Tax cuts and investment

One of the foundational beliefs of Econ 101 is that tax cuts put more money in the hands of businesses and investors, and thereby boost private investments. But there may be little empirical evidence to support this belief. This post points to evidence to the contrary, especially due to tax cuts on financial market incomes. 

I had blogged earlier questioning the conventional wisdom on lowering corporate tax rates. 

In one of her columns, Rana Faroohar had pointed to this graphic from a McKinsey study capturing the trends in investment and labour and capital incomes with changes in corporate tax rates. 

The empirical evidence from the last three decades show that contrary to conventional wisdom, tax cuts, as in UK and US, actually lowered investment whereas tax increases boosted investment.

Noah Smith has a very informative article that questions another version of this belief. It holds that if public policy encourages financial investment with financial market deregulation and rewards it with the likes of lower capital gains and dividend taxes, people will save more, envelope of financial market capital will expand, cost of capital will decline and business investment will increase. 

However, the reality has been very different. While corporate bond yields have been on a secular decline, net domestic private investment as a share of GDP has not only not risen but may actually be also tapering down. 

There are three assumptions. One, deregulation and lower taxes will boost financial capital. Second, the expanded supply of capital will lower cost of capital. Third, the lower cost of capital will boost investment. 

The first two are accounting realities. However, it's debatable as to how much of lower cost of capital is due to the deregulation and lower taxes, and how much is due to structural factors in the world economy. The long secular decline in interest rates pre-date the monetary accommodation of the last thirteen years. 

The third assumption, as the graphic below from the St Louis Fred shows, is not borne out by reality. 

The findings of two studies quoted by Noah Smith go against the conventional wisdom. This study on dividend tax cut,

This paper tests whether the 2003 dividend tax cut—one of the largest reforms ever to a US capital tax rate—stimulated corporate investment and increased labor earnings, using a quasi-experimental design and US corporate tax returns from years 1996-2008. I estimate that the tax cut caused zero change in corporate investment and employee compensation.

And this on capital gains tax cut,

But the case for large investment effects of lower capital gains rates appears overstated. First, preferential capital gains treatment incentivizes some income sheltering that may cause misallocation and prevent capital from being employed in its most productive use. Second, the majority of venture capital comes from large institutions like pension funds, endowments of universities, charitable foundations, and sovereign wealth funds, which are already tax-exempt. Third, it is hard to imagine entrepreneurs making decisions about investment and risk on the basis of the capital gains tax regime: Mark Zuckerberg was not focusing on the capital gains tax when he was in his dorm room coding up Facebook. Bell, Chetty, Jaravel, Petkova and Van Reenen reach the same conclusion based on comprehensive data on U.S. inventors, arguing that tax cuts do not produce more Einsteins. Finally, in a related context, empirical evidence suggests that dividend tax cuts that decrease firms’ cost of capital in similar ways to the capital gains tax do not affect investment.

Smith has this definitive conclusion,

In other words, making asset markets more attractive, in the hopes that this will entice businesses to invest, has been a bit like pushing on a string. It’s likely that when capital costs get low enough, big business finds financing to be less of a constraint. The broken link in trickle-down economics — even the smart kind of trickle-down — is the one between financial investment and business investment. We may use the same word for both of those activities, but rich people and mutual funds buying up stocks and bonds simply isn’t the same thing as companies purchasing equipment, building buildings or training workers. The economic theories that draw a link between the former and the latter are simply not good descriptions of the way the business world makes decisions.

Instead of tax cuts, he argues in favour of public investment and industrial policy to spur private investment. 

As I blogged here, I am inclined to take a nuanced view on this. For long tax rates were high and it indeed constrained investment decisions. However, over the last two decades, financial market and business tax rates globally have come down. In this changed circumstances, tax rates are no longer a constraint on investment decisions. In the present situation, arguments in favour of lowering tax rates are purely self-serving and serve little public interest or aggregate economic welfare.

Fortunately, in recent times, the trends on corporate tax rates have reversed and there is a genuine belief that corporate tax rates should increase. It may only be a matter of time before the same winds of change reverse the conventional wisdom on tax rates on dividends and capital gains.