Policy against overvaluation plausible?

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Dear Iowa State economists:

This question is predicated on five assumptions: first, that investors generally now prefer capital gains over dividends, a shift that occurred in the '60s or '70s; second, that this preference for capital gains encourages corporations seeking equity funds to appear to have potential for growth; third, that this appearance causes equity markets to overvalue such firms; fourth, that the second and third factors cause managers to make deceptive decisions, ultimately misallocating capital. This story is based on a couple essays I read defending short selling as a way to devalue overvalued firms.

Whether or not short selling is "encouragable", the story was convincing enough that I came to think it would be a good thing to push investor preferences back towards dividends, so that capital would be at least somewhat more allocated towards sustainable profitability instead of unsustainable growth.The policy that occurred to me to accomplish this was to raise the capital gains tax and lower corporate income tax.

What is your opinion of this story and policy proposal? Are either plausible? Where do these views sit in today's economic rhetoric?

Answer: 

Thank you for these interesting questions. As they indicate, you are already well aware of potential distortions associated with tax policies. It is quite possible that your suggested policy proposal would be associated with distortions and unintended consequences as well.

I urge you to "dig" a little deeper and examine what underlies the stated assumptions. In particular, with regard to the investor preferences: Is the indicated preference shift solely due to differential tax treatment of capital gains vs. dividends? Could it also be due to capital gains effectively giving more flexibility to investors as to when to realize investment returns? Or, could it be that investors believe (perhaps correctly) that executives of companies issuing growth stocks have superior ability to identify investment projects with high potential return (especially in the case of new, as opposed to long established, industries)? Or, could it be that the overall risk tolerance of investors has increased resulting in higher demand for stocks of companies that pursue riskier investment opportunities? Or, could it be that the overall time preferences of investors have changed so that future (i.e., delayed) profits are effectively discounted by less? Etc. etc.

If the differential tax treatment is the whole story, your proposal could address the possible distortions you worry about. (In that case, perhaps an even more straightforward policy would be to *increase* the corporate income tax and eliminate taxation of dividends and capital gains at the individual investor level.) I doubt, however, that the tax treatment is the whole (or even a major part of) story, because many, if not most, dividends paid out by U.S. corporations come in the form of qualified dividends, which are taxed at the same rate at capital gains. Thus, if other factors (changes in risk tolerance or time preferences, managers' ability to identify good investment opportunities, etc.) underlie the preference shift, you proposal could, in fact, lead to other forms of distortions and capital misallocation.

I am unsure what you mean by "today's economic rhetoric" for me to be able to elaborate on such rhetoric.

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Last updated on May 1, 2020