Chart of real private domestic investment.
Real Private Domestic investment has not grown as expected following the tax cuts/. CHART: St. Louis Federal Reserve Bank

Despite a tax cut that strongly incentivized business investment, recent economic data suggests companies are not spending significantly more on new equipment. Fear of tariffs may have something to do with it.

The 2017 tax bill reduced the corporate tax rate from 35% to 21%. That should encourage firms to spend more on expanding their business. Yet, after a short-lived spike last year, business investment has languished. In the second quarter of this year, gross private investment fell 5.5%.

Why is among one of the bigger economic mysteries of late.

Tariffs Breed Supply Chain Uncertainty

So, what’s going on? At least part of the answer may lie in another Trump administration economic policy working at cross purposes to the tax cuts.

One possible explanation is uncertainty surrounding President Trump’s trade wars. As Trump’s trade war ramped up, business leaders grew more conservative about expanding. Federal Reserve Chairman Jerome Powell recently testified to Congress that concern that trade spats could disrupt supply chains is holding back businesses.

“If you’re a manufacturing company in our economy, of any size, chances are pretty good that your supply chain goes across national borders,” Powell said in his testimony. “That supply chain is really part of how you do business, and you just assume that it’s working and you can focus on your clients. When your supply chain is called into question — we hear this a lot from businesses — when it’s called into question, you pull back.”

Even companies that make things in America depend on parts imported from abroad. So, when tariffs rise on imported goods, the input costs of American-made products rise too.

Tariffs meant to hold off foreign imports don’t necessarily help U.S. manufacturers. Even companies that make things in America depend on parts imported from abroad. So, when tariffs rise on imported goods, the input costs of American-made products rise too.

Mr. Trump’s scattershot approach to trade policy exacerbates the problem. Mr. Trump announces new trade fights on Twitter seemingly at random. It’s hard for businesses to know what’s coming next. As a result, manufacturers can never be sure that Trump won’t hit the parts they depend on with tariffs. So, they conclude the risks of ramping up outweigh the potential benefits.

This uncertainty was especially pronounced in the second quarter of this year. In May, President Trump threatened Mexico with tariffs unless it took more robust action to keep illegal immigrants from crossing its border with the U.S. This spooked American companies who depend on parts imported from Mexico.

Trade Wars and the Fed

Mr. Trump has demanded that the Federal Reserve cut interest rates at its next meeting. Analysts expect that they will do exactly that. The Fed holds its independence sacrosanct. They won’t cut rates just because Mr. Trump told them to do it. However, his actions on trade may have contributed to the Fed’s view that a rate cut is needed to shore up a weakening economy.

“All Trump had to do was keep up geopolitical trade uncertainty for a while and he’d get the Fed to cut rates,” Ed Yardeni, president and chief investment strategist of Yardeni Research Inc. told Politico this week. Mr. Yardeni pointed out that Mr. Powell mentioned uncertainty surrounding trade as a headwind to economic growth eight times in his recent Congressional testimony.

The problem with protectionist trade policies is that they come laden with unintended consequences. These can be hard to predict.Protectionist tariffs often undermine the very outcomes they are meant to accomplish.

Increases in input costs for imported parts nullify the benefits to American firms. Further, when we slap tariffs on foreign products, foreign countries are likely to put tariffs on American products too. For example, after Trump levied tariffs on Chinese products, Beijing replied with tariffs of their own. Chinese tariffs on American soybeans have hit U.S. farmers hard. President Trump has spent billions to pay farmers for lost revenues.

Trade protectionism is intended to bolster American businesses. But, recent events suggest that they can end up doing the opposite.

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