How to tell if tax reform is working

It's still too early for a definitive verdict on whether last year's corporate tax reforms have led to an increase in business investment. But the absence of any clear signs — as Matthew Klein notes in Barron's, not much seems to have changed at all — is fueling an increasing sense of anxiety, if not disappointment.

All of which raises the question: What was the point of tax reform? Is the federal government going deeper into debt simply to allow corporations to hoard even more cash on their balance sheets?

Maybe. There is one indicator, however, that offers reason to be optimistic. It's called Tobin's Q, named for late economist and Nobel laureate James Tobin, and it can be calculated for a single business or the entire economy.

For a single business, Tobin's Q is the market value of that business divided by what it would cost to buy all of its assets. If Tobin's Q is greater than 1, that implies the market value of the business is greater than the total value of its assets — that the whole is worth more than the sum of its parts. In this case, it makes sense for businesses to expand operations by buying more assets. If it can put the new assets to use as profitably as the ones it already has, the business will increase in net value.

The same theory can in principle be applied to the economy as a whole. The Federal Reserve provides a commonly used measure of Tobin's Q based on its annual flow of funds report. Looking at the Fed's estimate of Q can help explain the quandary that the U.S. economy has faced in the last two decades, and how tax reform is helping the U.S. work its way out of it.

In the late 1990s, Tobin's Q soared as the market valuation of technology companies rapidly outpaced their net assets. At the time many considered this a purely irrational bubble, but in hindsight, it marked a fundamental turn in the landscape of U.S. business, which today is dominated by technology firms.

As the tech boom matured, however, the economy languished in a period of lackluster business investment. Despite extraordinary efforts by the Fed, Tobin's Q remained below 1 for more than a decade. Investment was flowing largely into homebuilding, financed by new and poorly understood debt instruments.

Indeed, that seemed to be exactly what happened when the Fed first tried to normalize monetary policy by slightly raising rates in 2015. Financial markets deteriorated, financial conditions worsened, global growth slowed and the U.S. entered a near recession.

To put this in terms of Tobin's Q: Fed policy was pushing down on it, discouraging business investment. Was there some way to allow the Fed to continue to normalize monetary policy while also encouraging businesses to invest?

As it turns out, there was: tax reform. By lowering the overall tax rate on businesses and allowing immediate expensing of capital, tax reform would increase the return on investment, raising Tobin's Q. Shortly after the 2016 election, the probability of significant tax reform increased dramatically. Tobin's Q began rising.

The Fed resumed its normalization policy, steadily raising rates and reducing the size of its balance sheet. For nearly two years the U.S. market has held up well. Tobin's Q has increased and investment has held strong.

Of course, there are strong signs that the administration's trade policy is beginning to jeopardize that process. Export growth is falling around the world, stock markets are troubled and financial conditions are starting to tighten. The Fed will likely have to take a pause in its slow but steady rate increases.