investment,overhang,andtaxpolicy.doc

Investment, Overhang, and Tax Policy Mihir A. Desai Harvard University and NBER Austan D. Goolsbee University of Chicago, American Bar Foundation and NBER November 2004 We thank Mark Veblen and James Zeitler for their invaluable research assistance and Alan Auerbach, Bill Brainard, Kevin Hassett, John Leahy, George Perry, Joel Slemrod, and participants at the BPEA conference for their comments. Dale Jorgenson was kind enough to provide cost of capital estimates. Desai thanks the Division of Research at Harvard Business School for financial support. Investment, Overhang and Tax Policy ABSTRACT 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. Controlling for fundamentals, there is little evidence of capital overhang. 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 forecast revenue cost of more than $400 billion