Article

Investment, overhang, and tax policy

Harvard University and NBER; University of Chicago, American Bar Foundation and NBER
12/2004;

ABSTRACT The unusual behavior of investment in the 1990s and early 2000s—abnormally high investment in the 1990s and abnormally low investment in the 2000s, despite several major tax cuts intended to stimulate investment — prompts two questions that we tackle in this paper: Did "capital overhang" contribute to the dramatic investment collapse of the early 2000's? and Why has fiscal policy been unable to revive investment? We use firm level evidence to show that capital overhang – the notion that the late 1990s stock market bubble led to excess investment and prevented a rebound – is not a meaningful factor in explaining the fall of investment. There is little correlation between the growth of investment during the boom and the declines of investment during the bust across industries, asset classes or firms. Nor did firms with larger growth during the boom experience any reductions in sensitivity to fundamentals in the 2000s. We believe the standard investment model continues to be quite relevant for studying investment. We then modify the tax-adjusted q model to allow for clearer identification of tax effects in the presence of mismeasured q. This modification yields estimates that are larger and more precisely measured suggesting that the tax-adjusted q model does a reasonable job in explaining investment patterns. Using this q model we then investigate the effects of the tax cuts. First, in keeping with the "new" view of dividend taxation, the evidence suggests that dividend taxes do not influence marginal investment incentives. This evidence indicates that the dividend tax cut, with forecasted revenue cost of more than $100 billion from 2003-2008, would have had little, if any, impact on investment. Second, the partial expensing of equipment provisions (revenue cost of approximately $130 billion from 2002-2004) did have an effect on investment but were too small to counteract the large aggregate investment declines stemming from market movements. The results put the investment increases resulting from the tax policies of 2002-2004 at only one to two percent.

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