Inflation, Taxation, and Corporate Investment: A Q Theory Approach

Working Paper: NBER ID: w0604

Authors: Lawrence H. Summers

Abstract: This paper presents an analysis of the effects of tax policy on capital accumulation and valuation based on James Tobin's q theory of investment. As Tobin has explained, aggregate investment can be expected to depend in a stable way on q, the ratio of the stock market valuation of existing capita1 to its replacement cost. For example, increases in the rate of return on physical capital raise its market value and cause increased investment until equilibrium is restored. Although models linking the stock market to investment have been estimated, they have not previously been used to examine the impact of tax policies. The basic idea underlying the approach taken here can be described quite simply. It is generally assumed that the stock market valuation of corporate capital represents the present value of its future dividend stream. In the model of this paper, the effects of tax changes on future profits are used to estimate the impact of those changes on the stock market. These estimates in turn are used as a basis for gauging the impact of the tax changes on capital formation. This approach, working through q, can provide estimates of the effects of policy announcements and of personal tax reforms as well as estimates of the distributional impact of alternative reforms. A distinct feature of the model developed here is that it is rooted in a microeconomic theory that integrates the interests of the corporation and its shareholders.

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Causal Claims

Cause	Effect
tax policy (H20)	stock market (G10)
inflation (E31)	stock market (G10)
inflation (E31)	capital stock (E22)
tax policy (H20)	capital stock (E22)
inflation + tax policy (H29)	stock market (G10)
inflation + tax policy (H29)	capital formation (E22)
tax policy (H20)	speed of adjustment of capital stock (E22)