Assumption About Global Capital Markets Explains the Differences Between the JCT’s and the Tax Foundation’s Estimates of Bonus Expensing

November 12, 2015

Update: The private investment offset of $0.33 per dollar of added government debt reported in this blog is the offset used by CBO. It is likely that the actually offset calculated by JCT is larger than $0.33 per dollar of added government debt, given the strong effect of crowding out from deficit spending reported by the authors, but we cannot be certain without a reported offset. Moreover, since the CBO has such a high exogenous offset, a model resulting in a high offset at the JCT would unlikely receive much scrutiny.

The private investment offset in JCT's MEG model is endogenous, and the resulting value is not reported in the paper. Unfortunately, there is no means of checking JCT's results or the quality of their work without speculating on the magnitude of the offset from a verbal description of their results.

Both the Joint Committee on Taxation (JCT) and the Tax Foundation have scored the budgetary and economic effects of bill H.R. 2510, which would “modify and make permanent bonus depreciation.” In practice, this bill allows businesses to immediately expense half of their equipment purchases, while the remainder of the cost is written off according to a tax depreciations schedule. Both the JCT and the Tax Foundation found the bill would increase economic activity and federal tax revenues over the 10 year budget window, but the Tax Foundation found more robust growth from the provision.

The difference between the two budget scores stems from differences in the structure of the JCT’s Macro-Economic Growth (MEG) model and the Tax Foundation’s Taxes and Growth (TAG) model. The TAG model estimated that permanently implementing bonus expensing would lead to higher average output of 0.55 percent, while the MEG model estimated a gain of only 0.2 percent over the budget window. These differences stem largely from differences in capital investment. The TAG model estimated a 3.3 percent larger capital stock while the MEG model estimated only a 1.2 percent increase.

In the final sentence of the overview in the JCT report, the authors noted that “in the longer run, increasing Federal debts is expected to reduce the investment incentives provided by the proposal.” This statement suggests that the authors attribute the lackluster economic growth and capital accumulation to the crowding-out effect of deficit spending."

Indeed, accelerating tax-depreciation schedules often have temporarily high revenue losses due to the overlap of old and new tax depreciation schedules. The temporary increase in deductions should only persist for 3-5 years, since most equipment has relatively short depreciation schedules. Once all the equipment purchased under the old schedule is completely depreciated, the tax revenues should rebound.

The temporary loss of tax revenue requires the federal government to increase deficit spending during the transition period. If government borrowing intensively competes for investment with the private markets, then the deficit could temporarily increase interest rates and raise the cost of private investment, which would slow – but not permanently prevent – the expansion of the equipment stock. If this reaction were extreme, the higher interest rate effect could outweigh the benefits from the accelerated depreciation of equipment.

Since most of the revenue losses occur immediately after the change in the tax depreciation schedule, some analysts worry that the crowding out of private investment by deficit spend could kill the possible economic growth before it begins. This creates a type of transitional gains trap, but the trap is predicated on how much the deficit crowds out private investment.

There are several sources of savings to fund a capital expansion. Most capital investment comes from retained earnings of a business. Retained earnings are income that is not paid to the investors but instead, reinvested in the business. When taxes on business income decrease, the amount of available retained earnings increases, which can be used to fund the capital expansion.

The issue then becomes the extent to which other sources of savings, such as household savings, would have been invested in the business sectors if the new government debt had not been issued. This is referred to as the offset of private savings by government debt.

CBO assumes that for each dollar of government debt issued, $0.33 comes from savings that would have been used for private investments. In a Congressional Budget Office (CBO) paper on the long-run effects of federal debt, the authors survey the academic literature to support this assumption. The survey found private-saving offsets as low as $0.34 and as high as $0.97 per dollar of debt in the long run. Most of the studies estimate the offsets from the OECD panel data and do not consider international capital flows.

Feyrer and Shambaugh (2009) used U.S. and aggregate “rest of world” data from the 1973 to 2005 and found that “tax cuts in one country will lower the pool of savings available for investment around the globe.” This suggests that the reduction in private savings available for investment due to government debt, particularly U.S. debt, is borne by the entire world, not just by the domestic economy.

Chinn et al. (2011) argues that deficit spending leads to a change in capital flows as well as an increase in private savings. Using current-accounts panel data from 1970-2008, the study suggest that a dollar of deficit spending in industrialized countries increases private savings by $0.52 and increases investment from abroad by $0.29. The remainder, $0.19, is assumed to offset private investment.

Chinn et al. estimates of foreign capital inflows captures the general findings of Feyrer and Shambaugh (2009). That is, the U.S. is an open economy with fluid capital markets. When the U.S. government deficit spends, it does not rely on domestic savings to cover the debt but the savings of the entire world.

U.S. treasuries are extremely attractive to foreign investors looking for a low risk investment. According to the U.S. Treasury, overseas investors hold $6.1 trillion dollars of the federal debt or about two thirds of all notes and bonds not held by the Federal Reserve or government entities. Of these overseas investors, China only holds $1.27 trillion, the largest holder, followed by Japan with $1.2 trillion.

If we exclude Japan and China, the rest of the world holds $3.57 trillion dollars of debt. This group has increased its holdings of U.S. treasuries by 1.7 percent over the last year, despite some of the lowest long-term interest rates in history. This suggest that a small increase in the interest rate, although costly to the U.S. government, would increase foreign investment considerably. As such, the estimates of Chinn et al. of how much the deficit offsets private investment are far more likely than the JCT’s estimates in today’s economy.

It should also be noted that these studies, which look into the reallocation of existing levels of savings from one country to another, tend to neglect the response of global saving to higher returns. Insofar as people increase their saving as a result of the higher yields, there is an additional source of funding for the deficit.

The deficit’s impact on private investment should continue the fall as the U.S. GDP becomes a smaller portion of the global economy. The United States is considered a large open economy, which suggests that changes in interest rates or the cost of capital have an effect on prices in the rest of the world. This was likely the case after World War II when the United States made up almost a third of the free world’s economy. Since the 1980s, the Eastern Bloc and China have become more integrated into the world economy, and the U.S. GDP has been on a steady march downward from a quarter of the world’s economy to less than 18 percent today. This trend is likely to continue as the developing world continues to make headway.

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As such, the United States should become more like a small open economy over time. Small open economies have little effect on world prices and interest rates because small economies are too small to change the momentum of the overall world markets. Small open economies can borrow relatively large amounts by offering risk-adjusted interest rates slightly above international rates. In other words, deficits in small open economies have little bearing on the cost of funds available for private investment.

The end result is that reasonable amounts of U.S. deficit spending are unlikely to have a significant effect on the availability of private investment for capital accumulation, and the JCT’s measurement of private-investment offsets due to deficit spending is likely exaggerated.

The choking-off of investment due to the deficit spending through the transition period to permanent bonus expensing is also unlikely to occur. As such, the Tax Foundation estimate of growth is more likely to be the actual growth experienced after permanently implementing bonus expensing.

World markets are more than willing to invest in U.S. debt, as long as the markets believe that the U.S. is a riskless investment. If faith in the U.S. economy erodes, world investment will dwindle, both for U.S. treasuries and capital investment. Developing a strategy for long-run growth is an essential part of maintaining that faith. The true peril to capital investment is not the U.S. deficits but excessive taxation of capital income and the resulting sluggish economic growth.


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