Investment, overhang, and tax policy

Harvard University and NBER; University of Chicago, American Bar Foundation and NBER

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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    ABSTRACT: This paper derives and estimates models of nonresidential investment behavior in which current and future tax conditions directly affect the incentive to invest. The estimates suggest that taxes have played an independent role in affecting postwar U.S. investment behavior, particularly for investment in machinery and equipment. In addition, the paper develops a method for assessing the impact of tax policy on the volatility of investment when such policy is endogenous. Illustrative calculations using this technique, based on the paper's empirical estimates, suggest that tax policy has not served to stabilize investment in equipment or nonresidential structures during the sample period.
    Journal of Public Economics. 02/1992; 47(2):141-170.
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    ABSTRACT: Under the ‘new view’ of dividend taxation developed by Auerbach (Quarterly Journal of Economics 1979;93:433–446), Bradford (Journal of Public Economics 1981;15:1–22) and King (Public Policy and the Corporation, Chapman & Hall, London, 1977), the marginal source of finance for new investment projects is retained earnings. In this case, the tax advantage of retaining earnings precisely offsets the double taxation of subsequent dividends: taxes on dividends have no impact on the investment incentives of firms using retentions as a marginal source of funds and paying dividends with residual cash flows. We show that the same invariance with respect to dividend taxes may hold under weaker conditions with respect to the source of funds, if the use of funds follows the same pattern. We find evidence that there is significant heterogeneity in our sample of US firms, with some firms exhibiting dividend behavior consistent with this expanded version of the new view, and others exhibiting behavior consistent with the traditional view that retained earnings are not an important marginal source of funds.
    Journal of Public Economics 08/2000; · 1.46 Impact Factor

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May 22, 2014