This is the first in a series of pieces by E&F resident economist, Joshua Land, who will be writing about money.
During his State of the Union Address last week, President Obama proposed to restore the top tax rate on capital gains and dividend income to 28 percent, effectively undoing one provision of the Bush tax cuts.
Economists hate taxes on capital income. The traditional view has been that taxes on dividends increase the cost of capital to firms by reducing the amount of money potentially available for investment. A higher cost of capital then causes a reduction in investment, which in turn reduces the rate of overall economic growth. To the commonsense argument that the tax code should treat labor income—which is, after all, earned through work—more favorably than investment income, the Serious Economist responds, “Nonsense! Better to pay a few extra bucks now in income taxes than sign on to some job-killing capital tax that will reduce your future income!” Case closed.
It’s a sensible argument, as long as one accepts the initial link between dividend taxation and capital cost.
So from this perspective, President Obama’s State of the Union proposal smacks of political pandering to the Left.
Or maybe not. A new paper from UC Berkeley’s Danny Yagan provides new evidence that the relationship between dividend taxation and investment may not be so straightforward (h/t to Mike Konczal, whose Next New Deal post brought this paper to my attention last week .)
The issue of how changes in tax policy affect investment is difficult to study empirically, as it can be impossible to separate the effects of taxation from the myriad other factors that might affect investment. Yagan’s paper comes up with a nifty solution to this problem, exploiting the difference between C- and S-corporations. All corporations are required to adopt either “C” or “S” status for purposes of federal taxation. There are a number of differences between the two, but the most important for the purposes of Yagan’s study is that C-corporations are subject to dividend taxation while S-corporations are not. If we make the assumption that the two classes of corporations should trend similarly in the absence of a change in tax policy, then it becomes possible to identify the effects of the policy change on investment. Yagan looks at corporate tax returns from 1996-2008, the years immediately before and after the Bush tax cuts. He finds no difference whatsoever between investment trends for the two types, either before or after the tax cuts. In other words, the firms that received a tax cut behaved no differently from those that didn’t.
So if the extra money from a dividend tax cut isn’t being invested, then where is it going? Yagan’s paper suggests into the pockets of wealthy investors. He finds that payouts to shareholders by C-corporations spiked by 21% in 2003 relative to S-corporation payouts. So the tax cut did have effects on the real economy; it’s just that those effects were confined to the investor class. This result is consistent with changing norms in finance. For example, it is now commonplace for firms to borrow money to increase payouts to shareholders, behavior that in most cases would have been considered unethical 30 years ago. Clearly, further research is needed, but Yagan’s paper provides the strongest evidence yet that the new era of “disgorge the cash” may be undermining traditional models of tax policy. Perhaps the pandering politicians are right after all.
Joshua Land is a freelance writer who lives in Madison, Wisconsin, with his wife and son. He is currently a fourth-year PhD student in applied economics at the University of Wisconsin.