Risky business: policy uncertainty and investment

International Tax and Public Finance https://doi.org/10.1007/s10797-022-09757-7 Risky business: policy uncertainty and investment Giacomo Brusco1 · Benjamin Glass2 Accepted: 26 July 2022 © The Author(s) 2022 Abstract Previous work has shown that nonlinear taxation can affect the willingness to undertake risky investments. We show that similar results can arise if agents are uncertain regarding future tax rates. Uncertain taxes distort investment decisions when tax rates are correlated with marginal productivity. We demonstrate this result in a simple theoretical framework, which can also explain some well-known results on the effects of tax progressivity and tax asymmetry on investment. Time-series estimates for the post-WW2 era suggest a negative correlation between effective tax rates and total factor productivity in the USA, yielding an effect on firm investment equivalent to an investment subsidy of around 1 percent. Our results have wide-ranging implications for a variety of tax-related work, including effective tax rates, optimal audit policy, and principal-agent problems between investors and managers. Policy uncertainty · Investment · Tax asymmetry · Tax progressivity · Taxation asinsurance · Audit policy · Effective tax rate JEL Codes H21 · H25 · H26 · H30 · H31 · H32 1 Introduction It has long been known that tax progressivity and tax law asymmetries can dampen investment. We develop a simple yet general framework that explains several empirically documented effects of nonlinear tax policies on investment. Our model also offers the novel insight that a similar effect can arise if tax policy is uncertain when agents make decisions, even if agents know that tax rates will be linear. Facing higher tax rates in states of the world where investment happens to be more * Giacomo Brusco Benjamin Glass 1 RSIT and Department of Economics and Social Sciences, University of Tübingen, Tübingen, Germany 2 U.S. Department of the Treasury, Washington, D.C., USA 13 Vol.:(0123456789) G. Brusco, B. Glass productive will depress the after-tax expected return, a mechanism largely ignored by previous work. We offer the first empirical estimate of this impact, finding a negative correlation between productivity shocks and tax burden that provides a stimulus to investment equivalent to a subsidy of around 1%. Our theoretical result has implications for disparate topics such as probabilistic tax policy (such as random auditing), estimates of effective tax rates, and principal-agent problems in firm management. While our main results hold under risk-neutrality, risk aversion entails a trade-off: a higher covariance between tax rates and productivity implies a higher expected (after-tax) return, but also greater risk. To fix ideas, suppose a firm chooses how much to invest, x, to maximize expected after-tax profits. The firm faces an uncertain productivity shock, 𝜖 , and an uncertain tax rate, 𝜏 . [ ] max 𝔼 (1 − 𝜏)(𝜖f (x) − x) . x≥0 The production function f (⋅) satisfies f �� (⋅) < 0 < f � (⋅). Then optimal investment x∗ satisfies:1 f � (x∗ ) = 1 − 𝜏̄ . (1 − 𝜏) ̄ 𝜖̄ − Cov(𝜖, 𝜏) (1) Here 𝜖̄ and 𝜏̄ indicate 𝔼[𝜖] and 𝔼[𝜏], respectively. There are three main takeaways from Eq. 1. First, if Cov(𝜖, 𝜏) = 0, then the choice of the firm will be identical to the efficient choice it would have made in the absence of taxation, namely x0 satisfying f � (x0 ) = 1∕𝜖̄. Second, if Cov(𝜖, 𝜏) > 0, then x∗ < x0. A positive correlation between productivity and tax rate dampens investment for the simple reason that facing a higher tax rate when profits are higher means facing a higher tax rate on average. One cause of this correlation is tax progressivity or tax law asymmetries. In their study of how income taxation affected risk-taking, Domar and Musgrave (1944) were the first to note that failing to rebate taxes on losses would make risky investments less attractive. Subsequent work has expanded this reasoning and documented its effects empirically. For instance, Gentry and Glenn Hubbard (2000) showed that states with more progressive tax schedules induced slower entry into entrepreneurship. Their later work has shown that tax progressivity also dampens job turnover by making it less rewarding to invest time and effort looking for a new job (2004) and has ambiguous effects on innovation (2005). Others have documented the effects of tax law asymmetries—for example, how imperfections in the tax carryback and carryforward systems lead to an ultimately asymmetric treatment of profits and losses, thus dampening investment. See Auerbach (1986) and Altshuler and Auerbach (1990) for a discussion of the effects of tax asymmetries; see Devereux et al. (1994), Clifford (1999), Edgerton (2010), and Goodman et al. (2020) for empirical evidence. 1 The first-order condition is 𝜖f ̄ � (x∗ ) − 𝔼[𝜖𝜏]f � (x∗ ) − (1 − 𝜏) ̄ = 0. Since 𝔼[𝜖𝜏] = 𝜖̄𝜏̄ + Cov(𝜖, 𝜏) we can re-write this as f � (x∗ )(𝜖̄ − 𝜖̄𝜏̄ − Cov(𝜖, 𝜏)) = 1 − 𝜏̄ , which yields Eq. 1. We assume interior solutions throughout this paper. 13 Risky business: policy uncertainty and investment Third, if Cov(𝜖, 𝜏) < 0, then x∗ > x0. A negative correlation between tax rates and productivity will yield a higher expected payoff on investment, thus incentivizing it. While concave tax schedules tend not to be the norm, the correlation need not be driven by nonlinear tax schedules. A negative correlation may result from economies of scale in tax planning, whereby bigger, more productive firms face lower effective tax rates. Similarly, reported income may increase with positive income shocks, reducing audit risk and thus the effective tax rate. Alternatively, policy may depend on the business cycle, or the political process could correlate with economic conditions. Naturally, the correlation between tax rates and productivity resulting from policy uncertainty of this nature is ambiguous. Our empirical exercise explores to what extent productivity covaries with average tax rates, yielding an implicit tax rate on investment. We find a negative correlation, which encourages aggregate investment to a degree dependent on the elasticity of investment. For instance, the estimate by Zwick and Mahon (2017) regarding the elasticity of equipment investment to the user cost of capital would imply that aggregate investment is 1.41% to 1.63% higher due to the correlation between productivity and tax rates. However, our aggregate estimate conceals heterogeneity in covariances that could result in greater distortions for specific investors. This interpretation also depends on the assumption of risk neutrality. When agents are risk averse, a negative correlation between tax rates and productivity acts as insurance, potentially mitigating or even reversing our result. A thorough account of the impact of this covariance on investment would consider both investor preferences and principal-agent dynamics. Previous literature has looked at the effect of policy uncertainty (...truncated)