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 BEA.gov., 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?
Can you change the formatting of your post so it fits completely within the box? Right now, much of the text is overflowing underneath link bars on the right (this is true for both IE and Safari) and cannot be viewed.
Interesting find.
Formatting fixed, post re-dated.
If I see a $1000 bill on the ground, I’m just as likely to pick it up if I have to pay 30% Federal Income Tax on my gain as I would if I didn’t have to pay any Income Tax. That is, the tax rate has no influence on my decision to invest my time in picking up the bill. The only reason I might not pick up the bill would be if my after-tax net were so small that the benefit of stopping to pick it up exceeded the value of my leisure time (i.e., a preference for leisure over employment).
On the other hand, if I have the choice between paying 30% tax on US income vs. paying no tax if I build my factory in a third world country, then there may be an advantage to building it elsewhere. But, the tax rate itself is not the crux of the issue. Instead, this is essentially an arbitrage situation that allows me to take advantage of the difference in tax rates.
One potential problem with the data is diversity within category. Four doc medical groups are often C Corps, General Motors is a C Corp. Avon ladies are proprietorships, partnerships range from 2 to hundreds.
I’m not certain what this would do with the results, just wondering.
What I do know well from lots of experience is small entrepreneurial startups (family and otherwise) with no intention of going public. These companies (whatever the entity) tend to be cash lean and every penny paid in taxes is a penny not available for payroll and the next truck.
On a related note, these small entrepreneurs do not tend to care much about capital gains rates, at least not early on, because they have no intention of selling the business – it is also their job.
Spencer:
The fastest growing business entity is the LLC, combining advantages of partnerships and corporations. That change might answer one of your questions (many states allow one person LLCs, replacing proprietorships.
There was a federal tax on the income of corporations starting in 1909, even before the 16th amendment. In order to pass constitutional scrutiny, this tax was formulated as an excise tax on the privilege of doing business in the corporate form. However, since the value of this taxab;e “privilege” was deemed to be the corporation’s net income, this tax was, for all practical purposes, a corporate income tax.
Recent Article in The Atlantic
http://www.theatlantic.com/business/archive/2010/08/why-higher-taxes-wouldnt-kill-small-business/60973/
save-the-rustbelt—my experience is like yours, most people starting a small business expect to be highly successful and the tax rate is one of the last things on their mind. And also, once they get the firm going they are so surpised by how hard it is that tax considerations are still one of the last things on their mind.
For small firms there is a very, very long lag between the time they start a business and the time a “taxable event” occurs when the capital gains tax comes into play — either when they go bublic or sell the business.
Combine a subchaper S status with the LLC and you get the a great situation. Liability protection except for fraud, and the better tax situation of a corporation. Chapter S means that the corp is taxed as if a partnership, i.e. things are shared back to the owners tax returns. It is beyond me with these new forms of doing business why anyone would still have a sole proprietorship or a partnership in an active business i.e. not an investment partnership.
spencer,
Nothing to add except that I really liked this post.
A simple model of the economy takes all the domestic product and either reinvests it in capital goods or consume it. Thus, just to maintain the capital stock we need a constant stream of new investment. If everyone that is purchasing private goods are taxed more they will buy less stuff. If they buy less then we need less capital in the private sector. Also, investment are made out of investible funds that are provided with the expectation that the investment will produce a return. If you have higher taxes on business then the returns are less and investing is less attractive. Also if you tax people more they have less money to invest.
The argument that taxes reduce private investment are not very sophisticated. Less money in your pocket means less purchases and thus a need for a smaller capital stock in the private sector. This seems simple enough. Also, less money to lend because the money is diverted to taxes means less investment in the private sector. Also, higher taxes reduce profit and taxes on dividends further reduces the beneift of investing. Sophisticated econometrics? Not really.
So the obvious resolution to that scenario is to tariff the imported goods from the off shore tax haven manufacturing site. Some one has to pay the cost of military preparedness aronf the globe. Social Security, the working man’s enititlement, is self funded. Militgarty adventurism requires a tax supported funding stream.
The argument taht tax increases incraese private investment are not very sophisticated. The government spends every dime it gets, so increased taxes mean increased spending. (This is unlike private entities who simply start saving money once they get a big enough pile of it.) Increased spending means more money for people selling their goods and labor, and that means a higher return on investment than in a stagnant economy where everyone is saving. Higher returns encourage more investment.
No one is going to invest if there aren’t enough people with money to buy what they’re planning to sell. Not every businessman is stupid.
Templeton –
Those tax dollars don’t go into a black hole. They get spent. Hence stimulus.
The rich tend to accumulate. Taxing and spending pumps the economy more than letting Jow Billionaire sit on his next billion.
Riddle me this, someone: With an accelerated (or actually any) depreciation schedule, the cost of (some portion of) a capital investment is subtracted from gross profit before the tax is levied on the resulting net profit. The higher the tax rate, the more value the depreciation exemption has. It seems, then, that while you are still below the peak of the relevant Laffer curve equivalent, increasing the corporate tax rate should encourage investment.
Where am I going wrong?
Cheers!
JzB
Prior to Reagan (and mainly post Eisenhower) several democrats were for tax cuts as a means to stimulate private demand and encourage business investment. Here are some cases.
Truman Tax cut 1945 — motivation to spure both consumer spendng and business investment to repace government demand with private demand following WWII. Truman: “Full employment in peacetime can be assured only when the reduction in war demand is approximately offset by additional peacetime demand from millions of consumers, business, and farmers…We must overhaul the wartime tax structure to stimulate consumers demand and to promote business investment. The elements of such a tax program should be developed now so that it can be put into effect after victory”
Kennedy Tax cut 1964 — Motivation faster long-run growth. President Kennedy “Our present tax system is a drag on economic recovery and economic growth,…,This administration intends to cut taxes in order to build the fundamental strength of our economy, to remove a serious barrier to long term growth”.
Jimmy Carter tax cut 1977 – Generate above normal real growth. “This budget includes the economic stimulus package, which will reduce unemployment and promote steady, balanced economic growth”
Jimmy Carter tax cut 1978 – motivation to raise growth from normal to above normal. The 1978 economic report states “The longer-term prospects for economic growth would become increasingly poor. Because of the fiscal drag imposed by rising payroll taxes and inflation, economic growth would slow substantially in late 1978 and fall to about 3 1/2 percent in 1979. The unemployment rate would stop decling and might begin to rise again”
Obama seems to saying that all these democrats were fools along with the republicans that made similar arguments. More and more he looks like the odd man out.
FS: “If I see a $1000 bill on the ground, I’m just as likely to pick it up if I have to pay 30% Federal Income Tax on my gain as I would if I didn’t have to pay any Income Tax. That is, the tax rate has no influence on my decision to invest my time in picking up the bill. The only reason I might not pick up the bill would be if my after-tax net were so small that the benefit of stopping to pick it up exceeded the value of my leisure time (i.e., a preference for leisure over employment).”
*Exactly* right.
The problem with the tax-investments-and-people-will-invest-less argument is that if people want returns on their money, there is no alternative to saving/”investment” (buying stocks, bonds, cdos, etc.)
There’s no alternative “good” to investing. (As if it was a “good” in the first place: as if you could “buy” investing like you can buy goods and services.) Which means the supply/demand argument for investments is ridiculous.
The only alternative is spending/consumption, which doesn’t increase your wealth (QTC).
And I don’t think anyone will want to argue (will they?), that if we tax investment income more, so investors have less income, they’ll spend *more.*
And of course when you save/”invest,” you can consume from that store of money later. The reverse is not true; with consumption there is no store. Even if saving and consumption were goods (you can’t “buy” consumption either), they’d be completely noncomparable goods.
There is an alternative good to labor, of course: leisure. Which is why taxing it reduces supply. Not true with savings.
On whether “savings” translates reliably into productive investment, that’s a whole other post.
Ah, I’ve never seen anyone “sit on a billion.” Or any other amount of capital. Well, except drug trafficers who didn’t have enough laundering capabilities.
I know your theory, that is not my problem. Also note I did not say your theory is wrong,
rather, I said other factors appear to be more important.
My problem is that the data conflicts with the theory.
Repeatedly restating your theory does not deal with my problem.
Try explaining why the data and the theory are in conflict and I will take your seriously.
There’s a fundamental problem with economic theory. The entire ediface is based on erroneous assumptions (people act to maximize utility, people are rational decision makers, etc) that arise from modes of thinking that are fallacies (mis-characterization of humans as mechanical entities, the fatal allure of models, and the optical illusion that essentially different activites are the same.)
But when the economists’ models and reality don’t agree, it’s always reality that is wrong. Hence: government is the problem, gov’t. spending crowds out private investment, raising the minimum wage increases unemployment, all regulation is bad, raising taxes stifles business, etc. – all ideas that are either unsupported by or flatly contrary to real world events.
Funny how that works.
Cheers!
JzB
Correct on the fundamental problem, assuming that people are emotionless calculating machines. If that were the case the current problems would never have occured. Instead everyone followed the herd to the cliff and jumped off.
But economics wants to be a science and has physics envy, so they make simplifying assumptions because Hari Seldon has not yet invented PsychoHistory (Second Foundation by Asimov). In fact perhaps economics has PsychoHistory envy, as the economist have read second foundation and think thats what economics should be.