January 18, 2008
More Thoughts on Fiscal Stimulus: Business Incentives
What does the literature say about the efficacy of incentives for investment?
It's a good time to teach macro, as there's almost limitless material (for instance, one could have students critique the President's principles, here) being provided by the ongoing debate over the desirability (see Jim's post) and optimal structure of a discretionary fiscal stimulus (see my previous post).
One of the proposals I've heard mooted is for accelerated depreciation for capital investment (see ; ). There's no doubt that there's trouble coming on the investment front, given that nonresidential investment typically lags residential (see this post on timing).
Figure 1: Level of investment in equipment and software (blue), fixed investment (red) and nonresidential investment (green), in billions of Ch.2000$. NBER-dated recession dates in gray. Source: BEA, Dec. 20, 2007 NIPA release, and NBER.
Figure 2: Growth rate of investment in equipment and software (blue), fixed investment (red) and nonresidential investment (green), in billions of Ch.2000$, calculated as 4 quarter changes in log levels. NBER-dated recession dates in gray. Source: BEA, Dec. 20, 2007 NIPA release, NBER, and author's calculations.
As discussed in earlier posts (e.g. here, while business fixed investment has held up even as residential investment has collapsed, it is unlikely that such (relatively) strong spending will persist.
So, ideas to enhance investment spending sound good at first hearing. However, I think it's useful to revisit more recent thinking about investment behavior and tax incentives. From a May 2007 post entitled "Is the "Investment Disconnect" So Surprising?":
In a recent Brookings Papers on Economic Activity, Mihir Desai and Austan Goolsbee (2004) argue that earlier attempts to fit q-theory specifications to the data were hampered by adherence to a traditional view of how new investments were financed:
The investment model typically estimated in the literature follows the traditional view. In this view dividend taxes influence investment by, essentially, doubletaxing corporate income...
...Under this assumption, net new equity finances investment, so that investment is determined by the point at which shareholders are indifferent between holding a dollar inside or holding it outside the firm.
...If, however, retained earnings are the marginal source of finance, the traditional investment-q relationship ... will not hold.
In this view dividend taxes do not influence the tax term for marginal investments. Instead they are fully capitalized into existing share prices. In other words, changes in dividend taxes serve solely as a penalty or windfall on existing firm values. To see the intuition behind this, consider a firm that uses retained earnings at the margin to finance investment, with dividends determined as a residual. In this model dividends are the only means of distributing earnings to shareholders. In this setting, given that retained earnings are the marginal source of financing, investment is determined by the point at which shareholders are indifferent between receiving a dollar today as a dividend...
So, when q is properly measured, Desai and Goolsbee find it, as well as a tax measure, has a greater impact on investment. It is therefore instructive to examine the evolution of q, and the tax variable (where lower values of the variable indicate a lower tax burden).
q declines post-2001; no surprise. What is surprising -- at least to me -- is that the tax burden declines so little after 2001:This relatively small effect stems from several factors. First, the value of an acceleration in depreciation allowances is a function of the corporate tax rate: with corporate tax rates already lower than they were in previous decades, altering depreciation schedules has a more muted effect. Second, the well-documented shift of investment toward computers and other equipment with shorter lives has meant that accelerated depreciation provides less relief. The average net present value of depreciation allowances for equipment investment in 2001 was already approximately 90 percent of the investment value even before the tax cuts, suggesting that even complete expensing (raising the net present value to 1) would provide limited additional benefit. Given the smaller magnitude of the 2002 and 2003 cuts, it is unsurprising that such incentives could not overcome the dramatic drop in investment induced by the remarkable drop in q over the period. Our estimates suggest that these incentives do work as they are designed, but that their magnitude is simply too small to counteract the aggregate trend.
One implication of the "new view" is that the tax breaks meant to spur investment ended up being essentially a pure windfall to firms, given the small increment induced in investment. (For a contrasting view, see the comments by Kevin Hassett).
This tells me that, if we are to maximize the "bang for the buck" of fiscal stimulus, we want to look hard at how effective business fixed investment incentives are likely to be.
While accelerated depreciation might not make much sense, the authors did observe the following:
... Such a change [in q in recent times] is modest compared to changes like the investment tax credit of 1962, the restoring of the [investment tax credit] in 1971 or the Reagan depreciation allowance increases of 1981, all of which changed the overall cost of capital by around 0.10. .... Recent changes in investment incentives have been modest by historic standards. [text inserted by mdc]...
My interpretation of this text is that not all tax incentives are created equal in terms of spurring investment. An investment tax credit might have a different impact, quantitatively. To the extent that the ITC is temporary, it could reallocate planned investment forward. But real public finance types might be able to say in greater detail whether my conjecture is right or not.
There is a separate question of whether tax rebate induced multipliers or an ITC-induced business fixed investment multiplier is larger.
Posted by Menzie Chinn at January 18, 2008 11:20 AMdigg this | reddit
It might be worth noting that an investment tax credit can be more costly to the federal budget than accelerated depreciation. The latter merely postpones the collection of tax revenues while the former forgoes the revenues forever. But as your post points out, cheaper does not necessarily mean better.
Posted by: Joseph at January 18, 2008 04:34 PM
Menzie, I think the Y2K effect has to be factored in to the equipment/Software investment cycle. Most of the Y2K upgrades were done by the first half of CY 99. With a 3-5 year life cycle it is normal for the replacements to start in 02. What was different about Y2K investment was we had never invested in a complete inventory replacement in such a short period. I can not tell from your charts, but the Y2K investment should also have lowered/flattened the fixed investment. Y2K caused a serious perturbation in hardware/software investment which I think we will feel for some time forward with cycles.
As to the investment credits, then in 02, a year earlier than normal, we should see some increase in overall fixed and hardware and software investments. And I believe your charts may bear this out. So for one set of equipment (computer H/W and S/W) a tax incentive would be of little value as most had just been upgraded, again perturbing the investment cycle.
Posted by: CoRev at January 18, 2008 05:23 PM
Closing out that thought, it may be a bad period to use to compare investments and tax credits, as there was a perturbation in the force.
Posted by: CoRev at January 18, 2008 05:25 PM
CoRev, the point of the Desai and Goolsbee paper is that for computers and hardware, the depreciation life of 3 to 5 years is already so short that accelerated depreciation offers little incentive to upgrade. But an investment tax credit is an opportunity to get new computers and software for free even if the current equipment is only a couple of years old. That makes the investment credit a much more powerful incentive to upgrade.
Posted by: Joseph at January 18, 2008 07:00 PM
Joseph, I understood the point. My point was that the need and even the desire to upgrade computer H/W and S/W had been assuaged by Y2K investment; therefore, even investment tax credits were of little value until the 3-5 year window had passed.
The leveling in spending for computer products starting in 99 was a major factor in both bursting the tech bubble and exacerbating the oncoming slow down. It might have made the difference to turn a slow down into a recession. I dun'no. Just saying.
Posted by: CoRev at January 19, 2008 05:31 AM
CoRev: Am a right in interpreting your comments as concurring with the view that in current circumstances, an ITC would be more effective than accelerated depreciation, given the shift in overall equipment spending toward short-lived ICT equipment and software, and the fact that it has been eight years since the Y2K upgrading process?
Posted by: Menzie Chinn at January 19, 2008 03:20 PM
Menzie, that's what I believe. We still have a large inventory of relatively newer equipment.
The more expensive equipment has always had a longer life cycle, and it is easy to delay decisions on investment when it is based upon accel. deprec. An ICT should give a known benefit versus betting on making a profit big enough to take advantage of the accel. deprec.
My main point is Y2K was a hidden (or at least not frequently credited) contributor to the 2001 recession.
Posted by: CoRev at January 19, 2008 04:39 PM
Mark Thoma has an interesting discussion about the consumer spending leg of the stimulus plan. Bruce Barlett makes the point that tax rebates are an inefficient stimulus since many people will use it to either pay their mortgage or pay down their credit cards. Mark offers the suggestion that a better plan is direct government spending. Since it would take a while for federal spending projects to gear up, a faster way is grants to the states. Most states already have public projects in the pipeline or already started that have been put on hold because of the economic downturn. The fastest way to ensure 100% spending is to make sure these state and local projects continue.
Posted by: Joseph at January 19, 2008 06:17 PM
Menzie says, "My interpretation of this text is that not all tax incentives are created equal in terms of spurring investment..."
But I would say the proposition is self-evident.
It would be wholly unsurprising if dropping dividend taxes did not simply lead to a windfall for firms. The firms are paying shareholders to hold the shares, so that the firms don't have to issue debt. Lower taxes and the companies can pay out a smaller amount to deliver the same after-tax reward. If the shareholders are paying a higher effective rate than the companies, the companies can keep the extra.
By contrast, an R&D investment tax credit at least forces the firms to do something. They may build a golf course and label it a manufacturing support facility, but they have to spend some money.
Posted by: Charles at January 19, 2008 08:42 PM
Charles: It would seem self-evident, but one certainly doesn't hear much about ITC vs. accelerated depreciation in the ongoing debate, so I thought it useful to highlight this distinction. In addition, if one were to use a static model (not recommended for analysing investment decisions, I grant you), the differential effect would not necessarily be highlighted.
Posted by: Menzie Chinn at January 19, 2008 10:16 PM
The Stimulus Package Will Backfire
Inflation has two causes, too much money chasing too few goods and the rising cost of broadly relied upon commodity (such as oil... or taxes). The latter, though it drives prices up, like excess taxes, creates recessionary pressure that can later result in recession. For a while the rising cost of oil didn't seem to impact our economy because there was enough momentary excess funds (albeit paper gains of rising real estate an stocks), but those "funds" have been depleting, ultimately hitting homeowners hard enough to affect foreclosures, in turn, real estate prices and mortgage backed securities. Incidentally, the same strategy of risky mortgages repackaged as securities is, was, a worldwide practice, making the crash in that market also worldwide.
Inflationary prices plus a recession is called "stag-flation" and as in the early 80's also accompanied by a weak dollar. A weak dollar is caused by too many dollars circulating overseas - petrodollars, tourist dollars and the result of our spending on imports. Greenspan handled it the early 80's by tightening credit, essentially wringing those excess dollars out of the world economy, repatriating them back in the U.S. by way of U.S. government securities. In the 80's our stag-flation began to ease when other governments had to begin raising interest rates on their government securities to compete with interest rates provide by the U.S. That process resulted in the longest period of U.S. economic stability, ever.
However, true to its thought disorder form, this administration is simply trying to solve a problem by throwing money at it; sounds good, good P.R., but it will exacerbate inflation pressures by adding money to the inflationary fire, just what oil companies would like, more money for oil...
High interest rates is a bitter pill to swallow, but it is not permanent; spending on business expansion, real estate prices and new home sales will be kept low for a couple of years. More importantly though, it will also drive down the price of oil, the main inflationary factor. It is a necessary step to stabilize and re-sync our currency and economy with that of the rest of the world.
Posted by: Elliot Siemon at January 20, 2008 01:18 AM
"The fastest way to ensure 100% spending is to make sure these state and local projects continue."
Oh, no need to worry there. Legislators love pork.
Since it appears that self-regulation has failed how about an apolitical regulator emerge that helps monitor the mortgage lenders? (It's not all their fault; some blame falls squarely on the borrowers.)
How about cutting the payroll tax by phasing out Social Security? Maybe lower corporate and personal tax rates?
Above all else how about cutting spending?
Posted by: Babinich at January 20, 2008 08:35 AM
Elliot: I completely agree although one shouldn't just blame the administration - there are plenty of other mistakes that they are far more culpable in. This is yet another example of the old Walt Kelly saying that we have seen the enemy and he is us. Americans want and are used to quick, painless solutions even though many us know that most solutions are neither. There will be some sort of quick, bi-partisan, "painless" (and ultimately valueless) gov't plan. Then in a few short years these problems will have compounded and we will be facing something a lot worse than a little recession. I state again: the next president will be one term no matter which party and we will be in deep, deep kimchi.
Posted by: Footwedge at January 20, 2008 08:49 AM
Thank you, Baninich. I agree, the American public looks for quick, painless fixez. But also a correction: it was Volker who raised the interest rates in the early 80's. Whether the next pres' is a 1 term wonder... depends upon numerous factors. If the "stimulus package" messes things up too much the economy can be so messed up, almost any effort at correction can create further problems and take a long time (we shall see how long...) to be straighened out.
Posted by: Elliot Siemon at January 20, 2008 06:51 PM
I am not a proponent of the Keynesian theory that you need to "prime the pump". The pump is primed; people and especially the government know how to spend.
What these people, and this government, does not know how to do is save.
I stand firmly in Edward Prescott's camp.
This means that we should stop focusing our attention on tax cuts.
We should focus our attention on cutting tax rates and cutting expenditures.
Posted by: Anonymous at January 21, 2008 03:15 AM
Bush's fiscal stimulus package? How about the overseas signing bonus & combat salary of each soldier in Afghanistan & Iraq? [sic]
Posted by: Flow5 at January 21, 2008 07:17 AM
The only thing "untouchable" from an economic standpoint in the Federal Budget is interest.
Posted by: Flow5 at January 21, 2008 07:19 AM
My interpretation of this text is that not all tax incentives are created equal in terms of spurring investment.
You could have knocked me over with a feather. This statement is closest to a supply side statement that I have seen posted here. Thanks Menzie.
Posted by: DickF at January 21, 2008 11:03 AM
10 year is down to 3.65%.
Stimulate away! Why not, with borrowing costs so low, we would be fools not to back up the truck with rebates and all kinds of other nonsense.
Actually, I think that President Bush is second to none when it comes to throwing bones to every constituency under the sun. Rebates? Sure. ITCs? Why not? Accelerated depreciation? Go for it. Extended unemployment benefits? Yes, please.
Throw some marginal tax rate cuts in there for the heck of it, and he's got everybody covered!
Posted by: Buzzcut at January 21, 2008 12:36 PM
DickF: I think virtually all PhD economists trained in a US research university will be a supply-sider to the extent that we believe that incentives matter. Macroeconomists who believe in a vertical or near vertical long run aggregate supply curve are also supply siders, to the extent that equilibrium output is given by the intersection of LRAS and Aggregate Demand in the long run. Where the disagreements come is in the views regarding the elasticities, i.e., the elasticity of labor supply with respect to tax rates, the elasticity of capital investment with respect to the user cost of capital, etc. (Believe it or not, this was the point of my first term paper on macro, 25 years ago, in critiquing the Reagan program.) In fact, one could believe in a low long run elasticity of the capital stock with respect to user cost of capital, and yet believe that an ITC could reallocate the timing of investment either forward or later.
Posted by: Menzie Chinn at January 21, 2008 02:09 PM
Does the sum of purchasing power decrease due to mortgage interest rate resets, and, the increase in purchasing power due to walking away from one's mortgage add up to an increase or decrease in aggregate purchasing power?
How does this compare with a $150b stimulus on the demand side?
Posted by: Stephen Calhoun at January 22, 2008 04:42 PM
What you have outlined here seems to include elements of more widely applicable observations about tax changes. One is that at lower rates, changes in tax policy will generally have less impact. We should be cautious when were are instructed by tax-cut proponents that Kennedy did it (making it respectable for liberals, I suppose) and that it worked. What were the rates from which Kennedy's cuts were made? Higher that today's I believe. Higher than the rates from which the early Reagan cuts were made, as well.
The other is that, in terms of fiscal stimulus, cutting corporate tax rates is a repeatable stragegy only if the cuts are temporary. If permanent cuts are employed to cure cyclical problems, you soon lose the tool. As my first paragraph argues, you lose the tool well before you eliminate corporate taxes altogether, because tax cuts from very low rates provide very little incentive.
Posted by: kharris at January 25, 2008 12:16 PM
By the way, I think we are doing the language a disservice when we attribute to "supply-side economics" standard textbook views. In understand that there can be "supply-side policies" in a purely objective sense, but I am not so sure about "supply-side economics". If I recall that first chart in the high-school econ text, there were two lines. On labeled "S" and the other labeled "D". That represents, in the broadest terms, the study of economics. "Supply-side economics" is missing one line, and is not economics at all. There is a supply side to economics, just as there is a demand side, but nothing like "supply-side economics" in reality.
The term is a term of faith, a label used to sell belief in a set of policies which, taken to the extremes to which they were taken, had no support in theory or data. Agreeing that some reasonable conclusion is a supply-side policy it tricky, but true. Calling them "supply-side economics" taints notions of legitimate economics with the voodoo of supply-side religiosity.
Posted by: kharris at January 25, 2008 12:30 PM