Investment, overhang, and tax policy

Harvard University and NBER


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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Available from: Kevin A. Hassett, Feb 15, 2014
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    ABSTRACT: Recent evidence on the effect of dividend taxes on firm behavior is inconsistent with neoclassical theories of dividend and corporate taxation. We develop a simple agency model in which managers and shareholders have conflicting interests to explain the evidence. In this model, dividend taxation induces managers to undertake unproductive investments by retaining earnings, and creates a first-order deadweight cost. In contrast, corporate taxes do not distort the manager's payout decision and may only create second-order efficiency costs. Corporate income taxation may therefore be a more efficient way to generate revenue than dividend taxation, challenging existing intuitions based on neoclassical models. (JEL D21, G35, H25, H32)
    Preview · Article · Aug 2010 · American Economic Journal Economic Policy
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    ABSTRACT: Motivated by the Jobs and Growth Tax Relief Reconciliation Act of 2003, we study the effects of capital income tax cuts in a framework where firms make investment decisions to maximize their market value and households are subject to uninsurable labor income risk. We find that the effects of capital gains tax cuts are qualitatively similar to those found in the absence of household heterogeneity. However, dividend tax cuts surprisingly lead to a reduction in aggregate investment. This is because they increase the market value of the existing capital. In equilibrium, households then require a higher return to hold this additional wealth, leading to a lower capital stock. This also implies that dividend tax cuts are welfare reducing in the long run, not only because of the traditional reasons of redistribution from poor to rich, but also because of a fall in aggregate output and consumption. Taking into account the transition mitigates the losses but the JGTRRA tax cuts still lead to a welfare reduction equivalent to a 0.5% drop in consumption. In line with empirical evidence, the model also predicts substantial increases in dividends and stock prices following the tax cuts.
    Full-text · Article · May 2011