In 2003, the Bush Administration introduced the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) which, amongst other reforms, lowered dividend and capital gains taxes. This act is expected to sunset at the end of this year and the current administration has to decide whether to extend it or not. This paper contributes to the current debate on this issue by analyzing the quantitative effects of these capital income tax changes in a dynamic stochastic general equilibrium model calibrated to US data.
Discussions on tax policy, especially capital income tax policy, have always been politically divisive. One of the reasons is that economic theory provides sound arguments for both sides of the discussion. On the one hand, reductions in capital taxes are viewed as providing incentives for investment and, hence, leading to higher economic growth. Indeed, one of the primary objectives of the JGTRRA reform was to promote capital formation. On the other hand, reductions in capital taxes are viewed as negative because of the resulting increase in budget deficits as well as inequality.
Although there seems to be a presumption that reductions in capital taxes would disproportionately favor the wealthiest part of the distribution, it is well known that those relying mainly on labor income could also see substantial benefits arising from the general equilibrium effects of increased investment on wages and employment. In this paper, we disentangle the effects of changes in dividend and capital gains taxes theoretically and provide a quantitative analysis of the size of the costs and benefits associated with these reforms.
To that end, we build a general equilibrium model in which households face uninsurable idiosyncratic labor income risk. In addition to risky labor income, households receive capital income from owning shares in firms. Both labor and capital income are taxed by the government. An important assumption is that the government taxes dividends and capital gains at potentially different rates. Firms in our model undertake investment with a view to maximizing shareholder value. As shown by Cárceles-Poveda and Coen-Pirani (2009), shareholder unanimity with respect to this objective can be ensured, despite the presence of shareholder heterogeneity and market incompleteness, by assuming constant returns to scale production and no short-selling constraints. We calibrate our model to US data and compute both long run steady states and transitions.
Our results regarding steady states are as follows. A reduction in dividend tax rates has the surprising effect of reducing aggregate investment and capital stock. The reason is that the dividend tax change does not directly affect the cost of capital but it raises the market valuation of the existing capital stock. As a result, aggregate wealth held in the economy increases and households demand a higher return in order to hold the additional wealth. In equilibrium, firms respond by reducing the capital stock and this increases the marginal product of capital and, thus, the rate of return. Note that this is the exact opposite effect on investment to the one intended by the proponents of the JGTRRA tax reform.
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Dividend and Capital Gains Taxation under Incomplete Markets
