Best Evidence Says Obama’s Tax Increase on Investors Harms Investment

January 22, 2015

The President’s latest proposal to raise taxes on capital gains and dividends, which follows two rounds of tax increases in Obamacare and the fiscal cliff deal, raises serious concerns about the impact on investment. That’s because corporations rely to a large extent on shareholders to finance investment. That’s in fact the essence of the corporate form!

And when investment goes down, workers are harmed, because they have less equipment and technology to work with – a relationship no one seems to disagree with.

However, Matt Yglesias at Vox claims tax increases on capital gains and dividends don’t reduce investment, based on the “best evidence”. The evidence he refers to is one study of the 2003 dividend tax cut, which found no impact on investment. The theory here is that corporations have access to other funds besides outside equity, namely retained earnings and debt. True, but it doesn’t mean there are no downsides to taxing outside equity. Again, one of the key advantages of organizing as a corporation is the ability to raise funds from thousands of shareholders.

Yglesias doesn’t mention another study published last year in the Journal of Financial Economics, which found investment is significantly harmed by raising taxes on shareholders. The study’s authors, Bo Becker of Harvard and Marcus Jacob and Martin Jacob of the Otto Beisheim School of Management, use a much larger data set than just the single event of 2003. They look at 25 countries over a 19 year period, covering 67 different changes in dividend and capital gains tax rates. Here are their findings:

When corporate payout is taxed, internal equity (retained earnings) is cheaper than external equity (share issues). If there are no perfect substitutes for equity finance, payout taxes may therefore have an effect on the investment of firms. High taxes will favor investment by firms who can finance internally. Using an international panel with many changes in payout taxes, we show that this prediction holds well. Payout taxes have a large impact on the dynamics of corporate investment and growth. Investment is ‘‘locked in’’ in profitable firms when payout is heavily taxed. Thus, apart from any level effects, payout taxes change the allocation of capital.

Here is their criticism of studies of the 2003 tax cut:

There are several challenges in testing how payout taxes affect the cross-firm allocation of investment. First, large changes in the US tax code are rare. The 2003 tax cut has provided a suitable natural experiment for testing how dividend levels responded to taxes (see Chetty and Saez, 2005; Brown, Liang, and Weisbenner, 2007), but investment is a more challenging dependent variable than dividends, so the experiment may not provide sufficient statistical power for examining investment responses. First, unlike dividends, investment is imperfectly measured by accounting data that, for example, leave out many types of intangible investment such as that in brands and human capital. This means that available empirical proxies (e.g., capital expenditures) are noisy estimates of the true variable of interest. Second, much investment is lumpy and takes time to build, so any response to tax changes is likely slow and more difficult to pinpoint in time. This suggests that a longer time window may be necessary (the payout studies used quarters around the tax change). Third, however, investment is affected by business cycles and other macroeconomic trends, so extending the window around a single policy change introduces more noise from other sources, and may not provide better identification.

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