertised them as if they would occur immediately. Nonetheless, Johnson’s claims can still be analysed at this stage, as economic stimulus is intended to have short term positive effects, which can offset shocks caused by recessions or by occurrences such as Brexit. Finally, the effects of the TCA corporate tax cuts on investment and wages are a useful comparison to Johnson’s proposed corporate tax cuts due to the immediate effect of the US cuts on stock buybacks and corporate income repatriation.
With respect to GDP growth, the CBO projected that the TCA would have a positive impact of 0.3% during 2018. Indeed, a much higher estimate of 1.2% additional growth was projected by the Republican-majority congressional Joint Committee on Taxation. The goal of the type of analysis done by the CRS is to isolate the effect of the tax cuts by comparing the observed 2018 figures to economists’ projections in the absence of the reforms. The observed figure from 2018 was 2.9% GDP growth and the CBO projected figure was 3.0%, which included the effects of the TCA. Without the tax reform, the CBO’s projection for 2018 was 2.7%. Comparing the observed to projected figures, the effects of the tax cut seem to have been to add an additional 0.2% to GDP growth, lower than the CBO’s conservative 0.3% estimate. But time series analysis is often far from perfect when concluding causal effects, so we must disaggregate the effects to provide further corroboration that the TCA’s short-run analysis was unimpressive in critical areas such as consumption and investment. In any case it is far from providing the level of rapid and significant stimulus and growth predicted by its proponents.
Considering consumption, there is reduced need for projections. Time series analysis should provide some evidence as to whether the tax reform increased demand for consumer goods in the short run by affording consumers more disposable income. Consumption increased by 2.6% in 2018, only 0.1% higher than 2017 and below the figures from 2014-2016. With the US economy continuing to expand and near full employment, consumer confidence was already high prior to tax reform. Overall, the absence of historical evidence of short run demand side effects is unsurprising for a few reasons.
First, as mentioned, the US already had low unemployment. Increased employment resulting from workers wanting to work more hours for higher wages (supply side) as well as from the decreased corporate tax burdens (demand side) would have little impact in an already tight labour market. As the UK is currently following a similar low unemployment trend as the US, this conclusion would likely hold here as well. Secondly, top income earners are less likely to spend additional income on consumption as they are presumably already consuming a relatively large, relatively stable amount. In economic terms, higher income individuals have lower marginal propensity to consume, and they tend to spend a lower portion of each additional pound earned on consumption than lower income individuals. Therefore, since most of the TCA’s impacts were on top income earners, there should not be much of an impact on consumption. On the balance of probabilities, Johnson’s cuts would have a similar result in the UK.
The TCA’s impacts on investment can also be discussed in more detail than its effects on overall GDP. The CBO projected that the tax reform would lead to an additional 1.5% growth in fixed nonresidential investment. Given that in 2018, US investment increased by 7%, it is plausible that the tax cut did cause the intended increase in investment. However, as seen from the chart and noted by the CRS report; the largest increase in 2018 investment occurred in the first two quarters. This implies that many of these projects, which take time to plan and coordinate, had begun before the tax cuts were in place and should not be considered as resulting from them. Secondly, the growth in the respective components of investment does not align with the incentives provided by the TCA. This can be seen through changes in the opportunity cost of capital for the three components included in the chart. The tax cuts included specific changes with respect to each, such as a lower tax rate and faster depreciation for investment in equipment. The opportunity cost of capital is the required rate of return for a particular investment, meaning that an investment must generate some return in excess of that hurdle rate to be ‘worth the money’. With other factors equal, a lower opportunity cost of capital for a particular opportunity means that it becomes a better or easier investment. The CRS estimates that the cost of capital declined by 2.7% for equipment and 11.7% for structures but increased by 3.4% for intellectual property.
These changes in cost of capital are very likely largely affected by the changes in the tax incentives for investments in these respective areas. Intuitively, this should result in the highest investment growth for structures, the second highest for equipment, and a decline in investment in intellectual property or at least a decrease in the growth rate of such investment. Rather, what is seen during 2018 in the second chart is that intellectual property investment experienced the highest growth and structures investment experienced the lowest growth, even decreasing in Q3 and Q4 2018. This is the converse of what might be expected or incentivised by the tax cuts and changes in cost of capital. This implies that the tax cuts had a dubious short-run effect on investment. In the words of the CRS, “it would be premature to conclude that the higher rate of growth of nonresidential fixed investment was due to the tax changes” and their effects of the return of certain investment opportunities.
Finally, the CRS found that the TCA corporate tax cuts did have certain short run effects, just not on wages or investment, the key components of any economic stimulus supposedly sought by a Johnson-led government. In 2018 US overall real wages grew by 2.0%. However, as ordinary workers were touted as the primary beneficiaries of the tax cuts, the wage growth of production and nonsupervisory workers is a better figure to consider. Wages for these individuals grew by only 1.2%, below the overall number, implying that any more substantial wage growth effects accrued to higher level, supervisory, non-production workers such as leadership and executives. With respect to earnings repatriation and increased investment, overall repatriation did increase substantially in 2018. However, repatriated earnings used for reinvestment or ‘plowback’ decreased remarkably by nearly a factor of 3. Further to this, dividends paid out increased by an even larger extent from $158 billion in 2017 to $664 billion in 2018. As the overwhelming proportion of firm shares are owned by very high-income earners, this change in dividend policy (alongside the additional $1 trillion in stock buyback which occurred in 2018) served to vastly increase top incomes. And, as stated above, these income increases seem to have had little effect on consumption and GDP.
Ultimately, recent empirical evidence can do well to inform the debate on UK public policy, especially in the midst of the contest for the selection of a new Prime Minister.
Week 24, 2019