Disentangling CAP Arguments against Tax Cuts for Capital Formation: Part 2

November 17, 2015

Part 2: Capital Does Respond to Tax Changes

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 in income on lack of investment in recent years. But they argue against the one policy response that might remedy the situation, a cut in taxes on capital formation. They suggest as alternatives “spending $100 billion per year on infrastructure investment, making college debt free, and increasing families’ access to high-quality child care” to raise productivity and incomes.

The paper states its arguments against tax reduction for investment very concisely: ”Some policymakers and analysts have argued that the key to increasing investment is cutting taxes on capital since that would boost the incentive to save and invest in new capital goods. This argument misses that higher after-tax returns also allow investors to do just as well in the future while saving and investing at a lower rate. Moreover, tax cuts themselves can lead to higher deficits, which reduce national saving. The balance of research on tax policy changes over the past four decades suggests that lower taxes on capital do not increase investment. Unfortunately, the nation’s decades-long experiment with tax cuts for the wealthy has produced only lackluster economic results at an exorbitant fiscal cost.”

The assertion in the first of these five statements is true. The three counter-arguments and concluding observation are false or irrelevant. I’ll review these statements one at a time in separate blogs. In this blog, I’ll discuss why tax reductions on capital is the key to promoting investment. I’ll cover the other claims in later pieces.

“Some policymakers and analysts have argued that the key to increasing investment is cutting taxes on capital since that would boost the incentive to save and invest in new capital goods.”

This statement is true. Trained analysts know that taxing capital is a good way to have less of it, and taxing it less is a good way to get more of it.

Corporate finance textbooks devote considerable space to teaching MBA candidates (who later go on to make the real world decisions on such matters) how taxes must be factored into the cost of creating and using capital; that when expected revenue from the use of the capital exceeds taxes and other costs, the investment is worth pursuing; that when the costs, including taxes, exceed the expected revenues, the capital is not worth buying. The higher the tax, the less capital that can be created and employed. The lower the tax, the more capital can be created and employed. More capital per worker boosts productivity. The demand for labor to work with the capital rises, and so do wages.

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. If capital were unresponsive to tax changes, the after-tax returns could wander all over the map with no anchor. That is not the case in reality. When after-tax returns are unusually high, as they are right after a tax reduction, additional capital is formed, which drives the after-tax returns back down to the long run average. When after-tax returns are unusually low, as they are right after a tax increase, investment slows, until the reduced availability of capital drives returns back up to the long run average. Abnormal returns are rapidly competed away. The CAP piece questions this, but a look at the historical data reveals great stability, decade-by-decade, in after-tax real returns on real capital in the United States over more than half a century.

The following chart is constructed with data from the Labor Department Bureau of Economic Analysis. It displays pre-tax and after-corporate tax returns to the non-financial corporate sector since 1960. Pre-tax returns have oscillated between 7 and 14 percent, with most of the period showing returns near 9 percent. Returns after corporate taxes have oscillated between 5 and 9 percent, with most of the period showing returns of 6 to 7 percent. These after-tax figures are after the corporate tax, but before the additional taxes on the shareholders’ dividends and capital gains, which would bring the returns down to between 3 and 4 percent.

When returns were in the upper portion of the ranges, capital expanded unusually rapidly. When returns were lower, capital formation lagged. These responses confined returns to a narrow band around this long run average return, which is apparently tied closely to the time value of money or “marginal rate of time preference” embedded in human nature and economic theory.

The returns show no significant trend over time. History tells us that shocks to the returns from major tax changes to capital income are quickly dissipated, undone by swings in the quantity of capital. This kind of stability in returns can only be achieved if the quantity of the assets is readily adjustable and responsive to the changes in yield. The adjustment periods were very short. There was a burst of capital expansion after the 1962-63 Kennedy tax cuts on business and individuals raised returns on capital. This expansion was nearing completion by 1969, even before it was beaten back by Johnson Vietnam surtax. The waves of capital formation triggered by higher returns following the 1981 Reagan cuts, the Clinton capital gains rate reduction, and the 2003 Bush tax cuts were largely completed within a few years, driving returns back to more normal levels. Provisions of the Tax Reform Act of 1986 that raised taxes on capital outweighed the provisions that reduced them. Investment growth slowed later in the decade, helping to bring on the 1990-91 recession.

The historical evidence is quite clear. Taxes do affect capital formation. They move the stock of plant, equipment, and structures to a considerable degree, and relatively quickly. 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.

Click here to see part 1, part 3, or part 4 of this discussion.


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