The ink on the U.S. tax bill wasn't even dry before Democrats said the measure was a failure. Republicans waited just minutes after Wal-Mart announced a $1 wage increase to crow that President Donald Trump's overhaul was already beginning to benefit workers and the economy.
These are examples of politics, not economics. And in both cases the truth is more complicated. The reduction in tax rates for corporations and households is a significant benefit to the economy and growth prospects because it enhances incentives to invest and work. The fiscal stimulus provisions are the worst characteristics of the legislation, because they would widen the budget deficit and would be applied when the economy does not need a stimulus. A better bill would have provided more tax restructuring and less red ink.
It is easy to be critical of the analysis from both political parties. Democrats argue simplistically that all of the savings from reduced corporate taxes will go to stockholders, who will benefit from increased dividends and stock buybacks. Both will occur, of course, but the critique fails to capture the longer-term effects of the tax changes and Democrats who make this argument display their lack of understanding of economics and the workings of markets. Markets do not permit companies to increase profit margins at their own discretion. If they did allow that possibility, all companies would be immensely profitable and none would ever fail. If profit margins increase initially, as should be expected, competition will fairly quick erode that benefit and market forces will pressure firms to reduce prices or pay more to attract scarce workers.
The Republicans are also guilty of mischaracterizing the tax legislation. Reducing corporate rates and allowing companies to expense investment outlays immediately are unambiguously positive incentives to promote investment and increase productivity and living standards over time. Had this been done while keeping net tax revenue neutral, the bill would have avoided its unfortunate budget-busting effects. Fiscal stimulus is appropriate public policy when the economy is in a recession or just coming out of one. Such measures when the unemployment rate is already exceptionally low are likely to produce higher inflation without lowering unemployment much further. And stronger growth will not provide the incremental revenues needed to avoid a surge in the budget deficit. All of the good from the improved investment incentives will be imperiled by the need to restore a modicum of budget discipline as the annual deficit careens out of control.
But the tax legislation has passed, so what are investors to do? The near-term implications of the new law are positive for the economy. The negative consequences will come later. Corporate profits will rise notably in 2018, reflecting the reductions in rates. Analysts have been busy raising their earnings estimates and have still not caught up to the new reality. Cash flows should also be enhanced because of the immediate expensing of investment outlays. And much of the cash held abroad to avoid U.S. taxes will come home to be used in ways that will stimulate growth, jobs and incomes. But some of the negative consequences should start to appear in 2018.
