Disentangling CAP Arguments against Tax Cuts for Capital Formation: Part 4

December 28, 2015

Part 4: Taxes on Capital Do Matter for Investment

This blog continues a discussion of a recent piece by the Center for American Progress, “Long-Termism or Lemons: The Role of Public Policy in Promoting Long-Term Investments,” by Marc Jarsulic, Brendan Duke, Michael Madowitz.  The authors correctly put part of the blame for the slow growth if income in recent years on lack of investment. But they argue against the one policy response that might remedy the situation, a cut in taxes on capital formation.

The authors state: “The balance of research on tax policy changes over the past four decades suggests that lower taxes on capital do not increase investment.”

This is a most astonishing claim, and not documented in the piece. Over the last several decades, economists have been building on the important work of Arnold Harberger and Dale W. Jorgenson describing the effects of taxation on investment. The nation’s major economic modelers have recognized the importance of taxation and the cost of capital, and most have altered their models to incorporate some elements of the cost of capital to better capture the effect of tax policy on investment. Jorgenson’s volume on how to measure the cost of capital, including taxes, and its relevance for capital formation is of particular note.i

Finance textbooks used in business schools teach MBA candidates (who later go on to make the real world decisions on such matters) how to factor taxes into the cost of creating and using capital; that when expected revenue from using capital exceeds taxes and other costs, the investment is not worth pursuing; that when costs, including taxes, exceed expected revenues, capital is not worth buying. The higher the tax, the less capital is created and employed. The lower the tax, the more capital is created and employed.

The historical evidence is clear. The amount of capital responds strongly to changes in taxation. Over time, the amount of capital employed expands or contracts in response to tax shocks to keep the after-tax returns to capital within narrow bounds. This was graphed and explained in Part 2 of this series: “Capital Does Respond to Tax Changes”.  As the capital stock moves, so does the productivity of labor, and, with a bit of a lag, so do wages. Other factors, such as education, also affect wage growth, but capital formation is still the major force for raising incomes across the board.

For a review of the literature on the relationship between taxes and growth, see Tax Foundation Special Report No. 207: What Is the Evidence on Taxes and Growth? by William McBride. He concludes: “This review of empirical studies of taxes and economic growth indicates that there are not a lot of dissenting opinions coming from peer-reviewed academic journals. More and more, the consensus among experts is that taxes on corporate and personal income are particularly harmful to economic growth, with consumption and property taxes less so. This is because economic growth ultimately comes from production, innovation, and risk-taking.”

True, there are papers that fail to find a relationship between investment and taxes on capital. In most cases, they make one or another error in setting up the studies. They may focus on changes in one tax or another, but omit other taxes or other important influences on capital during the time frame under investigation (the omitted variable problem) that are working in the other direction. Alternatively, they look at the wrong time frame. Capital is not put in place instantaneously. It can take weeks, months, or a few years for a business to design, order, receive, and put in place new machinery or buildings. If a study tries to relate tax changes to investment and growth in the same year as the tax change, it will miss most of the effect.ii

Other issues in the CAP paper

The authors blame the slowdown in investment in part on a heightened fixation by corporate leaders on short term returns to investors, “such as [stock] buybacks or dividend increases while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.”

Managers who indulge in such uneconomic behavior reduce the value of their firms, and risk reprimands from their boards, complaints from major shareholders, proxy battles, and having their firms taken over by companies with better management. It cannot be a widespread norm.

If businesses are slow to expand capital, does it help to have the government step in with more “infrastructure” and “human capital development” spending, as the authors recommend?

No. If the issue is inadequate stocks of plant and equipment, building more roads and bridges will not be an adequate substitute. Government should invest in infrastructure that passes a strict cost benefit test, returning as much yield as a private sector investment. Otherwise it is a waste of scarce resources. Government’s ability to foster more “human capital” is also limited. It already heavily subsidizes education (with questionable results), and cannot provide on-the-job training that is key to creation of a skilled work force.

The authors conclude: “Unfortunately, the nation’s decades-long experiment with tax cuts for the wealthy has produced only lackluster economic results at an exorbitant fiscal cost.”

But the effect of a cut in the taxation of capital does not depend on who got the tax cut; it depends on what tax was cut and what the tax cut did to the incentive to create and use capital. It does not depend on the initial incidence of the tax, but on the consequences. Cutting the top income tax rate on wages and salaries does less for economic growth than cutting the tax rates on capital gains or dividends, or accelerating depreciation allowances. A tax cut on capital results in additional capital formation, which in turn drives the returns on capital back down; the initial gains are competed away. Meanwhile, wages rise due to enhanced productivity. Most of the benefit of cuts in the taxes on capital are captured by workers.

Furthermore, tax relief has by no means been restricted to the wealthy. The United States has adopted the most progressive tax system in the developed world.iii  Most major tax bills of the last thirty years have provided serious tax reductions or refundable credits (resulting in negative taxes) for lower income families. These are extraordinarily expensive, but do next to nothing to promote capital formation to raise productivity, wages, and employment.

Enormous expansion of the burden of federal regulations has also acted to slow the economy, offsetting some of the economic benefits of tax reductions along the way. Reducing the burden of regulations and taxes on capital formation would lead to a new era of faster growth of GDP, employment, and wages.

Click here to see part 1part 2, or part 3 of this discussion.


[i] For an extensive exposition of the importance of taxation in determining investment and capital formation, and how to determine and model the cost of capital, see Dale W. Jorgenson and Kun-Young Yun, Investment, Volume 3: Lifting the Burden -- Tax Reform, the Cost of Capital, and U.S. Economic Growth, The MIT Press, Cambridge, Massachusetts and London, England, 2001.

[ii] For example, see my analysis of a CRS study attempting to link only the top personal tax income and capital gains tax rates to growth in the same year: “CRS Study on Tax Rates and Growth Still Flunks the Test” at http://taxfoundation.org/sites/taxfoundation.org/files/docs/ff350.pdf and “Retracted CRS Report on Taxes and Growth Flawed, But Still Cited” at  http://taxfoundation.org/blog/retracted-crs-report-taxes-and-growth-flawed-still-cited.

[iii] From the Tax Foundation, see:Record High Progressivity of Federal Income Taxes,” at http://taxfoundation.org/article/record-high-progressivity-federal-income-taxes.  Also see: “News To Obama: The OECD Says the United States Has the Most Progressive Tax System,” by Scott Hodge, October 29, 2008, at http://taxfoundation.org/blog/news-obama-oecd-says-united-states-has-most-progressive-tax-system.  And from the U.S. Department of the Treasury Resource Center, see: Office of Tax Analysis, Analyses and Estimates of Current and Proposed Tax Law, Distributional Analysis of the U.S. Tax System, at https://www.treasury.gov/resource-center/tax-policy/Pages/Tax-Analysis-and-Research.aspx.

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