How Tax Uncertainty Threatens Economic Recovery

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It’s often said that taxes are one of only two iron-clad certainties in life. But the degree of certainty attached to our tax-based expectations is by no means fixed.

As of this writing, for example, the Biden administration reportedly plans to hike the top long-term capital-gains tax rate from 20% to 39.6% – an increase which may apply retroactively. Commentators are currently debating whether and how the tax uncertainty thus generated may impact investment and saving.

We live in a world where uncertainty is advancing on many fronts, from the increasingly fractious political arena to the inscrutable future of international travel. This climate of generalized rising uncertainty has been linked to fiscal conservatism in the corporate sphere and the post-2008 decline of investment as a share of corporate profit.

School of Business accounting professor Kelly Wentland
Kelly Wentland

Kelly Wentland, an accounting professor at the George Mason University School of Business, recently published a paper in Management Science (co-authored by Martin Jacob of WHU – Otto Beisheim School of Management and Scott Wentland of the Bureau of Economic Analysis) that further specifies and quantifies firm response to tax uncertainty. Its main analysis focuses on exceptional or “lumpy” investments as analogous to constructing a new chemical plant or expanding factory equipment. The researchers surmise that because tax uncertainty exposes firms to greater financing costs, it would affect large investments more than, say, incremental R&D or hiring. Lumpy investments are also of particular economic import, representing up to 40 percent of a firm’s total capital expenditure over a 16 year period.

The paper hinges on the Internal Revenue Service’s phased rollout of Schedule UTP from 2010-2014. The new policy requires firms to list their uncertain tax positions – i.e. claimed tax liability adjustments that often fall into gray areas in the tax code – on their annual return. Taxpayer firms subject to the policy would therefore be in a situation where their uncertainty was expected to be more salient, compared to those beyond reach of the rule. Indeed, articles published at the time reported that corporations were concerned that Schedule UTP would lead to more audits and higher compliance costs. While ex post evaluations of Schedule UTP suggest it may not have been as revealing as originally anticipated, Wentland and her colleagues’ work shows that initial expectations matter in terms of investment. An analogous point would be how buyers continued to allow beliefs of a strong housing market influence their offer prices right up until the housing market tumbled during the financial crisis.

The largest firms, with assets of $100 million or more, were the IRS’s guinea pigs, receiving the Schedule UTP requirement in 2010. The threshold was lowered in the following years to cover all firms with at least $10 million in assets.

Over the course of the phased rollout, the researchers compared investment activity of firms (harvested from the financial database Compustat) that barely made the cutoff for Schedule UTP to those whose assets fell slightly short of the requirement. For firms subject to Schedule UTP, the researchers also made before-and-after investment comparisons using historical data going back to 2005.

They found that the onset of Schedule UTP eligibility was associated with lumpy-investment delays of 4.5 months on average. But even this non-trivial number understates the chilling effect of tax uncertainty. When Wentland and co-authors compared firms that were never affected by the new policy to those that were, the relative delay rose to 18 months. Recall that the Schedule UTP rollout coincided with crucial years of economic recovery. This research shows that smaller firms who never made the $10 million cutoff ramped up investment more readily as part of their rebound from the Great Recession. (Note that the researchers controlled for firm size, so the difference here wasn’t due to a disparity in investment behavior between large and small companies.)

The policy change had implications for the size of investments as well as their timing. Post-Schedule UTP, lumpy investments shrank by 0.27% of total assets, which translates to an overall 5.3% decline in investment activity.

The other main types of corporate investment – acquisitions, R&D, and employment – were surprisingly not impacted at all by the new policy. This is perhaps most unexpected in the case of acquisitions, which technically qualify as lumpy (i.e. a one-off, unusually large expenditure). Unlike classic capital expenditure, though, acquisitions are usually carried out by firms that are flush with cash. Financially constrained firms normally pursue growth through the more conservative route of enhancing or adding to existing resources. For obvious reasons, tax uncertainty looms larger for the latter group of firms than the former.

Companies’ response to tax uncertainty is an especially pertinent issue at the moment. The recent history revisited in Wentland’s paper is repeating itself; the global economy is in tentative recovery mode once again, this time because of a pandemic rather than a once-in-a-lifetime recession. The positive and negative ripple effects of governmental positions and policies should be weighed very carefully. Wentland’s analysis can help policymakers better understand the potential trade-offs involved.

If President Biden’s infrastructure agenda is implemented, a corresponding tax rate hike has been proposed to fund it. But in calculating costs and benefits of legislation such as the American Families Plan, policymakers should take into account the drag on investment that could come with how the process itself may alter economic prospects. In particular, they may want to be aware that extended deliberations about policy can have unintended consequences if the possibilities under consideration stir up tax uncertainty among the public. In sum, the success of a given policy depends not only on its direct effects but also on the indirect effects surrounding its creation.

The net real economic impact of such policy may only become clear in the fullness of time.

Source: Martin Jacob, Kelly Wentland, Scott A. Wentland (2021). Real Effects of Tax Uncertainty: Evidence from Firm Capital Investments