clock menu more-arrow no yes mobile

Filed under:

Obama critics say his tax proposal will hurt investment. The best evidence says it won't.

In his State of the Union address, President Obama called on congress to increase the tax rate levied on dividend and capital gains income — in other words, income earned from investment rather than from work. This seems like common sense to many people; investment income is currently taxed at a lower rate than earned income, and disproportionately goes to the very wealthy, so taxing it more is a progressive change. But the traditional view in economics is that investment income shouldn't be taxed at all, and that taxing investment income is actually bad for workers. The idea is that if you cut taxes on investment income, you'll encourage more investment. More investment will mean people have more equipment and technology to work with, which should increase wages and economic growth.

The case against investment taxes is one of those things that can be demonstrated in the abstract through some fairly elegant math, but it's difficult to confirm empirically. Fans of the Obama proposal will enjoy Danny Yagan's 2014 paper "Capital Tax Reform and the Real Economy: The effects of the 2003 dividend tax cut" which is probably the best recent empirical look at the question. Yagan's conclusion is that the Bush administration's big cut to the dividend tax "caused zero change in corporate investment" and had "no impact on employee compensation." It did have, however, "an immediate impact on financial payouts to shareholders."

S-corporations and C-corporations

The question of capital taxation lends itself to a lot of sloppy research. One could note that corporate investment surged in the years after the 2003 tax cut compared to where it had been previously, and conclude that it worked. Alternatively, one could note that growth was much faster in the high-tax 1950s and 1960s than in the low tax post-Reagan era, and conclude that tax rates don't matter.

In either case, there are tons of confounding factors that make rigorous analysis impossible.

What Yagan did instead was compare C-corporations to S-corporations. Here's why that works:

  • C-corporations are what most people have in mind when they think about "corporations." They pay corporate income tax on their profits, and they can have as many shareholders as they want — with shares traded on big stock exchanges. These corporations can, if they choose, pay dividends to their shareholders, and those shareholders then pay the dividend tax on those payments. So if dividend tax cuts boost investment, we should see C-corporations boosting investment when divided tax rates are cut.
  • S-corporations have income that is simply "passed-through" to their owners, without the payment of corporate income taxes or dividend taxes. The downside to these tax advantages is that S-corporations are limited to a small number of shareholders and can't be traded on stock exchanges. Since S-corporations' owners don't pay dividend taxes, S-corporations' behavior should not be responsive to the dividend tax rate.

The biggest companies in America are essentially all C-corporations, so Yagan focused on a "random sample of private C- and S-corporations with assets between one million and one billion dollars (the 90th and 99.9th percentiles of the U.S. firm size distribution) and revenue between 0.5 million and 1.5 billion dollars." What he found was that both before and after the 2003 tax cut, S-corporations and C-corporations investment behavior was extremely similar.

Two theories of corporate investment

Yagan's empirical finding speaks to a long-standing debate about what causes business investment. One theory emphasizes the "cost of capital" and says that firms will invest more when it is cheap to get investment funds. A cut in dividend taxes should make it cheaper to raise investment capital, which ought to raise investment.

The other major theory emphasizes the empirical reality that corporations almost never sell shares of stock in order to raise investment capital (see Doug Henwood's Wall Street for a long and thorough discussion). The vast majority of corporate investment is financed by retained earnings. Google earns revenue selling ads, and plows some of that revenue into driverless cars. Apple earns revenue selling iPods, and plows some of that revenue into developing a mobile phone. Even Initial Public Offerings of startup companies are rarely motivated by a desire to raise funds for investment. A much more typical story is something like the Facebook IPO, which was staged so that Mark Zuckerberg and other early employees and investors could get their hands on cash, rather than because Facebook itself needed money.

Yagan's empirical finding is in line with this second theory of corporate investment. Reducing C-corporations' cost of capital through a dividend tax cut doesn't change their investment behavior, because companies don't rely on external investment for financing.

What might this study miss?

Any empirical study can be nitpicked in a variety of ways. But the big thing Yagan's research methodology doesn't cover is venture capital and startups.

Most business investment is undertaken by established businesses, and established businesses don't rely on the stock market to fund their investments. But some firms do. Brand-new companies — and especially brand-new companies built around unproven technologies or business models — usually have their early investments financed by venture capitalists. These VCs are hoping to earn a long-term return after the company goes public, and the size of that return depends, in part, on the tax treatment of dividends and capital gains.

Consequently, higher taxes on investment income might depress VCs' willingness to finance startups.

The total quantity of money invested by startups is small compared to the overall economy, but the success or failure of startups in bringing new technologies to market is very important for the long-term prospects of the economy. So if you believe that the availability of early-stage VC money is an important binding constraint on the development of new technology (which, to be clear, is very debatable) you might still think that dividend tax hikes would damage long-term growth even if you accept Yagan's findings.

Sign up for the newsletter Today, Explained

Understand the world with a daily explainer plus the most compelling stories of the day.