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Policy uncertainty is holding back business investment and slowing economic growth

Last week, it was announced that the U.S. economy grew at an annualized rate of 3.5% in the second quarter of 2018. This is pretty impressive. Following 4.2% in the first quarter, it is the strongest back-to-back growth since 2014. The economy is on its way to its best annual performance since 2005.

But there are concerning signs when we look deeper into the data. One of the main planks of the reform of the tax code, passed by Congress at the end of 2017, was a cut in the rate of corporate tax from 35% to 21%. This, it was argued, would boost business investment which would raise productivity and wages.

Yet the data from the second quarter showed business investment growing at a modest annual rate of 0.8%. This included a contraction in investment in business structures. This had been doing well in recent months, driven by spending on oil and gas rigs resulting from rising energy prices.

So why aren’t businesses responding more strongly to the corporate tax cut? One major reason is uncertainty about policy.

This has probably already had a depressing effect on the response of business investment to the tax cuts. Investing is about acting now in the expectation of a return in the future. If the tax cuts had looked likely throughout 2017, we would have seen businesses preparing to take advantage then for their enactment. But passage of the the tax reform was doubtful until the last minute. As late as November, 2017, the state of Minnesota’s economic forecasters, IHS Markit, removed the stimulating effects of the tax cuts from their projections citing doubt that they would actually be passed. Given this prolonged policy uncertainty, businesses have had less time to react.

Sadly, businesses remain in the dark about future policy. If the Democrats are successful in next week’s mid-terms they will try to reverse the corporate tax cut. The Trump administration’s trade wars have imposed rising prices on inputs such as steel and provoked retaliation from trading partners, such as the 10% to 25% tariff on on recreational boats.

Remember, investing is about acting now in the expectation of a return in the future. If you were a business owner looking to invest, how could you formulate an estimate of the return faced with such policy uncertainty?

This morning, I appeared on Kerri Miller’s show on MPR and was asked how long businesses could get away with citing uncertainty as a reason for their lack of investment. I answered that they were entitled to as long as it remained a problem.

John Phelan is an economist at the Center of the American Experiment. 

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