CAPITAL TAX REFORMS WITH POLICY UNCERTAINTY

One important feature of capital tax reforms is the uncertainty regarding their duration. In a standard heterogeneous firm framework with financial frictions, we model policy uncertainty by assuming that reforms may be either repealed or maintained with some probability every period. We illustrate the effects of policy uncertainty in the context of the 2003 Bush tax cuts (2003 Job Growth Tax Relief Reconciliation Act), which lowered shareholder taxes. We show that policy uncertainty regarding dividend and capital gains taxes can explain why the Bush tax cuts had no statistically significant effect on investment, in line with the empirical evidence.