THE PAST DECADE HAS seen an unusual pattern of investment. The boom of the 1990s generated unusually high investment rates, particularly in equipment, and the bust of the 2000s witnessed an unusually large decline in investment. A drop in equipment investment normally accounts for about 10 to 20 percent of the decline in GDP during a recession; in the 2001 recession, however, it accounted for 120 percent. (1) In the public mind, the recent boom and bust in investment are directly linked due to overhang. Although the term is not very precisely defined, this view generally holds that excess investment in the 1990s, fueled by an asset price bubble, left corporations with excess capital stocks, and therefore no demand for investment, during the 2000s. The popular view also holds that these conditions will continue until normal economic growth eliminates the overhang and, consequently, that there is little policymakers can do to remedy the situation, by subsidizing investment with tax policy, for example. Variants on this view have been espoused by private sector analysts and economists, (2) and the notion of a capital overhang has certainly been on the minds of leading Federal Reserve officials and researchers. (3) Whether or not a capital overhang is the true explanation of the investment bust, it is clear that the drop in investment has motivated policymakers to try to stimulate investment through ambitious fiscal policy changes. (4) Under President George W. Bush, depreciation allowances for equipment investment have been increased twice, in 2002 and 2003, and in 2003 the tax rate on dividend income was cut sharply and that on capital gains income more modestly. These measures were mainly intended to increase after-tax returns and stimulate investment. The typical analysis of the investment collapse and policy response is summarized by the Republican chairman of the Joint Economic Committee: Excessive and bad business investments made during the stock market bubble have taken years to liquidate. In nine of the 10 quarters beginning with the fourth quarter of 2000, real business investment has declined. Fortunately, recent tax legislation signed into law in 2003 should promote business investment by increasing the after-tax returns from investing in capital assets and alleviating financing constraints among small and medium-size firms. (5) Yet, after several years of tax cuts, investment has still not risen impressively compared with previous recoveries. This contrast has reignited claims that tax policy is ineffective at stimulating investment, although some make the more specific charge that tax policy is impotent when it follows a period of excessive investment. This paper examines the evidence on the two related issues of capital overhang and taxes using data at the industry, the asset, and especially the firm level. Specifically, we address two questions: first, did over-investment in the 1990s cause the low investment of the 2000s, and, second, did investment in the 2000s become less sensitive to prices, and does this explain why tax policies, specifically the equipment expensing and the dividend tax cuts of 2002 and 2003, seem to have been ineffective in restoring investment to normal levels? We begin by examining the degree to which growth in investment during the boom was correlated with a decline in investment during the bust across different assets and industries. There are, of course, many possible definitions of overhang or excess investment. We will not try to show that there was no overoptimism in product or capital markets. Clearly equity prices rose substantially and then fell, as did investment rates. Instead we investigate whether investment grew the most in those assets and industries in which it subsequently declined the most. We want to know if any aftereffects of the investment boom of the 1990s persisted into the 2000s--whether firms behaved differently because too much capital remained from the investment decisions of the 1990s. …