God and the Investment Tax Credit

OK, this really doesn’t have much to do with God. The title is taken from that of a sermon by a (fictional) televangelist on an old sitcom. (I think it was Hail to the Chief, but I’m not sure, and I may have gotten the quote wrong, too.) I do think, however, that every good Christian (as well as every good Jew, every good Muslim, and for that matter every good atheist) ought to consider the importance of investment incentives at this point in the business cycle.

In my last post, I rather pooh-poohed investment incentives (“…the tax cuts were not irresponsible enough”), and I am rather skeptical about incentivizing investment by reducing taxes on the returns to investment. For one thing, I’m skeptical about the effectiveness: even with the tax cuts, the hoped-for investment boom has not materialized during this business cycle. (Contrast the last business cycle, which began with a tax increase.) Second (which is really the same thing), I don’t think these types of incentives are cost-effective with respect to lost revenue: to create a strong incentive you need to reduce taxes permanently, since the assets involved are long-lived; after a few decades, the revenue loss adds up. Finally, that very permanence means that it is impossible to put the genie back in the bottle if we encounter (like China today) a condition of overinvestment. Well, it’s impossible unless you break your promise by rescinding the tax cut. (I’ve never been a fan of policies that are known in advance to be dynamically inconsistent.)

So I favor, instead, direct investment incentives (hence the title of this post). Actually, rather than an investment tax credit, my preference would be for something like unlimited expensing, which is much more straightforward: when you buy something for your business, you can deduct the cost from your taxable income, period. But my point is that now is the time to do it. Instead of waiting for a recession before starting the legislative process, so that the tax cut goes into effect just in time for the recovery and the result scares the Fed into slowing down that recovery, pass the investment incentives now. (Hey, Republicans, do it while you still have a chance!)

The best case scenario, from the point of view of timing, is that we are poised to go into a recession at just about the time when the incentive would take effect. In that case, the incentive provides both a well-timed Keynesian stimulus to use up slack resources and an inducement to divert resources toward more prudent use. The worst case is that we are going into an economic boom, and the incentive exacerbates the boom. We should have such problems…but we won’t, I’m pretty sure. Realistically, the worst case is that we push this recovery just a little bit too far, and the Fed has to keep raising interest rates for longer than expected. Boo-hoo for the housing market, but if the excess demand goes into nonresidential investment and increases our long-term productive capacity, I won’t be crying too much.

In a worst-timing-case scenario, investment incentives could exacerbate the trade deficit by encouraging businesses to use up more of their savings, forcing households and government to borrow even more from abroad (if, as the worst case assumes, households refuse to start saving). In the longer run, however, investment incentives could help reduce the trade deficit, particularly if the timing turns out (as I expect) somewhat better. As Andrew Tilton of Goldman Sachs (channeled through The Economist and Brad Setser) notes, increasing exports will require increasing export production capacity. If we want to increase exports (and surely we do), why not make it easier for firms to increase capacity?