Capital Tax Reforms With Policy Uncertainty

One important feature of capital tax reforms is uncertainty regarding their duration. We use the Bush Tax cuts as the leading example to illustrate how uncertainty about reform duration may affect the economy’s path and erode political support for the reform. We model policy uncertainty by assuming that the reform may be either repealed or made permanent with some probability at a predetermined date. We show that policy uncertainty is a critical ingredient that can explain why the Bush tax cuts had no economically significant effect on investment, as confirmed empirically by Yagan (2015). While the permanent reform leads to positive aggregate welfare gains on impact, policy uncertainty may reverse this result. These observations hold both in a model with a representative firm and heterogeneous firms, but adding firm heterogeneity generates an interesting implication. In contrast to the permanent reform, policy uncertainty increases the TPF since it dampens investment by mature, less productive firms.