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Photographer: Charlotte Pollet for Bloomberg Businessweek Photographer: Charlotte Pollet for Bloomberg Businessweek

The Tax Cuts and Jobs Act of 2017 was as close as the real world gets to a laboratory experiment on whether supply-side theory works in practice. More than one year on, we have an answer. It’s “meh.”

The White House and congressional Republicans argued that easing the corporate tax burden would lift business investment out of the doldrums and reinvigorate the U.S. expansion. An analysis by Bloomberg Economics shows that while investment spending did pick up in 2018, the amount attributable to a lighter corporate tax burden is small. It’s not that tax cuts don’t matter. It’s that they don’t matter much. That view is informed by looking at a longer sweep of history, which makes clear that despite its size, the TCJA was always destined to fall short of the hype.

Supply-siders argue that the tax code is a significant factor in corporations’ capital-spending plans. The central premise is simple and intuitive: Allowing businesses to hold on to a bigger share of their profits motivates them to increase investment. Demand-side enthusiasts, on the other hand, argue that such decisions are driven more by the state of the economy and that businesses will invest when existing factories, storefronts, equipment, etc., are insufficient to meet demand for their products. In their conception, changes to tax law are of secondary importance.

The Big Corporate Tax Cuts Were a Lot of Huff for a Little Puff

Still, both sides would agree that the U.S.’s latest attempt at tax reform was a boon to corporate profits. The reduction in the top marginal tax rate for corporations, from 35 percent to 21 percent, helped boost profits almost 8 percent in the first three quarters of 2018, from the same period a year earlier. If the pace carried into the fourth quarter (we won’t know until the data are released later this month), that would be the fastest pace of profit growth since 2012.

Close Correlation Data: Bureau of Economic Analysis

The chart above suggests that higher profits do in fact lead to more investment. Capital spending rose 7 percent in 2018 after climbing a little more than 5 percent the previous year. But how much of that was in response to the tax cuts?

To adequately assess the impact of tax reform on investment, it’s important to look beyond the much-touted drop in the top marginal tax rate and consider other important changes to the corporate tax code, such as allowing businesses to immediately write off certain capital expenditures in full and limiting the deduction for business interest expenses. The effective tax rate, or the amount of tax paid divided by corporate profits, gives a more complete picture of a corporation’s tax liability. Note in the chart below that despite a sequence of tax changes in the 1980s, the effective rate was higher at the end of the decade. President Ronald Reagan’s Tax Reform Act of 1986 did lower the top marginal rate but barely moved the effective rate.

The Devil Is in the Deductions Data: Bloomberg analysis of Bureau of Economic Analysis and Internal Revenue Service data

While both of these rates have been trending lower for decades, the TCJA pushed them to their lowest levels since at least the 1950s. The latest round of tax reform lowered the effective rate from about 16 percent in 2017 to about 10.5 percent last year (again, the calculation is based on the first three quarters of 2018).

Bloomberg Economics estimates the 5.5 percentage-point drop in the rate led to a 1 percent boost to nonresidential investment, which added a tenth of a percentage point to gross domestic product in 2018. So without the corporate side of the TCJA, growth last year would have been 3 percent instead of 3.1 percent. That’s a much smaller boost than what White House officials had promised. In the months leading up to passage of the TCJA, Kevin Hassett, the chairman of the Council of Economic Advisers, estimated that the effect from a package of tax measures similar to those in the legislation would be “much more than 1 percent.”

So if tax cuts don’t have a large impact on investment decisions, what does? Our review of data going back to 1950 considered a host of variables related to investment, including the output gap, business confidence, capital depreciation, and interest rates. It showed that business confidence, or what John Maynard Keynes liked to call “animal spirits,” along with the basic laws of supply and demand, are more important drivers of investment.

Improving confidence and diminishing economic slack—approximated by the output gap, a measure that tracks how economic activity is performing relative to its potential—aren’t only better indicators of where investment is headed, but also have an effect magnitudes larger than that of tax cuts. The reason is simple. Businesses will expand production capabilities when they feel optimistic about their future prospects and when existing capacity can’t meet demand for their products. Reducing their corporate tax burden strengthens incentives to invest if other factors are in place. On its own, though, it doesn’t move the dial.

There’s little question the country’s corporate tax code was in need of reform. The U.S. was a comparatively more expensive place to do business, which motivated companies to locate operations offshore (though the TCJA may end up exacerbating that trend as income from subsidiaries abroad will have a tax rate roughly half that of domestic income).

While the TCJA hasn’t quite lived up to the supply-side sales pitch from a growth perspective, its effects on government finances have been broadly in line with what its detractors anticipated. Federal tax receipts from corporations plummeted almost 31 percent in the calendar year—the sharpest decline on record (the data only go back to 1982), save for the second year of the Great Recession.