Tax Reform Will Pay Growth Dividends

The effects will be even larger thanks to last-minute cuts in marginal individual rates.

By Robert J. Barro.

"My research with Charles Redlick, published in 2011 by the Quarterly Journal of Economics, suggests that cutting the average marginal tax rate for individuals by 1 percentage point increases gross domestic product by 0.5% over the next two years. This means the tax bill’s average cut of 3.2 points should expand the economy by 1.6% through 2019, or extra growth of 0.8% a year. This growth effect is temporary, but what it adds to the level of GDP is permanent.

Expansionary effects from cutting marginal income-tax rates also appear in a recent study, forthcoming in the Quarterly Journal of Economics, by Karel Mertens and Jose Montiel-Olea. But their estimated effects are roughly twice as large as those that Mr. Redlick and I calculated. They also find that incomes expand across the distribution, not primarily among the wealthy.

My evaluation of the tax bill’s corporate provisions relies on the “user cost of capital.” This is a concept economists employ to gauge how much it costs businesses to acquire and deploy capital. The calculation starts with the expected return companies need to undertake investments. This return is high—around 8% a year in real terms—because investing entails large risks.

The tax system is also included, in two ways. First is the tax rate on corporate profits. The recent legislation cuts the main rate on corporations from 35% to 21%. A second factor is the degree of expensing allowed on business investments. This gets a bit complicated because of the need to distinguish between equipment and structures.

On equipment, the generous depreciation allowances in the current system suggest that the effective expensing rate is already high, around 80%. The new law raises this rate to 100%. That change is scheduled to lapse after five years, but I treat it as permanent on the assumption that Congress will extend it. I estimate that this lowers the user cost for equipment by 10%.

On structures, the existing recovery period is long, depreciation allowances are heavily discounted, and the effective expensing rate is only 30%. The new tax law does not change depreciation schedules for most structures, such as factories and office buildings. But the lower corporate tax comes into effect here because whatever output is generated by the investment is taxed at the new rate of 21%. Overall, I estimate that the user cost for structures falls by 14%. Surprisingly, this is larger than the drop for equipment, mainly because equipment already is effectively expensed at a high rate.

Lowering the user cost of capital increases the long-run ratios of corporate capital to labor—that is, companies are willing to provide each worker with more equipment and structures to do their jobs. My estimate is that the capital-labor ratio will rise in the long run (after 20 or more years) by 14% for equipment and 20% for structures. These changes imply a 7% long-run increase in both corporate output per worker and real wages paid to workers. This is “trickle-down economics” at its best—raising wages by cutting corporate taxes."

"As a bottom line, I estimate that the total tax package will create extra GDP growth of 1.1% a year through 2019."

"Over the following eight years, the projected growth rate rises by 0.2 to 0.3 percentage point a year because of the law’s expansionary effects on long-run capital and GDP per worker."