When thinking about tax policy, economists typically distinguish between the short run and long run. While there might be temporary boosts to the economy in the short term from a tax cut due to increased incomes, changes in tax policy alter the incentives to work, save, and invest, which can produce benefits to economic growth in the long run. New research finds that while the benefits of personal income tax cuts are often concentrated in the short run, corporate income tax cuts generate “large and persistent” positive effects on the economy in the long run.
The Tax Cuts and Jobs Act (TCJA) of 2017 permanently cut the statutory corporate rate from 35 percent to 21 percent. However, most of The CJA’s individual and business provisions are set to expire after 2025. For example, full expensing for short-lived equipment and software begins phasing out next year, meaning firms will no longer be able to fully deduct the costs of these investments from their taxable income. The temporary nature of these provisions suggests that the economic benefits are likely to be concentrated in a shorter time horizon.
When it comes to reductions in the corporate tax rate, the motivation for this policy is specifically to alter the long-run incentives for firms to invest and boost productivity, rather than providing a short-term stimulus to the economy. However, many analyses of tax policy tend to focus only on the short-run impacts, typically one to two years after a policy change. This will miss many of the positive growth effects from cutting the corporate tax rate.
In a new paper, a team of economists studied post-WWII U.S. federal tax policy changes to estimate their long-run impacts, looking specifically at changes in average tax rates. For personal income tax cuts, they found large and significant effects on GDP for the first six quarters, but none after two years. But for corporate income tax cuts, the short-run impacts on the economy were small while the long-run impacts were strong, peaking after eight years. Personal income tax changes had temporary impacts on productivity and an insignificant effect in research and development (R&D) investment, while corporate income tax cuts boosted R&D investment and led to a sustained increase in productivity. The authors identified the innovation channel from these R&D investments as the main channel through which corporate tax cuts generate long-run growth.
The economists also examined how total employment and hours worked changed in response to tax cuts. They found that for corporate tax cuts, labor supply response was modest, while personal income tax cuts had a temporary impact on hours worked and smaller effects on employment. However, the increases in investment and consumption following corporate tax cuts indicates that they do raise labor income overall, consistent with other evidence on the effects of corporate taxes on wages.
Broadly, the evidence presented in this paper is largely consistent with economic theory regarding corporate tax cuts: In the long run, they incentivize firms to invest in capital, especially R&D, which raises the productivity of their workers and increases their incomes. And these economic impacts are larger and more persistent than changes in personal income tax rates. Policymakers should continue to focus on longer term impacts rather than emphasizing the short-term stimulus effects of tax cuts.
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This post was written by prismatax