Unpredictable Tax Policies Increase Investment

Unpredictable changes in tax laws towards investment can boost overall investment. That is the conclusion of Professors Kevin Hassett of the American Enterprise Institute and Gilbert Metcalf of Tufts University, writing in the latest issue of the Economic Journal. They argue that random changes in tax policy provide opportunities for firms to wait out high tax regimes and invest more heavily in low tax regimes. Because firms can choose when to invest, the uncertain tax environment can be used to their advantage by ”loading up” investment in times of low taxation.

The random nature of taxes is not simply an academic issue. The UK has changed tax regimes repeatedly over the years, shifting from a two-tiered corporate tax system, to a classical corporate income tax similar to the one used in the United States, to a corporate tax system integrated with personal income taxes. The United States has changed the tax credit that can be applied to capital investment in machinery once every three years on average.

With policy-makers repeatedly changing depreciation schedules, tax rates and investment tax credits, managers who make investment decisions take a gamble every time they make a longlived investment – a gamble that taxes won”t change in ways disadvantageous to the firm”s investment project.

Hassett and Metcalf develop this idea using an innovative means of analysis that incorporates reasonable responses on the part of policy-makers. For example, while specific tax code changes may be unpredictable, the Hassett-Metcalf analysis allows for the likelihood of a change being related to the underlying profitability of businesses. If businesses are highly profitable, the odds of a tax increase naturally increase; such a measure of political reality is unusual in models of government tax policy.

Are Hassett and Metcalf trying to say that capital intensive industries should lobby their politicians to increase the unpredictability of tax policy? ”No”, says Professor Metcalf. ”Our model makes no claims about the welfare benefits of unpredictable tax policy. We argue that overall investment will go up. Whether shareholders are better off or not is something that our model cannot answer. But our model shows that claims that an unpredictable tax policy contributes to a low level of investment are simply wrong.”

”Investment with Uncertain Tax Policy: Does Random Tax Policy Discourage Investment?” by Kevin Hassett and Gilbert Metcalf is published in the July 1999 issue of the Economic Journal. Hassett is at the American Enterprise Institute, Washington DC; Metcalf is at Tufts University in Medford, Massachusetts.

Kevin Hassett

001-202-862-7157 | khasset@aei.org

Gilbert Metcalf

001- 617-627-3685 | gmetcalf@tufts.edu