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Markets and Economy

The Impact of Tax Cuts on Productivity

It can be difficult to predict the lasting effects of sweeping tax reform like the legislation now making its way through Congress, but one potential impact of the proposal could be an increase in labor productivity.
Jim Glassman, Head Economist, Commercial Banking
December 13, 2017

Congress is working to finalize a major tax reform package known as the Tax Cuts and Jobs Act, but assessing the bill’s future economic impact is not a straightforward matter. Critics of the legislation say that the economy is already operating near its full capacity, and further attempts to stimulate growth will simply lead to inflation. But if the tax cuts spur a labor productivity surge, economic growth could continue to accelerate—even as the labor market begins to tighten.

Potential Impacts of Reform

The Tax Cuts and Jobs Act could make sweeping changes to the US tax code. In its current form, it lowers individual and business tax rates, raises standard deductions, caps other deductions and brings the business tax structure more in line with international tax rates.

These measures could provide a significant boost to economic activity in the coming years. A direct benefit would come from deficit-financed tax cuts, estimated to reduce the nation’s total taxes by approximately $50 billion in 2018 and $225 billion in 2019. This tax relief will leave more money in the private sector, likely boosting economic growth by a full percentage point in 2019.

Other impacts of tax reform are more difficult to quantify. By simplifying the tax code and reducing the tax burden on corporations and individuals alike, the legislation could create new economic incentives that affect decisions about consumption and investment for decades to come.

Like any economic stimulus measure, the tax bill is expected to create a multiplier effect. Changes to the business tax code can have the effect of boosting business sentiment, which can then encourage greater capital spending. As individuals join businesses in spending their windfall—in their case, from new wealth created by gains in the equity market—the economy will likely grow more quickly.

The Need for Labor Productivity Growth

Some economic watchers are concerned the tax bill could be counterproductive. They say that economic stimulus will be wasted at the peak of the business cycle. Optimism about the economy is already running high; with full employment on the horizon, faster growth could simply lead to inflation and little real economic activity.

But these concerns reflect an overly narrow view of economic growth. While the labor market’s remaining slack may run out as the economy continues to create jobs at an above-trend pace, worker productivity likely has plenty of room to grow.

The economy’s total output is largely dependent on two factors: the size of the workforce and its productivity. The size of the workforce is fundamentally constrained by demographics; as baby boomers retire, growth in the labor force will slow over the coming years. But labor productivity grows in volatile bursts, with no inherent restraint. It is here that the tax bill’s indirect stimulative effect is most likely to take hold.

An Impending Productivity Boom

The recovery has seen an impressive rate of job creation, but productivity growth has been relatively sluggish over the past decade. The reasons behind the productivity slowdown are unclear; the pace of innovation is obviously accelerating, and the current trend toward a gig economy is increasing the productive capacity of underused workers. The stage may be set for a productivity boom.

As the labor market tightens, rising wages and competition for workers may compel businesses to invest in productivity-enhancing technologies. When the supply of available workers dwindles, higher-productivity jobs naturally should be filled first.

Past business cycles have seen worker productivity surge as the labor market tightens. Relatively weak productivity growth throughout the current expansion likely has left plenty of room for additional economic expansion. A tax bill that stimulates the economy could create a productivity boom as the peak of the business cycle approaches.

View our economic commentary disclaimer.

 

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