Using Business Tax Cuts to Stimulate the Economy

Publication Date: January 2009

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

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Abstract:

Increased interest in providing business tax cuts to stimulate the economy has followed the terrorist attacks of September 11, 2001, which heightened concerns about an economic slowdown. Among the tax proposals discussed were a corporate rate cut and an investment subsidy; the final version of H.R. 3090 enacted in March 2002 contained the latter: temporary partial expensing for equipment. Interest in this issue continues, including proposals by President Bush for reductions in taxes on corporations through dividend relief.

Some economists suggest that additional fiscal stimulus is not needed; others also doubt the efficacy of fiscal policy in general, especially in an open economy and given the difficulties of achieving proper timing. Also, deficit financing of a tax cut has potential negative long run effects because it crowds out investment; a stimulus designed to increase investment spending (rather than consumption spending) would, if successful, reduce that negative effect. Investment subsidies had largely been abandoned as counter-cyclical devices over the last two decades, in part because of lack of evidence from statistical studies relating investment spending to the cost of capital. However, the empirical studies were subject to a number of serious flaws. More recent empirical evidence has found some larger effects, at least with some studies, although not enough to suggest that all of the tax cut is spent (especially with corporate rate reductions). Moreover, the average behavioral response identified in these studies may be larger than responses during a downturn when many firms have excess capacities, and planning lags may make investment responses poorly timed.

An investment subsidy has more "bang-for-the-buck" than a corporate rate cut, since the latter benefits existing as well as new capital. A corporate rate cut is estimated to produce between one-third and two-thirds of the investment induced by an investment credit with an equivalent revenue loss. The most common type of investment subsidy is the investment credit, although the same effect could be achieved with accelerated depreciation or partial expensing. A temporary investment credit would be more effective than a permanent one, and a temporary investment credit could also be made incremental. (It is not really possible to structure a permanent incremental credit.) One disadvantage of a permanent investment credit is that it distorts the allocation of investment and can easily produce negative tax rates, particularly with current lower tax rates and lower inflation. A 10% investment credit would produce negative tax rates in excess of 100% for short lived assets.

Arguments have been for a corporate tax rate cut because of estimated large effects on the stock market. These stock market calculations are overstated because they do not take into account the adjustment process and the possibility of interest rate increases. Given the uncertainty about the size of stock market effects or their beneficial effect on the economy, there is a case for not considering stock market effects an important factor in choosing an investment subsidy. Indeed one could argue that the prospect of future tax cuts are causing the stock market values to decrease by increasing future interest rates (and also discouraging investment for the same reason). This report will be updated to reflect major legislative developments.