JPM JP Morgan Chase and Co

By Nick Timiraos 

President Trump and Republicans bet that the 2017 tax overhaul would invigorate the U.S. economy after a long but slow expansion, putting controversial economic theories about growth to a crucial test.

A broad measure of business investment surged early in 2018 but slowed in the second half of the year, in part reflecting changes in energy prices. Shipments of capital goods tailed off after rising briskly early in the year.

Some economists have said uncertainty over trade, aggravated by tariffs imposed by Mr. Trump in 2018, might dull the business-investment boost the large cut in the corporate-tax rate was designed to spur.

Lower individual rates and fewer breaks for households are designed make the economy more efficient and put more money in the pockets of people to decide on their own whether to spend or save. Revamping tax laws governing profits earned abroad is designed to bring home corporate funds parked overseas and encourage new investments to happen in the U.S.

U.S. economic output expanded by 3% for the 12-month period ended Sept. 30, 2018, up from a gain of 2.3% a year earlier.

Economists expected the tax cut to boost the gross-domestic-product growth rate for a year or two, but they also expected GDP to accelerate because Congress approved a two-year, $300 billion federal spending boost.

Goldman Sachs Group Inc. revised up its growth forecasts for 2018 and 2019 by 0.8 percentage point and 0.5 percentage point, respectively, to 3.1% and 2%. Roughly half of the boost came from the estimated effects of the tax cut, and half came from the federal spending increase.

Mixed historical evidence

It is less clear whether tax cuts can raise the economy's growth rate over a longer period of time. For that to happen, the tax cuts will need to spur an increase in business investment. Goldman still sees long-run potential growth at 1.75%.

History offers mixed evidence. Economic growth advanced solidly in the 1960s and 1980s after Democrats and Republicans lowered individual and corporate rates, but growth languished in the 2000s after two rounds of tax cuts. Moreover, a tax increase on top income earners in the early 1990s didn't hamper a burgeoning economic boom.

The Trump administration says sustained growth rates of 3% or more are possible after a decade of near 2% growth. To get there, the economy must overcome significant headwinds that include an aging workforce full of retiring baby boomers and sluggishness in worker productivity that economists are struggling to understand. A December 2017 Wall Street Journal survey of private-sector economists showed that nine out of 10 professional forecasters expect the tax law to boost the U.S. growth rate in the next two years, but with most seeing a modest increase. Forecasters are split on long-term effects, with nearly half saying growth will eventually return to or fall below the pace that prevailed before the tax cut took effect.

If the tax cut doesn't deliver the long-term growth Republicans have promised, larger deficits are likely. Independent budget analysts that evaluated the bill for Congress say the cuts will drive deficits higher by $1 trillion over a decade even after accounting for the benefits of stronger growth.

Corporate optimism

For months leading up to passage of the tax cuts, and for several weeks after, markets rocketed higher. "For the first time in several decades, tax reform enables us to competitively consider investment in the U.S.," Amgen Inc. Chief Financial Officer David Meline said in a conference call with analysts after the tax cut. Three-quarters of its $3.5 billion in capital spending over the next five years will be in the U.S., up from about half in recent years, he said.

But markets' optimism turned to concern in the fourth quarter of 2018, when rising worries over a global growth slowdown and higher interest rates buffeted investors. Stock markets ended the year down for the first time since 2008. Nearly half of U.S. corporate finance chiefs surveyed by Duke University in December 2018 predicted the U.S. economy would be in recession at the end of 2019, while four in five predicted a recession would have begun by the end of 2020.

One issue is whether Washington and Beijing can avoid escalating trade tariffs that have the potential to raise costs and revamp global supply chains.

Companies take time to plan their investment decisions, "but then if you see the price of steel goes up, you see the price of machinery goes up, it makes it less and less compelling to build those factories," former Trump economic adviser Gary Cohn told CNBC in January 2019. "My view is that investment will come when there is more and more clarity in what our trade relationships are with countries around the world."

The market softness in 2018 showed the difficulty in teasing out how much corporate optimism is due solely to tax cuts and how much is due to broader economic trends. Walmart Inc., for example, announced it would raise starting pay for hourly workers to $11 in February 2018. But it has done that before. The pay increase follows two others, in 2015 and 2016, when the retailer boosted starting wages to $9 and $10 an hour, respectively.

"I don't get up in the morning and take my after-tax income and figure out how I'm going to spend it," said Joel Shine, chief executive of Woodside Homes Inc., which builds homes in four Western states. "That's driven more by whether you see opportunities to drive expansion in your product areas."

In December 2018, Apple Inc. announced a $1 billion, 5,000-person Texas project, part of an earlier promise to invest $30 billion and create 20,000 U.S. jobs over five years. The tax law offered Apple and other multinational companies a measure of certainty and made it easier to use their foreign profits in the U.S.

"There are large parts of this that are part of the tax reform," CEO Tim Cook told ABC News in January 2018, "and there's large parts of this that we would have done in any situation."

Housing market's winners and losers

The housing market illustrates how the GOP tax bill created winners and losers. Stronger job growth and consumer confidence should boost overall housing demand, particularly from nearly five in six households who should enjoy stronger purchasing power as their after-tax income rises.

But some changes -- such as caps on the deductibility of state and local income and property taxes -- made housing less affordable in expensive metro areas situated in high-tax states, such as New York, San Francisco and Washington, D.C.

The fiscal stimulus also influenced interest-rate policy in 2018 because it convinced more officials at the U.S. Federal Reserve of the need to keep lifting interest rates.

The upshot is that high-end housing markets saw a notable pullback in housing demand in 2018, with inventories of homes for sale rising after several years of declines. Higher after-tax housing costs and rising interest rates rob sellers of the strong pricing power they enjoyed for several years, when rates were lower.

Fed officials raised their short-term benchmark rate four times in 2018, to a range between 2.25% and 2.5% in December 2018 from a range between 1.25% and 1.5% one year earlier. That was up from a baseline projection of three interest-rate increases before the tax cut passed.

In January 2019, amid rising market volatility and the risks of slower growth abroad, the Fed signaled it was moving to the sidelines until it could see more evidence of stronger demand and inflation.

More stimulus also could lead to bigger deficits later. Goldman and J.P. Morgan expect deficits to grow from $664 billion in the fiscal year ended September 2017 -- or around 3.4% of GDP -- to $1 trillion, or 5% of GDP, in 2019. Larger deficits, in turn, could push up borrowing costs further and leave the government with less capacity to fight the next downturn.

The economy, in other words, is enjoying an upswing now, but may pay a price for it down the road.

Theo Francis and

Richard Rubin

contributed to this article

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

February 15, 2019 08:14 ET (13:14 GMT)

Copyright (c) 2019 Dow Jones & Company, Inc.