Do tax cuts encourage investment? Tepper School researchers reveal surprising results

A new study published in the Journal of Financial Economics examines the effects of the 2017 Tax Cuts and Jobs Act (TCJA) on U.S. multinational corporations. James F. Albertus and Brent Glover of the Tepper School of Business at Carnegie Mellon University, along with Oliver Levine of the University of Wisconsin-Madison, Wisconsin School of Business analyzed how the TCJA, which made almost $1.7 trillion in previously inaccessible international funds available, impacted corporate behavior.

The TCJ, intended to stimulate the economy by encouraging companies to repatriate and invest foreign profits domestically. Despite this significant liquidity shock (an unexpected change in how easily a company can access cash), the researchers found that companies did not increase investments in capital expenditures, employment, research and development, or mergers and acquisitions, even those that had previously struggled with access to funds. Instead, they primarily used the newfound liquidity for shareholder payouts and cash retention, which challenges existing financial theories and provides new insight into corporate responses to large-scale tax policy changes, as detailed in the study, “The real and financial effects of internal liquidity: Evidence from the Tax Cuts and Jobs Act."

The researchers used data from the Bureau of Economic Analysis to track how companies used the repatriated funds. They found that even companies with the largest amounts of previously "trapped cash" were more likely to save than to invest. "Firms paid out only about one-third of the new liquidity to shareholders and retained half as cash," the authors wrote. This means that for every $3 given to shareholders companies put $5 into savings. This behavior contradicts traditional economic theory, which suggests that companies with extra cash will typically invest it in profitable ventures or distribute it to shareholders. "The high propensity to retain the liquidity shock as cash, even among well-governed firms with limited financial constraints, is difficult to reconcile with existing theory," the study concludes.

This raises questions about the effectiveness of tax cuts as a tool for stimulating economic activity. The study suggests that other factors, such as uncertainty about the future or a preference for financial security, may be driving decisions to hoard cash. "The high retention [of cash] was not associated with poor governance," the study emphasized, indicating that even well-managed companies were choosing to save. The research underscores the need for a deeper understanding of the complex factors influencing corporate financial decisions.