Over the last couple of months, there have been dozens of news stories of companies offering bonuses to employees. Supporters of the recently passed Tax Cuts and Jobs Act have pointed to these bonuses as proof that the bill is working to boost the take-home pay of workers throughout the economy. Meanwhile, opponents of the bill have pointed to record levels of stock buybacks as proof that the Tax Cuts and Jobs Act is simply benefiting shareholders at the expense of the federal Treasury. This back and forth has set up an inevitable debate over whether the Tax Cuts and Jobs Act is helping a narrow set of shareholders or workers more broadly. Unfortunately, both sides are missing the nuances of how business taxes impact worker pay and are being too quick to judge the success or failure of the bill.
It is true that many economists think that a reduction in the corporate income tax rate has a positive impact on workers’ take-home pay. However, the economic effects are a little more complicated than the simple story of companies passing tax savings to workers or shareholders immediately in the form of bonuses or buybacks. In fact, wage gains will probably be slower and a lot harder to measure.
To understand why, it’s important to review the theory of why lower business tax rates should be expected to raise worker pay. Broadly speaking, the amount that workers are paid (both wages and other forms of compensation) is largely determined by productivity. The more workers can produce in goods and services, the more they are paid. Over time, productivity and pay go up, as technology improves and businesses accumulate more machines, tools and buildings with which to work.
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The amount companies are willing to invest in productivity-enhancing investments is determined in part by the expected after-tax return. When a company is deciding whether to make a new investment (such as building a new factory or purchasing a new drill), it tries to predict what return this new investment will yield over its life. The company examines the potential revenues of the project and compares them to all of its costs, including the taxes paid on the income from the investment. If, after considering all that, the company thinks the investment will yield a sufficient return, it will go ahead with the project. If not, the company will not. Several studies have shown that changes in the after-tax return on projects drive corporate investment decisions.
When lawmakers cut the corporate income tax rate to 21 percent, they made it more likely that companies would invest in new projects. Investments that were previously not viable due to the higher corporate income tax rate may be worth pursing now at the lower rate. The Tax Foundation estimated that the new tax law would eventually boost the stock of productive capital by 4.8 percent, which would lead to higher productivity and wages that are 1.5 percent higher. This finding corresponds with research that shows that corporate tax rate changes do benefit workers.
However, this boost in investment and wages won’t happen overnight and won’t be as obvious as a big bonus check with “Tax Cuts and Jobs Act” on the memo line. It will take time for companies to ramp up their investment in response to the tax bill, for these investments to translate into productivity gains and for higher productivity to translate into wage growth. As a result, it is more likely that workers will see slightly higher pay increases every year than they otherwise would have, as productivity and the economy grow faster.
If we take the Tax Foundation estimate that wages will be 1.5 percent higher in the long run, and assume that this change will happen linearly over a decade, wage growth should be about 0.15 percentage points higher each and every year than it otherwise would have been. This is much different than workers getting a large and obvious bonus right after the passage of the tax bill.
On the flip side, the fact that many shareholders are receiving an immediate benefit from stock buybacks or increased dividends does not necessarily contradict the claim that workers will also benefit from the recently passed tax bill.
When the federal corporate tax rate is cut, two things happen. First, as described above, companies are able to expect a lower tax burden on new investments that they make in the future. But in addition, companies also see a lower tax burden on profits that they would have been making no matter what. To put this another way, a corporate tax cut delivers a windfall to the owners of businesses on investments that have already been made in the past.
As a result, it is not surprising that companies have increased stock buybacks in the weeks following the recent tax bill. If companies are receiving higher profits from investments they made in the past, it is not surprising that they would distribute these profits to shareholders in the form of buybacks. But this does not preclude the possibility that companies will also increase their investment spending – which would help workers in the long run.
Another relevant nuance about the recent buyback announcements is that buyback levels were unusually low in 2017, perhaps because companies were waiting to see how a federal tax reform package would shake out. As a result, the elevated buyback amounts in 2018 may partially reflect a timing shift, rather than a longer-lasting level change.
Ultimately, the effect of buybacks will also depend on what shareholders do with the money they receive. For instance, shareholders might just reinvest the money they receive from some companies’ buybacks into other stocks. In this case, the buybacks could actually have a positive economic effect, transferring capital from less productive businesses into more productive ones. Or, perhaps, the buybacks would lead some shareholders to increase their personal consumption, which would not have a positive economic effect in the long run. Either way, looking at the total amount of buybacks doesn’t tell us which story is playing out.
Inevitably, supporters and opponents of the new tax law will continue to debate whether the corporate tax cut provided benefits to workers or to just wealthy shareholders. So far, both sides are being too quick to judge how the corporate tax cut will play out.
