Académique Documents
Professionnel Documents
Culture Documents
October 1993
*Research Associate of The Jerome Levy Economics Institute and Associate Professor of Economics, Washington University in St. Louis.
I. Introduction
Investment accumulation,
is key to policy analysis for at least two reasons. First, it is the source of capital and therefore a major determinant of both the economys long-run output capacity of aggregate
has been the subject of much economic research over past decades, policy debate. Of late, discussions linking policy and
have been near the top of the policy agenda, most importantly
held view that the federal budget deficit competes for the scarce pool of private saving and raises interest rates. The concern therefore crowd-out that higher interest rates will increase is, for many economists firms cost of capital and
private investment
and policymakers,
the primary
reason for cutting the federal budget deficit. Also, the concern that higher deficits will weaken investment response in the long run has handcuffed to the 1990s stagnation. proposals to employ stimulative fiscal policy in
although
economics
in some circles.
investment,
benefit the entire economy by increasing output, improving labor productivity, Indeed, the Bush administration
lobbied for a capital gains tax cut on the basis of this reasoning. for capital gains by raising the tax rates on the
wealthy for labor income, while keeping the top marginal tax rate on capital gains income at 28 percent. The direct beneficiaries who save substantial of such tax initiatives, however, may well be wealthy taxpayers
These influential policy positions take for granted that the cost of capital-appropriately for taxes and inflation-is importance a fundamental (if not the fundamental) determinant
adjusted The
of investment:
economic
theory predicts a link between capital costs and investment, does not make any quantitative empirical work has addressed predictions
This paper analyzes the existing literature on investment the economic foundations
of current policy debates. I find that the largely exclusive emphasis on is unjustified. The evidence shows that interest of investment
rates and the cost of capital play a small and uncertain role in the determination when compared with the strength of firms financial condition
Furthermore, fastest-growing
the determinants
of investment
of the
by reduced
economic
benefits little from lower interest rates. One must pay attention to this heterogeneity
The policy lessons of these findings are developed In summary, I emphasize three major points:
determinant
of investment
The indirect
impact of taxation and spending initiatives on overall economic effect on investment than the influence
effect of government
is likely to be small. Moreover, in the current weak economy, increases and government
to investment is more
that occurs from falling interest rates. Therefore, likely to reduce investment simulation Table 21.
in todays economy,
deficit cutting
is supported
firms. Accelerated
credit are examples of this kind of policy since they not only reduce the cost of capital, but also increase firms cash flow. Tax changes designed this sense. Therefore, They must work solely through to increase saving, however, the empirically costs of regressive weak are not robust in channel. to raise
cost-of-capital (designed
tax reform
explores
the determinants
of private investment
of policy
on
at least briefly,
before the
Historical
has been weak in recent years. In spite of the fact that the second widely thought to be more severe investment relative to GDP averaged 6.3
recession-gross
percent less from 1987 to 1992 than it did from 1980 to 1986. Its level in 1991 and 1992 was below the trough reached conclusions. following the 1981-82 recession. 2 Other measures lead to similar
For example Harris and Steindel (1991, p. 6) report that net capital supplies from
both foreign
and domestic
sources dropped
1953-79 to an average of 4.0 percent of GNP from 1980-89. (Their figures for domestic supply alone were worse, dropping from 7.2 to 3.0 percent of GNP for the same period.)
agreement
across the political spectrum that policy should attempt to boost over the optimal means to pursue this goal. The Reagan and economic growth by lowering
to increase investment
U.S. productivity growth is thus to be found...in the capital markets. To raise the rate of productivity growth, the national rate of investment should be increased (Economic Report of the President, 1992, p. 93, emphasis in the original). During the 1992 presidential campaign, even
Democratic candidates Bill Clinton, Paul Tsongas, and Jerry Brown embraced capital gains tax fiscal
and wages have lagged (1991, p. 150). Murray Weidenbaum, Advisers during the Reagen administration, equipment
for manufacturing
(quoted by Youngblood,
investment
must
Suppose output is given at a constant level. Consequently, involves the sacrifice of some goods or services that could
an increase of investment
have
been used
for current
consumption.
It is not entirely
obvious,
therefore,
investment sufficient
is good. That is, the future benefits to society from higher investment to justify the sacrifice of current consumption.
private investment.
continues resources.
goods, these businesses will increase production will rise, causing an increase in the demand
stimulating effect
and employment
(what economists
will propagate
through
Therefore, investment
A longer-term
concern
that the U.S. would benefit from higher predicts that the ratio
private investment.
workers who pay social security taxes will rise from 1991, figure 6). This widely discussed will either greatly increase the burden
0.3 in 1990 to 0.5 about 40 years later (see Carlson, change, caused by the aging of the baby-boom generation,
borne by future workers to support retirees or lead to substantial retirees. potentially the social composition: Much has been written serious intergenerational security problem,
conflict in the next century. The popular understanding is clouded by what economists call a fallacy
however,
in essence, incorrectly
concluding
applies to the
society as a whole. The obvious remedy for an individual is to save while working retirement. Through and then to use accumulated
their personal saving, people see themselves from their individual perspective
transfer of the actual goods that retirees want to consume occurs in the society taken as a whole. Baby-boom retirees will want to drive nice cars, eat good food, and consume No one accumulates high-quality stocks of such
medical care that will be the products of the future economy. goods in massive warehouses and third decades consume planning
to take them out for use when they retire in the second The goods and services that the baby boomers of society. will
production
The best thing, therefore, that we as a society can do today to provide for the retirement baby boomers is to enhance the ability of the economy to produce
of the
future. This objective requires higher investment the downward trend of investment
that economic
of Investment?
To understand
with investment,
of investment
academic literature on the subject can be divided into three broad categories: interest rates and various tax effects), output or sales variables, and in some detail.
work (Meyer and Kuh, 1957, for example) In the 1960s however, in the economics
emphasized
of the
determinants.
Dale Jorgenson
developed
view of investment
mainstream:
the neoclassical
model
1971, for a survey). This theory is most widely used to illustrate a link between underlies most current policy
analyses of investment.
According decisions
model,
investment,
and production
their profits (more precisely, the present value of profits over time). The arise from market prices (which they cannot and technology (which determines affect under of
assumptions)
the amount
framework,
then, investment
is determined
by technology
affects relative prices. In principle, other input prices, for example), capital. In economists sinking money
the opportunity
owners
investment. momentarily),
In a simple world without taxes on capital income the two components of this sacrifice are reasonably
(an assumption
we shall relax
new machine tool for $100,000 rather than paying out these funds to its shareholders.
of equity will sacrifice the return they could have received by putting these funds into financial assets. This opportunity anticipated inflation. cost is usually measured by the interest rate adjusted for risk and
In addition,
likely to fall as it wears out from use and becomes obsolescence Assuming
technically
are also part of the sacrifice the firm owners make when the firm buys the machine. it will purchase the machine for
shareholders
to profits, determined
by the
interest rate is 5
if it adds
In this simple environment, rates or the productivity technology, government framework However,
policy effects are limited. Policy can do nothing about depreciation of capital, which are usually thought to depend on the exogenous forces heavy
policy
deficit
interest rates can rise.3 Therefore, the neoclassical Monetary policy may also affect interest
on capital income. On the one hand, corporate profits generated by capital investment to the corporate income tax. On the other hand, capital investment creates depreciation
that reduce corporate taxes: For most of the period from 1962 until the Tax Reform Act of 1986, investment further reduced corporate taxes through a special subsidy called the investment made by firms that finance their investment who provide equity finance tax with for
paid to shareholders
cannot be deducted.
Even personal taxes can have an impact on the cost of capital shareholders. For example, the literature has
10
can be integrated
above is modified to predict that firms will invest in a new factory or machinery
value of such a project exceeds the after-tax cost of capital. These tax effects introduce lever for policy to affect investment. Changes in depreciation
of capital gains, to name two examples capital and potentially affect investment.
This discussion
of the neoclassical
investment
most versions assume that firms can purchase all the inputs and sell all the output they want to at given prices (firms operate in perfectly competitive have sufficient funds to finance a desirable investment markets). In addition, if firms do not project themselves, the model assumes
that they can obtain all the resources they need externally by issuing new shares at a fair market price or by borrowing assumptions analysis, at an economy-wide interest rate. There is little doubt that these strong question for policy adequately This question
are violated
to some degree in reality. The more important a theory based on these assumptions
however,
is whether
nevertheless decisions.
by empirical
theory immediately
encounter
on the theory links the cost of capital effect with variables that measure firms output or sales
11
through the cost of capital and interest rates. Section IV of some of this uncertainty.
that they can sell all they want to at the given market price. The only arise from their technology does not adequately and market prices. This
however,
Typically,
firms have at least some control over the price they for
charge, and the sales they can make at a given price are limited by the strength of demand their products. In these conditions, one would expect that firms expectations
in the recent past, will likely cause expectations the incentive to invest in new productive
capacity. Low sales growth will reduce the incentives successful investment
to invest. This intuition underlies one of the oldest and most empirically models (going back at least to Clark, 1917): the accelerator.
investment
12
results.
As mentioned
previously, model
effects
have clouded
the
evaluation
of the neoclassical
versions
of the neoclassical
approach allow the cost of capital to affect investment sales or output. Therefore, one often cannot determine
only through variables that also include the separate impact of sales and the cost importance of these
of capital from this research, and it is difficult to evaluate the independent channels for policy analysis.
the separate effects of sales and the cost of capital for (1991, p. 14) writes, although
empirical results with versions of the neoclassical model differ widely, they suggest to this author that output (or sales) is clearly the dominant of capital] assumption, magnitude having a modest effect. determinant of investment spending with the [cost implicit
Therefore,
largely unquestioned
likely to arise from deficits or tax reform will have an important effect on investment. evidence to address this problem is presented in Section IV.]
[New empirical
If sales dominate
of investment,
in part by the general health of the economy, spending summarized the influence are significantly previously. different from
then the links between fiscal policy and capital the policy implications of the orthodox working model through
of taxation on aggregate spending and firms sales, may dominate the direct effects through deficit
of taxes on the cost of capital. In other words, the damage done to the economy
13
reduction
the impact of a capital gains tax cut with an across-the-board tax relief.
tax cut of
Cuts in the capital gains tax rate may since the tax bite will be smaller on But, as indicated above, the empirical the impact of cutting capital most capital
reduce the cost of capital required by firms shareholders, the appreciation in firm value that results from investment.
gains income accrues to relatively wealthy individuals, to change much as the result of marginally
it has little direct influence on the cost of capital, may stimulate consumer firms sales, thus improving of influence the investment climate through the accelerator empirically
Similar arguments
can be made about the impact of government deficit spending hurts investment
But, again,
Deficit spending also stimulates demand and sales, however, Therefore, and by
through the accelerator effect, which is strong empirically. program designed private investment, to improve
it is not clear that a public capital accumulation national infrastructure, for example, will crowd-out
education
even if it is financed
14
an increase in the deficit. Through the accelerator effect, such a policy may lead to rn~~e private investment.7 cost-of-capital examined These observations suggest the need to evaluate the empirical strength of the an issue
of investment,
would qualify this discussion in an important though empirically strong, are widely operates
viewed
circumstances
effects, although
in neoclassical
theory, and they affect the desired stock of capital even at full that policies designed channel. to insure the long-run health
of the economy
the cost-of-capital
There are several important Presently, resources standards substantial, the economy
reasons, however,
continues
to suffer in an extended period during which capital and labor The sacrifice imposed more important, by the slack economy sense of well-being, on material has been
the national
objective of investment
policy over the short to medium horizon must productivity, and increasing incomes.
be to invigorate
the economy
There is little doubt that the accelerator in this area. More specifically,
the economys interest may be much better served by a tax policy over a three- to five-year horizon (the typical
15
operative period for the accelerator) than a policy that may have a more persistent effect, but one that is weaker and less certain (through the cost of capital).
The argument for greater emphasis on the accelerator may go even deeper because it is not clear that its effects are necessarily accelerator a full is temporary short term. The view that the investment that the economy of its own natural stimulus through converge mechanisms. are assumed the to
employment
equilibrium
Furthermore,
forthcoming
to be largely independent
reasons to question both of these critical assumptions. The natural stabilizing forces in the economy that are usually assumed to restore full employment can be quite weak, and they may be dwarfed investment economy stimulus toward through the accelerator when by destabilizing channels.8 If this is the case, effect by pushing to stagnate. the If
full employment
it otherwise stabilization
policymakers
on the weak
stabilizing forces of the market alone to overcome may not occur at all. Indeed, this perspective
pace of economic recovery in the United States. During the recession (and even thereafter), many forecasters discouraged deficit. After a prolonged advisers still sticking the use of a fiscal stimulus to fight slow-growth period of disappointing economic performance, problems because of the the group of economic
16
In addition, own,
equilibrium
on its
the short-run
may impact
of its long-run
equilibrium.
Such effects
arise because
short-run performance
affects the extent of technical of labor. As Frank entailed by unique weak, short-run
Hahn recently wrote, We do not have to settle for the historical determinism steady state growth rates (1990, p. 35). Furthermore, investment permanently. investment unchanging, problems of a domestic in an open economy,
industry vis-a-vis its foreign competitors discount the importance assumption of which
of short-term
steady
suffered
by the economy.
macroeconomic
consequences.
on the link between financial markets and investment foundations of investment policy debates.
the economic
research on investment
a cost of capital based on market interest rates). New theoretical and empirical research, however, has made important advances in studying what are often called finance constraints. of traditional determinants The idea such as
17
interest
not universal)
support
among
Suppose a firm does not have sufficient internal cash to undertake a desirable investment It must then seek funds from external sources: finance, however, either new borrowing
project.
possible that some firms will not have access to any external funds.
Undoubtedly,
costs associated with external finance because of firms need that must cover their own costs and make a profit on the (see the papers cited by Fazzari, project that would be or not
suggest these costs can be quite substantial 1988, pp. 148-154). Therefore,
and Petersen,
an investment
on investment
Many of the problems center on different (asymmetric) lenders meaning that can lead to many nontraditional
available to borrowers
that interest rates do not equate the supply and demand for loans, leaving some firms their investment. Furthermore, the ability of a firm to undertake fundamentals of the project under
project may depend not only on the economic but also on the firms financial condition.
18
the project.
This research
program
new empirical
work examining
of In
support the idea that the financial condition the link between investment
sectors of
The evidence
that such firms face the most severe information in enhancing U.S. growth and
Finance
constraints
channel
through
which
accelerator
effects
operate. in
Fluctuations accordance
of internal finance are driven by fluctuations with the business cycle. Therefore, recessions
effect
on investment
financial problems that often arise in recessions also probably raise the cost and limit the amount of external credit that firms can obtain. The recent credit squeeze is a case in point.12 These observations imply again that the impact of fiscal policy on the course of the business cycle may than effects that work through the
19
interact with the business cycle in another more subtle way. Profit Firms can if
(or cash flow more broadly) is not the only source of internal finance for investment.
also finance capital spending by reducing the amount of other assets they hold. For example, firms face a downturn to new borrowing in cash flow but want to maintain investment spending
or stock issues, they can sell off (or simply not replace) inventories,
their cash holdings, or tighten their policies on collecting accounts receivable. The funds released by these reductions spending. l4 in liquid assets can be used to temporarily smooth a firms investment
The extent to which this kind of behavior can occur depends on the liquidity of firms. Firms ability to cushion investment liquid assets or are more against downturns heavily indebted in cash flow will be impaired if they hold fewer going into the recession. Again, this point is had
particularly
stocks and much higher debt than in recent history. This low liquidity may have of investment in the recent slow growth and recession period. The
the shortfall
metamorphosis fluctuations
of financial circumstances,
of macroeconomic
for investment,
and it correspondingly
20
IV. Empirical
Evidence
on the Determinants
of Investment
The theoretical
analysis
summarized
in the previous
section identifies
a number
of channels
Many of the papers cited above provide empirical and thus to and
that can be used to sort through the relative size of the various channels, basis for policy proposals. or contradictory. But this evidence
provide a quantitative
tends to be fragmented
Moreover,
even
though
the
analysis
of
investment
determinants
is
fundamentally
microeconomic
studies
approach precludes any evidence to support the view that heterogeneity for policy purposes. While some studies do analyze firm-level to support strong conclusions
for macroeconomic
reasons,
this section
presents
new empirical
evidence
on the determinants
of
in the approach taken here is in the data analyzed. The data files of the Standard and Poors COMPUSTAT firms from 1971 to 1990
21
Over this period, the total capital spending by these firms accounts these data capture a large part is, to the authors data. More will
for 42 percent of total U.S. fixed capital investment.15 Therefore, of the economy. knowledge, The extent of macrocoverage provided
by this sample
with firm-level
To measure investment
the sensitivity
of investment
to the major
determinants
discussed
previously,
the
flow, and the percentage by the accelerator constraints: investment When spending
change of the cost of capital. The sales growth variables are suggested the importance control of finance over their
theory. 16The effect of internal cash flow represents firms have higher
because they depend less on external funds (new debt or stock issues) that costly, or even impossible includes interest to obtain. l7 The percentage change in the financial the conventional
which
reflects
on investment.
The regression equations presented here are called reduced forms in the research literature. That is, they simply relate the dependent variable, firm investment in this case, to various determinants
suggested by theory without imposing any particular structure on the empirical relationship.*This approach has been criticized the empirical parameters for purposes of policy analysis because new policies may change from data generated under the old policies (this problem is
estimated
these
22
their significance
B. Firm Heterogeneity
of various determinants
of investment
will likely
differ across firms, I have divided the sample into groups based on each firms average real sales growth. This is only one of a number of interesting for the purposes across firms sample splits, but it is particularly appropriate
of this research. The interest is in the effects of fiscal policies on investment potential to contribute to the long-run growth of productivity,
with different
employment, Fast-growing
and international
competitiveness.
Sales growth
captures
at producing
These firms are most likely to be hiring new workers in the greatest numbers, and they are also most likely to develop and adopt new technologies.
The sample is split into four groups. The details of the sales-growth Appendix A. Inflation-adjusted sales of the negative-growth
classification
are given in
firms contracted,
percent or more over the sample period. Table 1 shows that these firms accounted percent of the observations, zero-growth proportion but under 4 percent of the total investment. negative 1 percent and positive
2 percent.
23
moderate-growth
class. These firms had real sales growth rates that averaged between 2 and 7 firms, with average growth rates above 7 percent were expanding very
24
Growth Class
Variable
Negative ClaSS
Zero Class
Moderate ClaSS
High Class
Range of Average Sales Growth Included Relow -1% -1% to +2% +2% to +7% Above +7%
Average
Average
Sales Growth
- 5.4%
+ 1.1%
+ 5.6%
+ 15.9%
High-Tech
Percentage
36.3%
40.8%
45.5%
64.8%
Average
Price Growth
Average Growth
Investment
Capital Ratio
Source:
Authors calculations
from COMPUSTAT
manufacturing
firm database.
See Appendix
25
more quickly, they are more concentrated classes provided much more employment spending
divided by the capital stock) was much higher. The stock market value of firms in the highest growth class rose more quickly than for the other firms. Finally, research and development
spending was much higher for the faster-growing moderate-growth firms and especially
classes. Together these statistics show that the firms represent the most progressive
the high-growth
competitiveness.
C. Regression
Results
discussion
of the specification
and standard
errors is
in Appendix B .]
A. For summary
regressions,
see Table 3 in
The impact of changing capital costs, which include interest rates, however, is much less certain. The evidence slow-growth undertake suggests that higher real rates cause investment firms. The estimated effects for the moderateto fall only for the negativeand fast-growth classes, and
which
over three-quarters
of the investment
26
The results did not change materially. that predicted the largest negative
One possible reason that I fail to find negative effects of changing firms is that the regressions corporate use rates determined in centralized
bond yield adjusted for inflation and corporate taxes, for the results in Table 3). The firms face may well vary substantially from such centralized important rates.
While this point is of interest for economic purposes. If policy affects investment rates set by the centralized firm-specific crowds-out borrowing a substantial
for policy
through interest rates, it certainly works through the interest rates may then, in turn, drive raises real interest rates and
rates).
of growing investment.
Furthermore,
it is unlikely that the firms that are not included in the sample will be more affected and contains much
by aggregate variables than the sample firms. While the sample is extensive heterogeneity, the U.S. firms not included in the sample are certainly
if any policy-induced
27
Let us put these results into a more relevant perspective. impact of the recently passed .Budget Reconciliation
How might they be used to evaluate the Act of 1993? Many private forecasters growth over deficit is points growth
lower over the next five years. Suppose that each percentage point reduction in economic reduces cash flow by a conservatively investment small 1.5 percentage
points.22 These factors will reduce impact of these changes of Table 3 for each of investment
through the strong channels discussed above. The predicted ratio are given in the first two columns
in the determinants
The depressing
28
Table 2 Estimated Change in Investment (Cumulative Due to Budget Reconciliation Results: 1994-1998) Act of 1993
Percentage Investment-Capital
Growth Class
Sales Growth
Cash Flow
Interest Rate
Net Effect
Percent of Investment
Negative
-0.28
-0.09
+0.34
-0.03
-0.26%
Zero
-0.32
-0.30
+0.34
-0.28
-1.83%
Moderate
-0.50
-0.53
+0.34
-0.69
-3.52%
High
-0.54
-1.19
+0.34
-1.39
-4.36%
Source:
Authors calculations A.
from a simulation
described
investment
model presented
in Appendix
What effects of deficit reduction offset the drag on investment resulting from a weaker economy? The conventional wisdom is that lower interest rates will boost capital spending, helping to justify the sacrifices necessary to achieve deficit reduction. Indeed, as it became likely that Bill Clinton would win the election in the fall of 1992, long-term interest rates began to fall. This trend continued through the ultimate passage of the deficit reduction bill. As of August 12, 1993 (after President Clinton signed the bill), the yields on long-term corporate bond rates had fallen an average of 1.13 percentage points from their peaks during the previous year.23
Although long-term interest rates should largely adjust to account for the impact of deficit reduction as the policy is announced and enacted, to be conservative I assumed that long rates
29
will continue
is implemented
over
also to be conservative,
class even though the estimated model implies that these effects for growing firms were actually weaker (or went the wrong direction) effect assumed reduction in the data. This assumption implies that the interest rate to the view that deficit
of all my estimates
The cumulative
for 1994
through 1998, appears in the third column of Table 2. For the negative-growth to investment and reduced due to lower interest rates almost offsets the depressing sales growth.
majority of investment
through weaker
are only illustrative. Predicting the impact of deficit reduction on sales growth, rates is a very complicated problem. Changes in the economic relative to the above).
and interest
environment
between investment
period from which the data were drawn (as suggested There may also be complex in the macroeconomic paper. Nevertheless, feedbacks
between investment,
system. A complete
30
of an interest rate-driven
boom in capital spending over the next several years is a risky gamble. of the implications of these results for fiscal policy
The research
summarized
and
States. In
contrast, the impact of changes in the cost of capital, including is decidedly weaker, especially for fast-growing
firms. What can we learn from these results that three broad lessons: that
will help guide government (1) the importance reduced especially investment
government
extent,
that will be effective through channels other than lowering the cost of capital.
will be also on
strong when firms perceive growing markets for their goods. A strong aggregate economy supports profits and improves firms ability to tinance evidence summarized capital spending without relying
evidence
about
on investment.
stagnates because
31
the Federal Reserve squeezes the economy in its zeal to reach zero inflation or because Congress and the president cut spending and increase taxes in ways that lower sales and profit growth, one of the costs will be lower investment.
Moreover,
temporary.
Capital, by its nature, is durable and takes induced by macroeconomic stagnation may
of investment
keep the capital stock below its long-run affected if economic weakness
trend for many years, and the trend itself may be innovation.
A realistic
assessment
of the determinants
of investment
changes the terms of what has become the dominant huge and persistent chief problem investment, Government spending.
concern in post-Reagan
federal budget deficit. In the minds of many analysts and policymakers, is that government consequences interest borrowing crowds-out private
capital
negative
raises market
discouraging
An often-cited
rationale for deficit reduction, therefore, is that lowering the deficit will borrowing, thus lowering interest rates and the cost
of capital. Most parties in the debate USSWTE that such an interest rate decline will spur corporate investment and stimulate economic growth.
to changing interest rates is weak (as my results clearly that lower interest rates will cause an
32
investment
support, especially
for growing firms. But the deficit will deficit reduction involves
not decline in a vacuum. As is becoming more apparent in Washington, pain. If taxes rise, someones depressed. spending Furthermore, disposable income
will be lower, and firms sales and profits through government in some firms taxes or lower
sales or someones
spending, depresses sales growth and firm cash flow. The evidence shows that such changes will likely have a negative impact on investment.25
from lower deficits and lower interest rates is highly But the threats of deficit reduction for
especially
in an economy
and growing
Consequently,
his second debate with George Bush and Ross Perot) appeared to have a better perspective
the benefits and costs associated with deficit reduction than President Bill Clinton (whose policy proposals especially have obviously by an effective been tempered filibuster by the political constraints imposed by Congress, argued that the are virtues to
The candidate
a lower deficit over some horizon, the first step should be to pursue policies to restore healthy
33
economic
performance,
the deficit
could be tackled.26
This analysis strongly suggests that concerns about investment, to fully utilize its labor and capital resources, that have important
especially
in an economy
failing
social value but that may also increase the deficit. Such policies infrastructure and to invigorate education.
As Eisner (1992) argues, of private capital in about the costs of the capital
and education
the long run, which can only be good for private investment. and benefits of deficit reduction various spending. empirical channels
Policy discussions
need to be better informed about the relative importance which the governments budget impacts private
through
A third lesson from the results presented here is that certain kinds of policy initiatives designed to lower the cost of capital, especially unreliable implies way to promote substantially investment. those that exclusively focus on increasing saving, are an
Again, it is often taken for granted that more saving Theoretically, this link occurs because higher saving
more investment.
the cost of capital. A large effect of saving on investment, sensitivity of investment to the cost of capital, which is not saving initiatives could well
strongly supported by the data. Indeed, in weak economic conditions, do more harm than good. More saving implies less consumption with lower sales growth and profits following.
34
paradoxically,
reduce investment,
especially
has successfully
engineered
wealthy
is increasingly
There is concern
that higher taxes on the class of agents that do the most saving will lower But since this process must work through the cost-of-capital weak, the results presented here suggest little need for effects on the level of
investment.
In addition,
the widespread
rely on the
view that lower taxes on the returns from capital will lower the price that savers require to make their funds administration Democrats. overhaul available to investing firms.28 While this idea was marshalled by the Bush
and Republican
members
In fact, a (relatively weak) capital gains tax break remains part of President Clintons 5). But according to the results presented here, even a
spectacularly
that lowered the real cost of capital by one small effect on investment for stagnant and
points-would
firms. For the growing firms in the economy, there is no clear evidence that the lower
35
track, because
uncertainty
strength
of the
of investment,
gains tax rate do not qualify as a robust policy. They will only be effective sensitive private
to the cost of capital. More broadly, any attempt to increase investment or public saving will not be a robust channel. policy because however,
by raising on the
it relies exclusively
questionable
cost-of-capital
Consider policies,
These policies would reduce the cost of capital. But they also will increase cash flow and relax financial constraints.30 This effect could well be more important cost of capital, especially constraints of research question in new high-technology for investment than the lower
1988a). Similar arguments can be made in favor and Petersen, 1994). The fundamental support for their
effectiveness
distributional
cost of capital, when we have the means to boost investment through a number of different channels?
with policies
Economic
ideas matter for policy. But the particular ideas that dominate
those with the strongest empirical support. The view that interest
36
rates and cost of capital constitute private investment policy positions is, unfortunately,
of
an example of a dominant
current here. I
of the macroeconomy
a shift of emphasis offers the best chance in the short run to restore healthy capital growth to the U.S. economy, with corresponding benefits for output, employment, productivity, and wages.
37
Appendix
Econometric
Study
Dejinition of Sales-Growth Classes To limit the effect of extreme observations in the classification of firms, annual real sales growth
sales growth data were then averaged for each firm. Firms were put into the negative-growth class if their average was less than negative from negative high-growth 1 percent to positive 1 percent. The zero-growth Moderate class includes averages and
2 percent.
Data Definitions Investment (I) is capital spending on plant and equipment from the firms sources and uses of
funds statements.
Sales (S) is total revenue from operations less discounts or returns. Cash flow and amortization expense, extraordinary items, and were
deferred taxes. The sales data were deflated by the GNP deflator. Cash flow and investment deflated by the implicit deflator for nonresidential fixed investment.
stock
(K) calculations
used estimates
and economic
to calculate
a replacement
in Fazzari, Hubbard,
and Petersen
38
acquisitions calculation
and divestitures
reported
yields on
corporate bonds carrying Baa ratings taken from the 199 1 Economic Report of the President. The percentage change in the real financial cost of capital (PCR), adjusted for expected inflation and of nominal interest on corporate tax returns is taken from Chirinko and Fazzari tests were conducted using one-year Treasury bill rates (real and nominal).
the deductibility
(1993). Additional
The results for these alternative variables indicated weaker cost of capital effects than those for the real Baa rates, and there was virtually no effect of using the alternative changes in the
financial cost of capital variables on the other results reported in the text.
put into the initial sample. The version of COMPUSTAT information from 1971 through 1990. The 1971 through
used to construct
Some observations
The regressions
in the sample exclude outliers of the ratios used in the regressions to capital (ILK) exceeding
defined as follows:
investment
2.0; real sales growth (SG) less than -75 percent or greater than 200
percent in a given year; cash flow to capital (CF/K) less than -2.5 or greater than 2.5. These limitations reduced the sample by just over 5 percent. The regression results were much more
39
the outliers, especially for sales growth. The cash flow and cost of capital in similar ways in the full sample and limited samples. Tighter sample limits did not change the results materially.
Regression Specification and Estimation The estimated regression equations had the form:
(I/K)j, = aj + (a,,) SGj, + (a,,) SGj,1 + (a,,) SGjt-2 + (a& (CFK)j, + (a& (CFK)j,, + (a& PCRtel + (a& PCR,, + (a,,) (CFK)jt-,
where the variables are defined as above. The a symbols represent estimated j subscript indicates different
coefficients.
The
firms; t indexes time periods. The ratios used for I/K and CF/K equivalent to SG and PCR. This kind of specification also were
make these variables dimensionally controls for the heteroscedasticity run using the level of investment
that would be substantial in firm data if the regression rather than the investment-capital used captures
term was allowed to vary across firms, the estimator within fixed-effects sum of the coefficients
estimator for panel data). The regression results reported in the text are the on the contemporaneous and two annual lags for each variable except
value of PCR was dropped from the regression because simultaneity of this coefficient. effect on investment When the contemporaneous in all the regressions. PCR variable Thus, excluding
40
PCR makes the cost of capital effect more negative, increasing cost-of-capital effect.
the strength of
in alternative
regressions.
The
longer lags did increase the sums of the SG and CF/K variables. Longer lags of PCR, however, made their sums less negative. Therefore, basing the analysis on the shorter lag specification effect. Including a lagged dependent is not an important variable also problem.
increases the relative size of the cost-of-capital had little effect on the results, suggesting
41
Regression Results Complete regression results for the specification that the coefficient analyzed in the text follow. The estimated on each variable is zero are in parentheses t
SGjt
0.069 (10.0)
SG
jt-I
0.052 (7.6)
SG
jt-2
0.024 (3.5)
CFK
jt
0.044 (9.2)
CFK
jt_1
0.060 (12.6)
CFK
jt.2
0.045 (10.4)
PCR
t_l
-0.032 (2.1)
PCR
t_2
-0.00 1 (0.1)
43
Appendix
effects) are very strong. Also the cash are quite important. Both the sales
growth and cash flow effects are much stronger for the faster-growing shall discuss in more detail in a moment. One can overwhelmingly
these effects are in fact zero, with the positive estimated effect due simply to random variation. These results leave no doubt about the importance of investment. of sales growth and cash flow as determinants
Table 3 Summary
of the Estimated
Determinants
on the
Investment-to-Capital By Sales-Growth
Cash Flow
Negative
0.145
0.149
- 0.033
Zero
0.159
0.185
- 0.023
Moderate
0.247
0.232
+0.05 1
High
0.267
0.300
+o. 137
Source:
Authors calculations
manufacturing
variables.
44
Endnotes
1.
tax changes
to stimulate
For example,
tax with steeply increasing tax rates as consumption of federal taxes for many individuals.
that have been put on the table to increase saving, the capital gains tax cut in particular, provide greater benefits to individuals with higher incomes.
2.
net investment,
which excludes depreciation, capital. But the statistical Recent net investment
3.
This assumption
especially
if the economy
is
I assume here that deficits do increase real interest rates If deficits do not increase
and then I estimate the effect of this increase on investment. real interest rates substantially, the policy discussion
the analysis presented here still applies, but the focus of different.
will be somewhat
4.
the personal
tax exclusion
for capital
gains
capital gains income still enjoys a substantial tax advantage because assets until they sell these
assets, and heirs pay no capital gains taxes on assets held until death. The size of this benefit rises the longer one holds an appreciating discussion. As mentioned previously, asset. See Auerbach (1992) for further
5.
the treatment
in Jorgenson
A less technical
and a discussion
6.
More recently,
much empirical
work on investment
has focused
on the estimation
of This
Euler equations derived from explicit dynamic models of firm value maximization. work is not particularly relevant for the discussion here since the structure
of Euler
equations usually imposes an important role for the cost of capital rather than testing this impact. Furthermore, rejected empirically. the assumptions that underlie the Euler equation approach are often
7.
Further stimulus
to private investment
from infrastructure
spending
of private capital. For example, better water and sewer of manufacturing plants. Robert Eisner (1992)
46
8.
stabilizing
The relevant
references
are too
to include here. See Caskey and Fazzari (1987) and Tobin (1993) for more
9.
advantages;
its
10.
Although mainstream,
the resurgence
of interest
it is prominent
Keynes (1936). Also see Meyer and Kuh (1957) and Minsky (1975). For a more extensive discussion of the ideas and results presented here, and for additional references, see
11.
point change
growth. See Carpenter, Fazzari, and Petersen (1993) for further discussion.
47
12.
and Lown
analysis
of the credit
squeeze
and
13.
Gertler and Hubbard (1988) find support for the view that financial conditions investment more tightly in recessions.
constrain
14.
in Fazzari and
(1993). Also see the analysis in Carpenter, Fazzari, and Petersen (1993).
15.
Because of changes in the number of firms tracked over time, the proportion fixed investment
of aggregate
covered by the sample changes. It peaks at 49.2 percent in 1981, and the
16.
Most accelerator
in
sales. At the firm level, however, this relation depends on the firms capital-output This ratio can differ substantially across firms. Under the assumption that
ratio. the
capital-output
ratio is constant for a particular firm, but not the same across firms, the the investment-capital ratio and sales growth captures the accelerator
17.
See Fazzari, Hubbard, and Petersen (1988b) and Fazzari and Petersen (1993) for extensive discussion of how to interpret the cash flow-investment link. In particular, these papers
48
18.
One must assume a functional form for the regression equation. It is usually linear, which can be viewed as a general approximation to more complicated functions.
19.
approach
to address
employs
economic
theory
to derive
of parameters such
specifications
are beyond the scope of this paper. Briefly, issues (the importance of financial it would be of the Lucas
of important
across different
in all respects.
Moreover,
to overcome
work on investment.
20.
I considered industrial
an observation
in a high-technology
classification
(SIC) two-digit
or 38 (instruments).
and Petersen
(1994) for a
of these industries
49
21.
See, for example, the article Economists Street Journal, economists August
Wall The
in real economic
growth of 0.25
to 1.00 percentage
22.
Carpenter,
Fazzari, and Petersen (1993) report that cash flow is four to five times more of variation).
23.
Lynch
Bond
Indexes,
averaging
across
and quality. The data were taken from page Cl6 of the Wall Street Journal,
24.
These effects refer only to business fixed capital investment. stimulus to residential investment
resulting from lower interest rates. Also, the simulated that lower interest rates might help investment this effect would require additional
effects do not account for the possibility indirectly equations by increasing that are beyond
offset reduced cash flow, the simulated net impact on would remain negative for the moderatein the sample. and
25.
deficits
of the
50
economic
26.
It should be noted that the Clinton administration, in the campaign, reduction, did pursue an economic
consistent
stance
stimulus
package
of deficit
albeit a small one. This measure was killed in the Congress, however. Two of concerns about the deficit to pay interest are the regressive on the national distributional effect of
reduced deficits do lower interest rates, deficit reduction could reduce the exchange value of the dollar and bolster exports and international competitiveness.
27.
If personal investment
and hurt
through the strong sales growth and cash flow channels. It is likely, however, effects of lower tax
that by targeting tax increases more toward the wealthy, the depressing consumption increase.
28.
that the capital gains tax rate operates venture capital. A detailed analysis
through
an
of this idea is
beyond the scope of this paper. I note, however, that venture capital accounts for a very small proportion of investment finance in the U.S. Moreover, the benefits from an overall to the owners of assets that do not
51
29.
Another investment
argument
often made for cutting capital gains taxes is that the allocation by lowering what is often called the lock-in
of
will be improved
effect.
Because capital gains are taxed only when assets are sold, the capital gains tax creates an incentive discusses, to hold on to assets longer than might be optimal. this problem But as Auerbach (1992)
could be solved by taxing capital gains at the time they are increasing the capital for lower capital
accrued rather than when they are realized by asset sales (effectively
gains tax rate). The lock-in effect alone is not an effective justification gains tax rates.
30.
William Vickrey (1992, p, 307) favors cutting or eliminating to capital gains initiatives formally is to recognize
corporate
because lower
taxes increase cash flow, rather than because lower taxes reduce the cost of capital, the average tax burden on firms is what matters. This point is made by Fazzari, Hubbard, and Petersen (1988a). Petersen (1991) provides empirical evidence that the cash flow impact of tax cuts is indeed important for investment. for a balanced discussion investment tax credit. about the marginal See Meyer, Prakken, and Varvares (1993) and average effects of an increase in the
52
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