Don’t Believe Amity Shlaes (or Most Neo-Classical Economists): Obama’s Accelerated Depreciation Proposal Will Boost Economic Growth and Is a Good Idea
President Obama recently proposed letting companies (big and small) expense 100 percent of the cost of their equipment purchases made late this year and in 2011. It’s a good idea. It would be an even better idea if the expensing were permanent. Given the slow growth of capital equipment investment by U.S. companies, particularly manufacturers, in the last decade, the non-competitiveness of the U.S. corporate tax code, and the dramatic decline in U.S. manufacturing output and jobs (and corresponding chronic and enormous trade deficits), you’d think that both sides of the aisle would jump on this.
But you’d be wrong. As they say, “it ain’t over ‘til the economists sing.” And when the economists sing these days, that usually means the neoclassical economists who dominate Washington policy making. They have almost veto-like power against fresh ideas like this one. Case in point: in a recent Bloomberg op ed by conservative economics writer Amity Shlaes says that allowing first-year capital equipment expensing is a bad idea. Oddly, some Democrats are pointing to the piece to question the wisdom of the President’s proposal. Shlaes states: “In reality, Obama’s idea isn’t such a noble idea. Because the investment tax credit has been around in different forms since the 1950s, it’s possible to examine the record. When you do, you find not great success but uneven performance.”
Shlaes attacks the idea of first-year expensing with numerous spurious arguments and a couple that appear more solid. But upon closer look, these are fundamentally flawed as well. Among the spurious arguments are these. She says Obama’s proposal is bad idea because after Democratic Senator Lloyd Bensten pushed an investment tax credit in the early 1980s and ,“The results at first were disappointing… many companies failed to boost investment even with the credit.” But correlation is not causation. She goes on to note that “high interest rates offset any desire businesses might have had to exploit the tax break.” So the lesson from that story is not “don’t do an investment tax incentive.” Rather, it’s “do it and also make sure interest rates aren’t too high.”
She then complains that the incentive was costly. This is rich, coming from someone who is a full-throated advocate of cutting taxes on high-income individuals and cutting the capital gains tax rate, which are more expensive than expensing. Besides, even if the incentive is expensive, that’s partly the point! U.S. corporate tax rates are among the highest in the world. We need to get the effective tax rates lower. An investment tax incentive not only leads to a lower effective rate (e.g., costing money in the short term) it spurs productivity-enhancing and job-creating investment (raising money for the government in the long term).
She proceeds to quote economist Amar Bhide, who can be faithfully relied upon to not only criticize most policy proposals to spur productivity and innovation, but also to flat out deny that there is even a problem. Bhide opines to Shlaes with no apparent evidence to back up his claim that, “Virtually all good companies, young entrepreneurial companies find that development doesn’t fit eligibility rules (for expensing).” Let’s parse this for a second. So Apple, IBM, Merck, Ford, Maytag, Boeing, etc. are not good companies since they are not young and we should not care about the fact that an investment tax credit would help them create U.S. jobs? Second, they don’t fit the eligibility rules. Really? The eligibility rules are: 1) you have to invest in something, like a computer or a machine; and 2) you have to have some taxes to offset. Certainly, even Bhide’s “good” companies buy a computer now and again. And while start-ups often don’t pay taxes because they don’t have profits, not every policy has to apply to every company. By this logic let’s not have lower capital gains for investors in tech startups because companies like Apple, IBM, etc., can’t take them. Finally, continuing his illogic, Bhide claims that the benefits of investment tax breaks often flow to precisely those companies that shouldn’t survive: “To bad companies, auto and drug companies that pour money down a sinkhole.” Merck is a bad company I guess when they commercialized Gardisal, the vaccine against the cancer-causing human papiloma virus. Amazing! By this logic cutting the corporate tax rate would lead to the same result of having benefits flow to “the companies that shouldn’t survive”, since “bad” companies would also pay lower taxes. This is just corporate bashing masquerading as informed academic reflection.
Shlaes doesn’t just offer hers and others’ illogical musings. She attempts to provide more objective arguments against the President’s expensing proposal from none other than two of the President’s top economic advisors. The first critique comes from the President’s chief economic advisor, Austin Goolsbee. To be sure, Goolsbee wrote his critique when he was in academia, but she applies it question the President’s specific proposals. Goolsbee was skeptical about investment tax incentives because, “The benefit of investment tax incentives does not go to investing firms but rather to capital suppliers through higher prices,” as well as to wage increases.
But let’s look at what Goolsbee actually said. A central conclusion from his study was, ‘The evidence that investment is only modestly responsive to price has been one of the most robust findings of the empirical investment literature.” In fact, he later says that, “Investment demand is actually very responsive to investment tax policy” (“very” sounds more effective than “modestly”). But he goes on to say “but in the short-run the increased demand for investment mainly increases capital goods prices rather than quantities.” But the reason for this finding is this: Since all the investment tax incentive policies he was studying were short-term and not permanent, they led to short-term spikes in demand in capital equipment which capital equipment makers couldn’t fully meet, so prices went up somewhat.
Shlaes then goes on to cite another big Democratic economist gun: Larry Summers, head of the National Economic Council (soon to be departed). She quotes a study by Summers and Alan Auerbach that concluded, “We find little evidence that the investment tax credit is an effective fiscal policy tool.” Goolsbee concludes the same thing, “For policy makers interested in using tax policy to stimulate investment or, especially, to smooth business cycle fluctuations, the results are not promising.” In other words, a temporary investment tax incentive doesn’t do as much to spur growth and recovery as more direct means like extending unemployment insurance. But that doesn’t mean it still does not spur growth in the short run, and more importantly spurs it in the long run as well by making the economy more productive.
But Summers and Goolsbee are evaluating the impact of the incentive as a temporary incentive. That’s not the right way to judge these. The right way is on the long-term capital investment in plant and equipment from making expensing permanent. And here the evidence is that it would have a positive effect as both Summers’s and Goolsbee’s research actually finds. Goolsbee’s study shows that in the longer run the incentive effect is more significant and that the increased price increases diminish. Summers finds that an investment tax “credit will spur investment in equipment.”
If we are looking at the past writings of current Obama economic policy makers to evaluate the wisdom of President Obama’s proposal, it might be good to also look at one appointed by President Bush: Ben Bernanke. In a 1983 scholarly article titled “The Determinants of Investment,” Bernanke found that investment tax credits do spur investment. In fact, “a one percentage point increase in the investment tax credit raises net equipment investment 1.9 percent… in the first year.”
Not only do the incentives spur more investment, they respond to a market failure and boost economic welfare. Even most neoclassical economists will acknowledge that markets will not allocate goods in the marketplace efficiently if there are negative or positive spillovers. It turns out that investment in new capital equipment is rife with market failures, particularly spillovers. Companies only get about half of the total societal return from their investment in new capital equipment. Van Ark finds that the spillovers from investment in new capital equipment are larger than the size of the benefits ac crued by the investing firm. Hitt finds that the spillovers from firms’ investments in IT are “signifi cant and almost as large in size as the effects of their own IT investment.” Xavier Sala-i Martin finds that both equipment and non-equipment investment are strongly and positively related to growth, but that equipment investment has about four times the effect on growth as non-equipment investment (e.g., buildings).
So, given that the evidence is really that investment tax incentives work, correct market failures and boost economic growth, why aren’t Brookings, AEI and all the other bastions of neo-classical economics holding rallies on the mall in favor of this? One word: ideology. For the dominant ideology that trumps all other considerations for neoclassical economics is what is called “allocation efficiency.” In other words, the goal of good economic policy is to not get in the way of “the market” making decisions. By definition, a tax policy that gives a preference to investments in new capital equipment is in their world view “distorting” allocation efficiency.
Shlaes wrote that Summers didn’t favor investment tax incentives because they crowded “out non- favored investment.” Shlaes obviously concurs, saying, “so sure, investment tax credits are a wonder, but for what they suppress as well as what they create.” And just what did Summers worry was being suppressed? Housing! Let me say it again, Housing!
Summers writes, “while it is relatively clear that the credit will spur investment in equipment, its effect on other forms of investment in ambiguous. The credit will bid up interest rates… discouraging purchase of non-favored capital goods, principally structures” So Summers finds that investment incentives will boost GDP and boost equipment investment significantly, but reduce housing starts modestly. And that’s enough to violate the 1st Commandment of the neo-classical religion. Thou shall not distort allocation efficiency! So he was against it.
If it weren’t for the vast amount of pain and suffering imposed by the global financial crisis and economic recession caused by overinvestment in housing (and by under-investment in real wealth producing investment) this statement would be laughable. Instead it’s just tragic. We should oppose a policy that boosts growth and investment, particularly in manufacturing, because a few less houses are built? And because of the advice of Summers and most of the neoclassical priesthood at the time, Congress eliminated investment tax incentives in the faulty 1986 Tax Reform Act (while of course keeping the most important one for housing, mortgage interest deductabillty). So a reform based on the idea of simplifying the tax code and getting government out of the way, contributed to reduced investment in equipment, U.S. industrial decline, and the housing bubble. But thank god it reduced distortions.
Perhaps one should be more charitable toward these and other similar economists. After all they wrote these studies before the U.S. began to face fierce international economic competition. They assumed that U.S. manufacturing was healthy (it wasn’t) and that investment swings were cyclical (they are not) and that housing was just as valuable as machine tools (it is not). When measured properly, U.S. manufacturing output as a share of GDP appears to have declined by an astounding 30 percent in the last decade, as mercantilist countries such as China have gained market share. And lack of investment in the U.S. has been a key cause. U.S. manufacturers’ capital stock increased 23.1 percent from 1989 to 1998, but just 4.5 percent from 1999 to 2008. Finally, let’s hope no one can still believe that spending in housing is investment. It’s just capitalized consumption creating an asset that does not boost productivity or innovation. Investing in a new computer numerically-controlled machine tool, or in broadband telecom, or a host of other capital equipment and software investments, on the other hand, does boost productivity and innovation. Tax policy should explicitly and proudly “distort allocation efficiency” by favoring real investment.
So where does this leave us? First, we simply can’t listen to neoclassical economists if we want to extricate ourselves from the mess we are in. When they say things like, “boosting science, technology, engineering, and math education is industrial policy,” “computer chips, potato chips, what’s the difference” and investment incentives are bad because they favor capital equipment over housing, we know something is wrong. We have trillions of dollars worth of proof. Both parties need to bring in a new crew of economic policy advisors and makers who understand the real economy and who put innovation and productivity and competitiveness ahead of theoretical concerns with allocation efficiency.
