Sunday, August 20, 2006

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?

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18 Comments:

Anonymous 2slugbaits said...

Regarding investment tax credits you said: "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."

I don't think that's right. The usual argument is that investment tax credits MUST be short-lived and perceived to be temporary, or else they will be ineffective. The intent of a tax credit is to pull forward planned investment. For example, investment planned for 2007 gets pulled forward to 2006. If businesses believe the tax credit is permanent, then that would completely defeat the rationale for a tax credit. Investment tax credits do not add new investment, they simply shift the timing of planned investment. If the primary macroeconomic problem is weak investment demand, then tax credits could be useful. Of course, accelerating planned investment might only kick the can down the road by reducing next year's planned investment that was executed this year thanks to the tax credit.

Tue Aug 22, 09:59:00 PM EDT  
Anonymous mvpy said...

"OK, this really doesn’t have much to do with God."

Econ is pretty spiritual stuff. Ever heard of the invisible hand?
(BTW, the classical economists did believe that free mkts promoted morality, by making one committed to producing quality goods and working hard and so on. There.)

"even with the tax cuts, the hoped-for investment boom has not materialized during this business cycle."

But, I think investment is mismeasured. With falling quality adjusted price of IT, the relative price on inv has plummetted. Also, should R and D be counted as investment too, and not an expense. Do you know, incidentally, what happened with R and D? I think the entire investment issue is becoming less important. The knowledge worker isnt working with machines etc; hes innovating in labs etc. Thats why I think R and D share is worth watching.


"to create a strong incentive you need to reduce taxes permanently"

2slugbaits (awful name, isnt it?) is right vis a vis the tax credit - intertemporal substitution and all that - make hay while the sun shines. Get it, knzn? But with tax rates, youd be right since what were concerned with is the PDV of tax adjusted future returns.

"it’s impossible unless you break your promise by rescinding the tax cut."

Any gov commitment to any exp or tax cut is dynamically inconsistent today, given all hells gonng break loose in 15 years.

"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"

Im really delighted you calling for supply side tax cuts, knzn. And you know what, itd really mobilize the increasingly disenchanted Rep base for the elections. While tax cuts sound good to me, Im surprised youre not leaving it to the FED to clean up any mess. Anyway.

Tue Aug 22, 11:14:00 PM EDT  
Blogger knzn said...

2slugbaits, The line you cite referred not to the ITC but to cuts in taxes on investment returns (dividends and capital gains, etc.). My point was that direct incentives such as the ITC are more cost-effective because they don’t have to be permanent, and in fact, as you point out, they are more effective if they are temporary. I think, though, that even permanent direct investment incentives (such as the ITC) are more cost-effective than cuts in taxes on capital returns. Even if investors/businesses have confidence in the permanence of both incentives, the salience is higher for a tax break you can take today, and subjective discount rates may be quite high.

mvpy, The data for equipment and software in the national accounts is already supposed to be quality-adjusted. There is room for disagreement in both directions, I think, as to whether there is too much or too little quality adjustment. I don’t have data on R&D, but I’m pretty sure it’s not booming quite as much as it was in the 90s.

Regarding dynamic inconsistency, the coming Medicare crisis is all the more reason that direct investment incentives would be more effective. The government can’t make a credible promise to keep dividend and capital gains taxes down, but it can give people a bird in the hand, which will be all the more effective because the tax break can’t be trusted to continue.

Ordinarily I would leave things to the Fed, but there is the issue of the composition of demand. The Fed was able to stimulate demand for residential housing (and indirectly, consumption, which feeds off home equity), and maybe next time around demand for exports, but apparently it needs help when it comes to nonresidential investment.

Wed Aug 23, 10:04:00 AM EDT  
Anonymous 2slugbaits said...

Hmmmm...not quite sure what I wrote that led you to believe that. Sorry about the confusion. Maybe we are talking past each other and using terms in a slightly different way. I am not a particularly big fan of cutting corporate tax rates or capital gains. Not agin 'em in principle, but I think their effects in terms of stimulating demand is ambiguous.

MVPY...sorry you don't like my name. On the other hand, I was always taught to genuflect making the sign of the cross whenever I saw the letters MVPY. ;-)

Wed Aug 23, 06:47:00 PM EDT  
Anonymous mvpy said...

"The Fed was able to stimulate demand for residential housing (and indirectly, consumption, which feeds off home equity), and maybe next time around demand for exports, but apparently it needs help when it comes to nonresidential investment."

Knzn, my reading of the literature is that firms are very irresponsive to FED changes in int rates, which confirms what youre saying. But, I think its inaccurate to say the FED "needs help". Theres a persistent "myth" that monetary policy acts via investment incentives (by changing int rates), which is not true. Basically, most investment is internally financed in any case and not via bank loans. I think monetary policy mainly acts via wealth effects on asset prices. In addition, Im very dubious about the FED affecting the dollar; generally any effect is washed out by another billion things.
By the way, do you know what happened new business formation
past few years. Really, I think looking at equipment investment is a rather crude and prob outdated way of looking at business activity these days. Ill have to look up R and D...

Thu Aug 24, 01:47:00 AM EDT  
Blogger spencerengland said...

We have a great theory how investment is driven by interest rates.

The problem with this theory is that no corporate vice president
worth his salt ever proposes a capital spending project that does not promise at least a 25% or 33% or higher rate of return.
They just adjust the forecast level of sales or pricing needed from the new project to get the justified rate of return.

This really came home to me as an investors in the early 1980s when rates were at all time record highs
and I would attend corporate presentation after corporate presentation and be told time and time again that the high rates did not impact their investment plans.

What drives corporate investment is the optimistic belief that they will be able to sell the new output at a profit and that is generaly driven by current profitability.

Thu Aug 24, 09:58:00 AM EDT  
Blogger JTapp said...

Maybe I'm too simple-minded. Wouldn't your approach lead many households to start at-home businesses so they could continue to buy things (new homes, cars, computers, etc). and write it off on their taxes?

Thu Aug 24, 10:49:00 AM EDT  
Anonymous mvpy said...

Knzn, this is from Larry Kudlows blog today (so we mightnt need your ITC, after all):

"Spurred by record profits and low tax rates on capital, business other than the ailing Ford and GM looks really strong. Major categories of new orders, shipments, and unfilled orders for non-defense non-aircraft capital goods surged in July at a double digit annualized pace. Over the past year, orders are up 13 percent, shipments increased 10 percent, and backlogs rose 14 percent. These are very big numbers."

Thu Aug 24, 12:37:00 PM EDT  
Blogger knzn said...

JTapp, The problem you cite already exists, in that people can write off depreciation, as well as the cost of nondurable goods and services purchased supposedly for a home business. Yes, the incentive I suggest would exacerbate the problem, but on the other hand, it would also simplify bookkeeping for legitimate home business expenditures. Legally, though, if you only use something partly for business, you’re only supposed to write off part of it, and that requirement presumably wouldn’t change; it’s just that there would be more of an incentive to cheat. The incentive for cheating is an oft-cited disadvantage of targeted tax incentives, but I still think it is outweighed by the advantages.

mvpy and spencerengland, I think you are overlooking “Tobin’s q” which is essentially like an inverse interest rate. Although firms’ response to interest rates directly may not be dramatic, the level of stock prices does affect their ability to raise money for new investment, and the level of stock prices, conditional on expected returns, is determined in large part by how the Fed sets interest rates.

mvpy, I think a lot of the observed demand for capital goods may be for export rather than domestic investment. The rest of the world is now growing quickly, and compared to the currencies of other capital goods producers (e.g. the euro) the dollar is relatively weak (at least compared to where it was last time the world was growing quickly). Export demand is good, especially if it spurs investment in additional export capacity, but I think it wouldn’t hurt to give that investment a bit of a push. (Note that we also got a weaker than expected housing number today, which suggests there will be more resources available to satisfy investment demand.)

Thu Aug 24, 01:45:00 PM EDT  
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