Investment by Legal Organizations and Tax Rates

I keep being told that the lower personal tax rates lead to greater business investments, especially by small businessmen that are not incorporated, those that flow their business income into their personal accounts so they are subject to the personal tax rates rather than the corporate tax code. Numerous, sophisticated econometric exist that conclude that lower taxes lead to greater investment. But interestingly, that all seem to use aggregate data on nonresidential fixed investment to support this conclusion. I assumed that they used this data because the data on investment by small “Mom and Pop” firms as compared to investment by large corporations was not available. So imagine my surprise when I found that the BEA published data on investment by legal form of organization. It can be found at, Table 4.7. Investment in Private Nonresidential Fixed Assets by Industry Group and Legal Form of Organization.

This data allows researchers to organize business investment into three groups. First is corporations that are subject to the corporate tax code. The second is sole proprietorship,partnerships and households that are subject to the individual tax code. Third is nonprofits. Since 1980 corporations have accounted for some 81% of nonresidential fixed investments while those subject to the individual tax code accounted for 13% and tax exempts accounted for the remaining 6%. But as this first chart shows the 13% figure is somewhat misleading as the share of investments attributable to those subject to the individual tax code as declining irregularly from almost 3% of GDP in 1950 to some 1% of GDP in 2008.

Yes, the BEA data goes back to 1901 and that creates the first surprise in the data. From 1901 through 1915 their was no income tax as it was introduced in 1916 — there had been an income tax during the Civil War but that tax was declared unconstitutional. The first surprise was that from 1901 to 1915 business fixed investment accounted for 10.5% of GDP, a smaller sum than the 11.1% of GDP in the 1916-29 era. But of course the 1920s was considered to be an era of very strong capital spending much like the 1990s. But since 1950 business fixed investment has been 10.6% of GDP, almost exactly what it was from 1901 to 1915 when there was no income tax. It may not be valid to compare eras so diverse as the 1901-15 period to the post-1950 period, but it does raise an interesting question of why didn’t investment fall after the income tax was introduced. If income taxes dampen investments one would have expected stronger investment in the pre-tax era. This divergence is especially true if you look at the data on investment by organizations subject to the individual income tax.

Those claiming that lower individual taxes, and especially lower capital gains taxes lead to greater investments particularly like to point out what happened when two Democratic Presidents cut taxes — Kennedy in the 1960’s and Clinton in the 1990’s. But this data shows that essentially all of the increase in capital spending in the 1960’s stemmed from higher investments by corporations as spending by individuals subject to the individual income tax actually declined in the 1960s.

If you want to attribute higher capital spending on lower taxes this data on the 1960’s strongly implies that it was accelerated depreciation for corporate investment that caused capital spending to rise in the 1960’s, not lower taxes on individuals.

Recently, Larry Kudlow has been attributing the 1990s investment boom to the Clinton capital gains tax cut. But the boom was well underway before the 1996 tax cut. In the three years before the tax cut –1993, 94 & 95 — business investment grew at a 10.5% average annual rate and in the next three years — 1996, 97 & 98 — under lower tax rates the growth rate actually slowed to 9.3%. For those subject to the individual tax code the slow down in growth was more severe, from 13.1% to 9.2%.

The bottom line appears to be that this data does not disprove the theory that lower personal income taxes and especially lower capital gains taxes leads to greater investments. But it does not appear to support the theory either. In particular I would ask the advocates of this theory why investment by those subject to the individual income taxes share of capital spending has dropped sharply during a period of falling personal income tax rates. For all I know it is because small firms are incorporating much more now than historically. After all, the effective corporate tax rate has fallen sharply during this period so maybe the advantages of incorporation have increased. I come to the conclusion that the impact of persoanl tax rates on business investment is marginal, at best. It is almost always swamped by other considerations like business profits, capacity utilization, the cost of capital and technology.
But this strongly conflicts with the standard position advocated by tax cutters and widely accepted by the business press.

So tell me, why should I not stick with this conclusion?